UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the period ended September 30, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ ------
Commission File Number 001-31792
Conseco, Inc.
Delaware 75-3108137
---------------------- -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
- -------------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act): Yes [X] No [ ]
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 November 1, 2004: 151,126,610
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
Successor
---------------------------------
September 30, December 31,
2004 2003
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
September 30, 2004 - $20,745.9; December 31, 2003 - $19,470.7)....................... $21,306.3 $19,840.1
Equity securities at fair value (cost: September 30, 2004 - $62.5;
December 31, 2003 - $71.8)........................................................... 67.6 74.5
Mortgage loans......................................................................... 1,089.4 1,139.5
Policy loans........................................................................... 465.9 503.4
Trading securities..................................................................... 908.9 915.1
Other invested assets ................................................................. 133.2 324.1
--------- ---------
Total investments.................................................................. 23,971.3 22,796.7
Cash and cash equivalents:
Unrestricted........................................................................... 1,078.0 1,228.7
Restricted............................................................................. 18.9 31.9
Accrued investment income................................................................. 318.1 315.5
Value of policies in force at the Effective Date.......................................... 2,706.9 2,949.5
Cost of policies produced................................................................. 327.7 101.8
Reinsurance receivables................................................................... 967.6 983.9
Income tax assets......................................................................... 12.2 24.6
Goodwill.................................................................................. 785.3 952.2
Other intangible assets................................................................... 149.4 155.2
Assets held in separate accounts.......................................................... 31.9 37.7
Other assets.............................................................................. 558.9 395.8
--------- ---------
Total assets....................................................................... $30,926.2 $29,973.5
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
2
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
Successor
--------------------------------
September 30, December 31,
2004 2003
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products............................................................ $12,432.5 $12,480.4
Traditional products................................................................... 11,589.5 11,485.2
Claims payable and other policyholder funds............................................ 922.3 892.3
Liabilities related to separate accounts............................................... 31.9 37.7
Other liabilities........................................................................ 847.8 573.0
Investment borrowings.................................................................... 584.8 387.3
Notes payable - direct corporate obligations............................................. 788.6 1,300.0
--------- ---------
Total liabilities.................................................................. 27,197.4 27,155.9
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Preferred stock.......................................................................... 667.8 887.5
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: September 30, 2004 - 151,123,275; December 31, 2003 -
100,115,772)........................................................................... 1.5 1.0
Additional paid-in-capital............................................................... 2,535.8 1,641.9
Accumulated other comprehensive income................................................... 302.8 218.7
Retained earnings........................................................................ 220.9 68.5
--------- ---------
Total shareholders' equity......................................................... 3,728.8 2,817.6
--------- ---------
Total liabilities and shareholders' equity......................................... $30,926.2 $29,973.5
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Successor Predecessor
--------------------------------- --------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Insurance policy income.............................................. $ 737.8 $256.2 $ 516.8
Net investment income:
General account invested assets.................................... 329.7 106.0 232.5
Policyholder and reinsurer accounts................................ (9.8) (2.1) 11.7
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc...................................... - (2.7) 2.0
Net realized investment gains (losses)............................. 6.0 6.7 (35.9)
Fee revenue and other income......................................... 5.2 2.2 9.0
-------- ------ ---------
Total revenues................................................... 1,068.9 366.3 736.1
-------- ------ ---------
Benefits and expenses:
Insurance policy benefits............................................ 688.4 243.3 390.9
Provision for losses................................................. - - 24.5
Interest expense (contractual interest of $73.7 for the two
months ended August 31, 2003)...................................... 12.9 7.0 55.4
Amortization......................................................... 91.9 26.9 61.3
Other operating costs and expenses................................... 170.8 51.3 108.0
Reorganization items................................................. - - (2,163.0)
-------- ------- ---------
Total benefits and expenses...................................... 964.0 328.5 (1,522.9)
-------- ------ ---------
Income before income taxes....................................... 104.9 37.8 2,259.0
Income tax expense on period income..................................... 37.6 13.6 17.7
-------- ------ ---------
Net income....................................................... 67.3 24.2 2,241.3
Preferred stock dividends............................................... 9.4 5.3 -
-------- ------ ---------
Net income applicable to common stock............................ $ 57.9 $ 18.9 $ 2,241.3
======== ====== =========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor
---------------------------------
Three months One month
ended ended
September 30, September 30,
2004 2003
---- ----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 150,885,000 100,098,000
=========== ===========
Net income................................................. $.38 $.19
==== ====
Diluted:
Weighted average shares outstanding........................ 189,195,000 144,671,000
=========== ===========
Net income................................................. $.36 $.17
==== ====
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor Predecessor
-------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Insurance policy income............................................. $2,223.2 $256.2 $ 2,204.3
Net investment income:
General account invested assets................................... 960.1 106.0 928.4
Policyholder and reinsurer accounts............................... (8.9) (2.1) 30.1
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc..................................... - (2.7) 10.5
Net realized investment gains (losses)............................ 27.5 6.7 (5.4)
Fee revenue and other income........................................ 17.1 2.2 35.5
-------- ------ ---------
Total revenues.................................................. 3,219.0 366.3 3,203.4
-------- ------ ---------
Benefits and expenses:
Insurance policy benefits........................................... 2,074.6 243.3 2,136.4
Provision for losses................................................ - - 55.6
Interest expense (contractual interest of $268.5 for the eight months
ended August 31, 2003)............................................ 65.1 7.0 202.5
Amortization........................................................ 272.4 26.9 343.7
Gain on extinguishment of debt...................................... (2.8) - -
Other operating costs and expenses.................................. 485.6 51.3 423.5
Reorganization items................................................ - - (2,130.5)
-------- ------ ---------
Total benefits and expenses..................................... 2,894.9 328.5 1,031.2
-------- ------ ---------
Income before income taxes and discontinued operations.......... 324.1 37.8 2,172.2
Income tax expense (benefit) on period income.......................... 115.7 13.6 (13.5)
-------- ------ ---------
Income before discontinued operations........................... 208.4 24.2 2,185.7
Discontinued operations, net of income taxes........................... - - 16.0
-------- ------ ---------
Net income...................................................... 208.4 24.2 2,201.7
Preferred stock dividends.............................................. 56.0 5.3 -
-------- ------ ---------
Net income applicable to common stock........................... $ 152.4 $ 18.9 $ 2,201.7
======== ====== =========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor
---------------------------------
Nine months One month
ended ended
September 30, September 30,
2004 2003
---- ----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 126,016,000 100,098,000
=========== ===========
Net income................................................. $1.21 $.19
===== ====
Diluted:
Weighted average shares outstanding........................ 145,592,000 144,671,000
=========== ===========
Net income................................................. $1.15 $.17
===== ====
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital income (loss) (deficit)
----- ----- --------------- ------------- -------
Successor balance, January 1, 2004................... $ 2,817.6 $ 887.5 $ 1,642.9 $ 218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 208.4 - - - 208.4
Change in unrealized appreciation of
investments (net of applicable income tax
expense of $46.1)............................. 84.1 - - 84.1 -
---------
Total comprehensive income.................. 292.5
Issuance of shares for stock options and
for employee benefit plans.................... 12.2 - 12.2 - -
Issuance of mandatorily convertible
preferred stock, net.......................... 667.8 667.8 - - -
Redemption of cumulative convertible
exchangeable preferred stock.................. (928.9) (928.9) - - -
Issuance of common stock, net................... 882.2 - 882.2 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 41.4 41.4 - - -
Dividends on preferred stock.................... (56.0) - - - (56.0)
--------- ------- --------- ------- ---------
Successor balance, September 30, 2004................ $ 3,728.8 $ 667.8 $ 2,537.3 $ 302.8 $ 220.9
========= ======= ========= ======= =========
Predecessor balance, January 1, 2003................. $(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...................................... 24.2 - - - 24.2
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $154.4)............................ 273.2 - - 273.2 -
---------
Total comprehensive income.................. 297.4
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 5.3 5.3 - - -
Dividends on preferred stock.................... (5.3) - - - (5.3)
--------- ------- --------- ------- ---------
Successor balance, September 30, 2003................ $ 2,797.4 $ 865.0 $ 1,640.3 $ 273.2 $ 18.9
========= ======= ========= ======= =========
The accompanying notes are an integral part
of the consolidated financial statements.
8
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Successor Predecessor
---------------------------------- --------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Cash flows from operating activities:
Insurance policy income............................................ $ 1,931.7 $ 223.7 $ 1,876.2
Net investment income.............................................. 1,082.6 103.6 928.6
Fee revenue and other income....................................... 17.1 2.2 35.5
Insurance policy benefits.......................................... (1,523.4) (178.1) (1,461.2)
Interest expense................................................... (60.4) - -
Policy acquisition costs........................................... (267.1) (25.6) (287.5)
Reorganization items............................................... - - (26.5)
Other operating costs.............................................. (418.8) (73.6) (362.0)
Taxes.............................................................. 11.7 .3 44.2
---------- --------- ---------
Net cash provided by operating activities........................ 773.4 52.5 747.3
---------- --------- ---------
Cash flows from investing activities:
Sales of investments............................................... 9,947.7 2,121.9 5,378.9
Maturities and redemptions of investments.......................... 1,450.0 288.7 1,854.7
Purchases of investments........................................... (12,396.4) (1,225.6) (7,385.9)
Consolidation of partnership which held General Motors building.... - 28.4 -
Change in restricted cash.......................................... 13.0 (17.0) 26.2
Other.............................................................. (35.5) 4.3 (19.6)
---------- --------- ---------
Net cash provided (used) by investing activities ................ (1,021.2) 1,200.7 (145.7)
---------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net..................................... 790.2 - -
Issuance of preferred stock, net................................... 667.8 - -
Issuance of common stock, net...................................... 882.3 - -
Payments on notes payable.......................................... (1,302.0) - -
Redemption of preferred stock...................................... (928.9) - -
Amounts received for deposit products.............................. 1,203.3 121.8 1,272.7
Withdrawals from deposit products.................................. (1,399.7) (133.1) (1,784.2)
Investment borrowings.............................................. 197.5 (700.0) (145.3)
Dividends paid on preferred stock.................................. (9.8) - -
Other.............................................................. (3.6) - -
---------- --------- ---------
Net cash provided (used) by financing activities............... 97.1 (711.3) (656.8)
---------- --------- ---------
Net increase (decrease) in cash and cash equivalents........... (150.7) 541.9 (55.2)
Cash and cash equivalents, beginning of period........................ 1,228.7 1,162.4 1,217.6
---------- --------- ---------
Cash and cash equivalents, end of period.............................. $ 1,078.0 $ 1,704.3 $ 1,162.4
========== ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2003 Form 10-K of Conseco,
Inc.
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.
OUR RECENT EMERGENCE FROM BANKRUPTCY
We emerged from bankruptcy protection under the Sixth Amended Joint Plan of
Reorganization (the "Plan"), which was confirmed pursuant to an order of the
United States Bankruptcy Court for the Northern District of Illinois, Eastern
Division (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.
BASIS OF PRESENTATION
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.
Pursuant to SOP 90-7, professional fees associated with the Chapter 11
cases are expensed as incurred and reported as reorganization items. Interest
expense is 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.
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly our financial position and
results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2004 presentation. These reclassifications
have no effect on net income or shareholders' equity. Results for interim
periods are not necessarily indicative of the results that may be expected for a
full year.
The balance sheet at December 31, 2003, presented herein, has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect various
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions in calculating values for the cost of policies produced, the
cost of policies purchased,
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
the value of policies in force 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 amounts recoverable from loans to certain
former directors and employees. If our future experience differs from these
estimates and assumptions, our financial statements would be materially
affected.
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
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.
Under fresh start reporting, a new reporting entity is considered to be
created and the Company was 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 could not be attributed to specific
tangible or identified intangible assets as goodwill. In addition, all
accounting standards that were 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.
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):
Two months Eight months
ended ended
August 31, 2003 August 31, 2003
--------------- ---------------
Gain on discharge of prepetition liabilities......... $ 3,151.4 $ 3,151.4
Fresh start adjustments.............................. (950.0) (950.0)
Professional fees.................................... (38.4) (70.9)
--------- ---------
Total reorganization items....................... $ 2,163.0 $ 2,130.5
========= =========
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.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 $166.9 million and $189.4 million in the nine
months ended September 30, 2004 and the four months ended December 31, 2003,
respectively). 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
-----------
Nine months
ended
September 30,
2004
----
Goodwill balance, beginning of period.................................. $ 952.2
Recognition of tax valuation reserve established at the
Effective Date.................................................... (166.9)
-------
Goodwill balance, end of period........................................ $ 785.3
=======
ACCOUNTING FOR 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); (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. All of our trading securities totaled $908.9
million at September 30, 2004. The change in the market value of these
securities is recognized currently in investment income (classified as income
from policyholder and reinsurer accounts).
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Accumulated other comprehensive income is primarily comprised of unrealized
appreciation on actively managed fixed maturity investments. These amounts,
included in shareholders' equity as of September 30, 2004, and December 31,
2003, were as follows (dollars in millions):
Successor
------------------------------
September 30, December 31,
2004 2003
---- ----
Net unrealized appreciation on investments............................................ $ 568.1 $ 375.2
Adjustments to value of policies inforce at the Effective Date........................ (89.0) (33.5)
Adjustment to cost of policies produced............................................... (7.2) -
Deferred income tax liability......................................................... (169.1) (123.0)
------- -------
Accumulated other comprehensive income........................................... $ 302.8 $ 218.7
======= =======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
Prior to its sale in December 2003, our venture capital investment in AT&T
Wireless Services, Inc. ("AWE") was carried at fair value, with changes in such
value recognized as investment income (loss). We recognized venture capital
investment income (losses) of $(2.7) million in the one month ended September
30, 2003; $2.0 million in the two months ended August 31, 2003; and $10.5
million in the eight months ended August 31, 2003, related to this investment.
AMORTIZATION OF THE 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 value 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. 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. Our future
estimated gross profits used to determine the value of policies inforce at the
Effective Date and the amortization of these costs, reflect assumptions that
current expense levels that exceed product pricing, will decline over time. If
we are unable to achieve such cost savings, the profitability of the policies
inforce at the Effective Date will be adversely affected.
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 value of
policies inforce at the Effective Date for the change in amortization that would
have been recorded if actively managed fixed maturity securities had been sold
at their stated aggregate fair value and the proceeds reinvested at current
yields. We include the impact of this adjustment in accumulated other
comprehensive income (loss) within shareholders' equity.
The 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.
In accordance with Statement of Financial Accounting Standards No. 97
"Accounting and Reporting by Insurance Enterprises for Certain Long-Duration
Contracts and Realized Gains and Losses from the Sale of Investments" ("SFAS
97"), we are required to amortize the value of policies inforce in relation to
estimated gross profits for universal life-type products and investment-type
products. SFAS 97 also requires that estimates of expected gross profits used as
a basis for amortization be evaluated regularly, and that the total amortization
recorded to date be adjusted by a charge or credit to the statement of
operations, if actual experience or other evidence suggests that earlier
estimates should be revised.
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
During the second quarter of 2004, we evaluated certain amortization
assumptions used to estimate gross profits for universal life-type products and
investment-type products by comparing them to our actual experience. We made
refinements to the previous assumptions related to investment income to match
the actual experience and our estimates for future assumptions. The changes we
made did not affect our expectations for the total estimated profits to be
earned on this business, but did affect how we expect the profits to emerge over
time. These new assumptions resulted in a retroactive reduction to the
amortization of the value of policies inforce at the Effective Date of $7.7
million in the second quarter of 2004.
EARNINGS PER SHARE
A reconciliation of net income and shares used to calculate basic and
diluted earnings per share is as follows:
Successor
----------------------------------------------------
Three months Nine months One month
ended ended ended
September 30, September 30, September 30,
2004 2004 2003
---- ---- ----
(Dollars in millions and
shares in thousands)
Net income................................................. $67.3 $208.4 $24.2
Preferred stock dividends.................................. (9.4) (56.0) (5.3)
----- ------ ------
Net income applicable to common stock
for basic earnings per share.......................... 57.9 152.4 18.9
Effect of dilutive securities:
Preferred stock dividends............................... 9.4 14.7 5.3
----- ------ -----
Net income applicable to common stock for diluted
earnings per share.................................... $67.3 $167.1 $24.2
===== ====== =====
Shares:
Weighted average shares outstanding
for basic earnings per share.......................... 150,885 126,016 100,098
Effect of dilutive securities on weighted average shares:
Class B mandatorily convertible preferred stock....... 37,809 19,054 -
Class A convertible exchangeable preferred stock...... - - 44,566
Stock options and employee benefit plans.............. 501 522 7
------- ------- -------
Weighted average shares outstanding for diluted
earnings per share.................................... 189,195 145,592 144,671
======= ======= =======
For the nine months ended September 30, 2004, equivalent common shares of
26.5 million related to the assumed conversion of Class A convertible
exchangeable preferred stock were not included in the computation of diluted
earnings per share because doing so would have been antidilutive.
Basic earnings per common share 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 earnings per share until
vested. Diluted earnings per share reflects the potential dilution that could
occur if outstanding stock options were exercised and restricted stock was
vested. The dilution from stock options and restricted shares are calculated
using the treasury stock method. Under this method we assume the proceeds from
the exercise of the options (or the unrecognized
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
compensation expense with respect to restricted stock) will be used to purchase
shares of our common stock at the average market price during the period,
reducing the dilutive effect of the exercise of the options (or the vesting of
the restricted stock).
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").
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 per share would have been as follows (dollars in millions, except per
share amounts):
Successor Predecessor
---------------------------------- ------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Net income, as reported ............................................. $67.3 $24.2 $2,241.3
Less stock-based employee compensation ..expense
determined under the fair value based method
for all awards, net of income taxes............................. (2.1) - 2.0
----- ----- --------
Pro forma net income................................................. $65.2 $24.2 $2,243.3
===== ===== ========
Earnings per share:
Basic, as reported.............................................. $ .38 $ .19
Basic, pro forma................................................ .37 .19
Diluted, as reported............................................ $ .36 $ .17
Diluted, pro forma.............................................. .34 .17
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Net income, as reported ............................................. $208.4 $24.2 $2,201.7
Less stock-based employee compensation ..expense
determined under the fair value based method
for all awards, net of income taxes............................. (3.2) - (7.2)
------ ----- --------
Pro forma net income................................................. $205.2 $24.2 $2,194.5
====== ===== ========
Earnings per share:
Basic, as reported.............................................. $ 1.21 $.19
Basic, pro forma................................................ 1.18 .19
Diluted, as reported............................................ $ 1.15 $.17
Diluted, pro forma.............................................. 1.13 .17
All outstanding stock options of the Predecessor were cancelled pursuant to
the Plan. Pro forma compensation expense in the two and 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.
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. 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.
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Operating information regarding our segments was as follows (dollars in
millions):
Successor Predecessor
--------------------------------- -------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.............................................. $ 13.4 $ 5.0 $ 9.2
Supplemental health.................................... 295.1 95.5 191.2
Life................................................... 42.7 10.2 24.6
Other.................................................. 4.1 1.0 2.0
Net investment income (a)................................... 105.1 31.0 68.6
Fee revenue and other income (a)............................ .1 .4 .2
Net realized investment gains (a)........................... 2.5 2.8 1.7
--------- ------ ------
Total Bankers Life segment revenues................ 463.0 145.9 297.5
--------- ------ ------
Conseco Insurance Group:
Insurance policy income:
Annuities.............................................. 6.1 2.3 6.8
Supplemental health.................................... 178.7 62.4 123.2
Life................................................... 96.0 33.4 70.2
Other.................................................. 3.4 4.8 6.5
Net investment income (a)................................... 172.1 59.3 145.7
Fee revenue and other income (a)............................ 1.0 - 4.9
Net realized investment gains (losses) (a).................. 2.5 3.7 (36.9)
--------- ------ ------
Total Conseco Insurance Group
segment revenues............................... 459.8 165.9 320.4
--------- ------ ------
Other Business in Run-Off:
Insurance policy income - supplemental health............... 98.3 41.6 83.1
Net investment income (a)................................... 41.8 13.5 26.7
Fee revenue and other income (a)............................ .1 .3 .1
Net realized investment gains (a)........................... 1.0 .6 .9
--------- ------ ------
Total Other Business in Run-Off
segment revenues............................... 141.2 56.0 110.8
--------- ------ ------
Corporate:
Net investment income (a)................................... .9 .1 3.2
Venture capital income (loss) related to investment
in AWE................................................... - (2.7) 2.0
Fee and other income (a).................................... 4.0 1.5 3.8
Net realized investment gains (losses) (a).................. - (.4) (1.6)
--------- ------ ------
Total corporate segment revenues................... 4.9 (1.5) 7.4
--------- ------ ------
Total revenues..................................... 1,068.9 366.3 736.1
--------- ------ ------
(continued on next page)
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Successor Predecessor
------------------------------------ --------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits...................................... $318.1 $ 94.5 $ 205.3
Amortization................................................... 48.8 15.5 29.1
Interest expense on investment borrowings...................... .6 .2 .6
Other operating costs and expenses............................. 41.3 10.8 19.5
------ ------ ---------
Total Bankers Life segment expenses....................... 408.8 121.0 254.5
------ ------ ---------
Conseco Insurance Group:
Insurance policy benefits...................................... 274.0 105.8 4.5
Amortization................................................... 39.0 9.9 24.1
Interest expense on investment borrowings...................... 1.3 .4 1.3
Other operating costs and expenses............................. 77.5 29.0 59.7
------ ------ ---------
Total Conseco Insurance Group segment
expenses................................................ 391.8 145.1 89.6
------ ------ ---------
Other Business in Run-Off:
Insurance policy benefits...................................... 96.3 43.0 181.1
Amortization................................................... 4.1 1.5 8.1
Interest expense on investment borrowings...................... - - -
Other operating costs and expenses............................. 23.3 8.1 21.1
------ ------ ---------
Total Other Business in Run-Off segment
expenses............................................... 123.7 52.6 210.3
------ ------ ---------
Corporate:
Interest expense on corporate debt............................. 11.0 6.4 53.5
Provision for losses and interest expense related
to stock purchase plan...................................... - - 24.5
Gain on extinguishment of debt................................. - - -
Other operating costs and expenses............................. 28.7 3.4 7.7
Reorganization items........................................... - - (2,163.0)
------ ------ ---------
Total corporate segment expenses.......................... 39.7 9.8 (2,077.3)
------ ------ ---------
Total expenses............................................ 964.0 328.5 (1,522.9)
------ ------ ---------
Income (loss) before income taxes and discontinued operations:
Bankers Life................................................... 54.2 24.9 43.0
Conseco Insurance Group........................................ 68.0 20.8 230.8
Other Business in Run-Off...................................... 17.5 3.4 (99.5)
Corporate operations........................................... (34.8) (11.3) 2,084.7
------ ------ ---------
Income before income taxes and
discontinued operations................................. $104.9 $ 37.8 $ 2,259.0
====== ====== =========
- -------------------
(a) It is not practicable to provide additional components of revenue by product
or services.
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.............................................. $ 39.2 $ 5.0 $ 32.9
Supplemental health.................................... 881.4 95.5 760.4
Life................................................... 116.7 10.2 91.5
Other.................................................. 9.7 1.0 7.9
Net investment income (a)................................... 307.7 31.0 258.2
Fee revenue and other income (a)............................ .6 .4 .9
Net realized investment gains (a)........................... 13.9 2.8 5.5
-------- ------ --------
Total Bankers Life segment revenues................ 1,369.2 145.9 1,157.3
-------- ------ --------
Conseco Insurance Group:
Insurance policy income:
Annuities.............................................. 17.1 2.3 51.6
Supplemental health.................................... 550.4 62.4 499.0
Life................................................... 294.3 33.4 303.9
Other.................................................. 12.1 4.8 38.3
Net investment income (a)................................... 519.1 59.3 582.6
Fee revenue and other income (a)............................ 4.3 - 17.0
Net realized investment gains (losses) (a).................. 13.6 3.7 (17.1)
-------- ------ --------
Total Conseco Insurance Group
segment revenues............................... 1,410.9 165.9 1,475.3
-------- ------ --------
Other Business in Run-Off:
Insurance policy income - supplemental health............... 302.3 41.6 418.8
Net investment income (a)................................... 123.0 13.5 101.5
Fee revenue and other income (a)............................ .6 .3 .5
Net realized investment gains (a)........................... 2.8 .6 6.3
-------- ------ --------
Total Other Business in Run-Off
segment revenues............................... 428.7 56.0 527.1
-------- ------ --------
Corporate:
Net investment income (a)................................... 1.4 .1 16.2
Venture capital income (loss) related to investment
in AWE................................................... - (2.7) 10.5
Fee and other income (a).................................... 11.6 1.5 17.1
Net realized investment losses (a).......................... (2.8) (.4) (.1)
-------- ------ --------
Total corporate segment revenues................... 10.2 (1.5) 43.7
-------- ------ --------
Total revenues..................................... 3,219.0 366.3 3,203.4
-------- ------ --------
(continued on next page)
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Successor Predecessor
---------------------------------- --------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits..................................... $ 932.8 $ 94.5 $ 795.1
Amortization.................................................. 138.1 15.5 113.9
Interest expense on investment borrowings..................... 1.7 .2 3.4
Other operating costs and expenses............................ 120.9 10.8 85.3
-------- ------ ---------
Total Bankers Life segment expenses...................... 1,193.5 121.0 997.7
-------- ------ ---------
Conseco Insurance Group:
Insurance policy benefits..................................... 848.3 105.8 746.3
Amortization.................................................. 120.7 9.9 201.8
Interest expense on investment borrowings..................... 3.4 .4 4.7
Other operating costs and expenses............................ 235.7 29.0 222.6
-------- ------ ---------
Total Conseco Insurance Group segment
expenses............................................... 1,208.1 145.1 1,175.4
-------- ------ ---------
Other Business in Run-Off:
Insurance policy benefits..................................... 293.5 43.0 595.0
Amortization.................................................. 13.6 1.5 28.0
Interest expense on investment borrowings..................... .1 - .2
Other operating costs and expenses............................ 71.7 8.1 75.2
-------- ------ ---------
Total Other Business in Run-Off segment
expenses.............................................. 378.9 52.6 698.4
-------- ------ ---------
Corporate:
Interest expense on corporate debt............................ 59.9 6.4 194.2
Provision for losses and interest expense related
to stock purchase plan..................................... - - 55.6
Gain on extinguishment of debt................................ (2.8) - -
Other operating costs and expenses............................ 57.3 3.4 40.4
Reorganization items.......................................... - - (2,130.5)
-------- ------ ---------
Total corporate segment expenses......................... 114.4 9.8 (1,840.3)
-------- ------ ---------
Total expenses........................................... 2,894.9 328.5 1,031.2
-------- ------ ---------
Income (loss) before income taxes and discontinued operations:
Bankers Life.................................................. 175.7 24.9 159.6
Conseco Insurance Group....................................... 202.8 20.8 299.9
Other Business in Run-Off..................................... 49.8 3.4 (171.3)
Corporate operations.......................................... (104.2) (11.3) 1,884.0
-------- ------ ---------
Income before income taxes and
discontinued operations................................ $ 324.1 $ 37.8 $ 2,172.2
======== ====== =========
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 (classified as investment
income from policyholder accounts). Option costs that are attributable to
benefits provided were $33.8 million in the first nine months of 2004; $5.2
million in the one month ended September 30, 2003; and $53.5 million in the
eight months ended August 31, 2003. 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 $20.3 million in the first nine months of 2004; $(3.1) million in the one
month ended September 30, 2003; and $83.6 million in the eight months ended
August 31, 2003. 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 $28.4 million and $119.6 million at September 30, 2004 and
December 31, 2003, 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 $204.7 million and $214.7
million at September 30, 2004 and December 31, 2003, 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.
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 September 30, 2004, 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 $31.4 million and $27.2 million at September 30, 2004
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 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.
GUARANTEES
In conjunction with the Plan, $481.3 million principal amount of bank loans
made to certain former directors and 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 loans which exceed $250 million. The former
bank loans and the
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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,
the credit worthiness of the participants and the current status of various
legal actions we have taken to collect the D&O loans. At September 30, 2004, we
have estimated that approximately $50.0 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 $23.0
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 two of the Company's former Chief Executive
Officer's employment agreements, certain wholly-owned subsidiaries of the
Company are the guarantors of the former executives' nonqualified supplemental
retirement benefits. The liability for such benefits at September 30, 2004 and
December 31, 2003 was $21.8 million and $18.1 million, respectively, and is
included in the caption "Other liabilities" in the liability section of the
consolidated balance sheet.
REINSURANCE
The cost of reinsurance ceded totaled $197.3 million in the first nine
months of 2004; $25.0 million in the one month ended September 30, 2003; and
$196.4 million in the eight months ended August 31, 2003. We deducted 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
$225.8 million in the first nine months of 2004; $24.9 million in the one month
ended September 30, 2003; and $199.2 million in the eight months ended August
31, 2003.
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. Reinsurance premiums
assumed totaled $53.1 million in the first nine months of 2004; $10.6 million in
the one month ended September 30, 2003; and $57.3 million in the eight months
ended August 31, 2003.
See the note entitled "Accounting for Derivatives" for a discussion of the
derivative embedded in the payable related to certain modified coinsurance
agreements.
INCOME TAXES
The components of income tax expense (benefit) are as follows (dollars in
millions):
Successor Predecessor
--------------------------------- -----------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Current tax provision (benefit).................................. $(2.2) $ .6 $17.7
Deferred tax provision........................................... 39.8 13.0 -
----- ----- -----
Income tax expense on period income........................... $37.6 $13.6 $17.7
===== ===== =====
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Current tax provision (benefit).................................. $ .8 $ .6 $(13.5)
Deferred tax provision........................................... 114.9 13.0 -
------ ----- ------
Income tax expense (benefit) on period income................. $115.7 $13.6 $(13.5)
====== ===== ======
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
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
U.S. statutory corporate rate......................................... 35.0% 35.0% 35.0%
Valuation allowance................................................... - - 25.8
Gain on debt restructuring............................................ - - (39.7)
Subsidiary stock basis adjustment..................................... - - (21.8)
Other nondeductible expenses.......................................... .6 .1 (.1)
State taxes........................................................... .1 .9 .2
---- ---- -----
Effective tax rate........................................... 35.7% 36.0% (.6)%
==== ==== =====
23
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
--------------------------------
September 30, December 31,
2004 2003
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to worthless investment in Conseco Finance Corp........... $ 1,545.6 $ 1,183.0
Other.......................................................................... 177.0 84.2
Capital loss carryforwards........................................................ 396.8 411.2
Deductible temporary differences:
Insurance liabilities.......................................................... 1,677.0 1,688.0
Reserve for loss on loan guarantees............................................ 207.3 217.2
--------- ---------
Gross deferred tax assets.................................................... 4,003.7 3,583.6
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (79.6) (80.9)
Cost of policies purchased and cost of policies produced....................... (738.8) (716.3)
Unrealized appreciation of investments......................................... (169.1) (123.0)
Other.......................................................................... (328.3) (301.3)
--------- ---------
Gross deferred tax liabilities............................................... (1,315.8) (1,221.5)
--------- ---------
Valuation allowance............................................................ (2,687.9) (2,362.1)
--------- ---------
Net deferred tax assets...................................................... - -
Current income taxes prepaid.......................................................... 12.2 24.6
--------- ---------
Net income tax assets................................................................. $ 12.2 $ 24.6
========= =========
Conseco and its affiliates are currently under examination by the Internal
Revenue Service (the "IRS") for tax years ending December 31, 1999 through
December 31, 2001. At the request of the Company, the IRS has commenced its
examination of the Company for years ending December 31, 2002 through 2003. 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, and is expected to resolve the Section 382
limitation and the life insurance limitation issues more fully discussed later.
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 $2.7 billion at September 30,
2004. 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 capital loss carryforwards and 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 an ongoing 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 September 30, 2004, 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
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
worthlessness of our investment in Conseco Finance Corp. ("CFC"), (which is more
fully discussed below), and the likelihood of future taxable income and capital
gains exclusive of reversing temporary differences and carryforwards.
The reduction of any portion of our deferred income tax valuation allowance
(including the capital loss carryforwards and 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 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. Changes in our valuation allowance
are summarized as follows (dollars in millions):
Balance at December 31, 2003............................................. $2,362.1
Realization of deferred income taxes recognized
in the current period(a)............................................ (114.9)
Release of tax valuation reserve related to unrealized
gains during the period(a).......................................... (46.1)
Recovery of amounts related to our bankruptcy and
state taxes(a)...................................................... (5.9)
Increase in deferred tax assets related to the worthlessness
of CFC as further discussed below................................... 500.1
Other.................................................................. (7.4)
--------
Balance at September 30, 2004............................................ $2,687.9
========
- --------------
(a) Goodwill has a corresponding reduction for these items.
As of September 30, 2004, we had $4.9 billion of net operating loss
carryforwards and $1.1 billion of capital 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 (dollars in millions):
Operating loss carryforwards Capital loss carryforwards
------------------------------------------- -----------------------------------------
Year of expiration Subject to ss.382 Not subject to ss.382 Subject to ss.382 Not subject to ss.382
------------------ ----------------- --------------------- ----------------- ---------------------
2005........................... $ .2 $ - $ 2.7 $ -
2006........................... .1 - 5.5 -
2007........................... 5.8 - 484.4 -
2008 .......................... 1.5 - 583.7 -
2009........................... 10.5 - - 57.4
2010........................... 3.6 - - -
2011........................... .5 - - -
2016........................... 20.9 - - -
2017........................... 51.3 - - -
2018........................... 57.8 4,452.4 - -
2019........................... .7 - - -
2020........................... .7 - - -
2023........................... 292.4 - - -
2024........................... - 23.1 - -
------ -------- -------- -----
Total.......................... $446.0 $4,475.5 $1,076.3 $57.4
====== ======== ======== =====
The timing and manner in which we will utilize the net operating loss
carryforwards and capital 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.
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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
as of December 31, 2003.
At the fresh-start date, we were required to estimate our tax basis in CFC
in order to determine the tax loss carryforward related to the worthlessness of
CFC. The determination of this amount and how the loss is recognized was subject
to varied interpretations of various tax laws and regulations. During the third
quarter of 2004, the Company and the IRS entered into a closing agreement which
determined that the tax loss recognized on the worthlessness of CFC was $6.7
billion, instead of our original estimate of $5.4 billion. This determination
resulted in $500.1 million of additional deferred tax assets being recognized.
We also recognized a $500.1 million valuation allowance, as we have deemed it
more likely than not that the deferred tax assets will not be realized. As this
increase relates to the period prior to our emergence from bankruptcy, a
reduction of any portion of the deferred income tax valuation allowance will be
accounted for as a reduction of goodwill pursuant to SOP 90-7.
The closing agreement with the IRS also determined that the loss recognized
on the worth