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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the period ended March 31, 2005
[ ] 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 May 2, 2005: 151,057,863
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of March 31, 2005 and December 31, 2004.................................. 3
Consolidated Statement of Operations for the three months ended March 31, 2005 and 2004................ 5
Consolidated Statement of Shareholders' Equity for the three months ended March 31, 2005 and 2004...... 6
Consolidated Statement of Cash Flows for the three months ended March 31, 2005 and 2004................ 7
Notes to Consolidated Financial Statements............................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements.............................................. 26
Overview .............................................................................................. 27
Critical Accounting Policies .......................................................................... 27
Risk Factors .......................................................................................... 27
Results of Operations.................................................................................. 28
Premium Collections.................................................................................... 40
Liquidity and Capital Resources........................................................................ 46
Investments............................................................................................ 50
New Accounting Standards .............................................................................. 56
Item 3. Quantitative and Qualitative Disclosures About Market Risk ............................................ 56
Item 4. Controls and Procedures................................................................................ 56
PART II - OTHER INFORMATION
Item 1. Litigation and Other Legal Proceedings ................................................................ 56
Item 6. Exhibits .............................................................................................. 56
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
March 31, December 31,
2005 2004
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
March 31, 2005 - $21,723.2; December 31, 2004 - $20,985.8)........................... $21,992.7 $21,599.0
Equity securities at fair value (cost: March 31, 2005 - $62.3;
December 31, 2004 - $62.3)........................................................... 68.1 68.3
Mortgage loans......................................................................... 1,116.9 1,123.8
Policy loans........................................................................... 436.4 448.5
Trading securities..................................................................... 858.5 902.3
Other invested assets ................................................................. 134.3 164.4
--------- ---------
Total investments.................................................................. 24,606.9 24,306.3
Cash and cash equivalents:
Unrestricted........................................................................... 287.4 776.6
Restricted............................................................................. 18.7 18.9
Accrued investment income................................................................. 324.3 308.4
Value of policies in force at the Effective Date.......................................... 2,606.4 2,629.6
Cost of policies produced................................................................. 503.2 409.1
Reinsurance receivables................................................................... 902.4 975.7
Income tax assets......................................................................... 1,017.7 967.2
Assets held in separate accounts.......................................................... 31.0 32.9
Other assets.............................................................................. 403.7 330.8
--------- ---------
Total assets....................................................................... $30,701.7 $30,755.5
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
March 31, December 31,
2005 2004
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $12,505.7 $12,508.2
Traditional products................................................................... 11,745.7 11,741.3
Claims payable and other policyholder funds............................................ 884.9 879.8
Liabilities related to separate accounts............................................... 31.0 32.9
Other liabilities........................................................................ 553.4 498.3
Investment borrowings.................................................................... 427.7 433.9
Notes payable - direct corporate obligations............................................. 758.4 758.9
--------- ---------
Total liabilities.................................................................. 26,906.8 26,853.3
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Preferred stock.......................................................................... 667.8 667.8
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: March 31, 2005 - 151,057,863; December 31, 2004 - 151,057,863)........ 1.5 1.5
Additional paid-in capital............................................................... 2,600.1 2,597.8
Accumulated other comprehensive income................................................... 155.4 337.3
Retained earnings........................................................................ 370.1 297.8
--------- ---------
Total shareholders' equity......................................................... 3,794.9 3,902.2
--------- ---------
Total liabilities and shareholders' equity......................................... $30,701.7 $30,755.5
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended
March 31,
-----------------------
2005 2004
---- ----
Revenues:
Insurance policy income............................................................. $ 727.7 $ 748.4
Net investment income (loss):
General account assets............................................................ 337.8 312.0
Policyholder and reinsurer accounts............................................... (23.3) 15.7
Net realized investment gains..................................................... 1.6 27.1
Fee revenue and other income........................................................ 4.2 7.4
-------- --------
Total revenues.................................................................. 1,048.0 1,110.6
-------- --------
Benefits and expenses:
Insurance policy benefits........................................................... 671.0 719.7
Interest expense.................................................................... 14.7 29.1
Amortization........................................................................ 94.7 98.2
Other operating costs and expenses.................................................. 140.4 151.2
-------- --------
Total benefits and expenses..................................................... 920.8 998.2
-------- --------
Income before income taxes...................................................... 127.2 112.4
Income tax expense on period income.................................................... 45.4 39.6
-------- --------
Net income...................................................................... 81.8 72.8
Preferred stock dividends.............................................................. 9.5 22.9
-------- --------
Net income applicable to common stock........................................... $ 72.3 $ 49.9
======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding............................................... 151,058,000 100,116,000
=========== ===========
Net income........................................................................ $.48 $.50
==== ====
Diluted:
Weighted average shares outstanding............................................... 186,764,000 100,588,000
=========== ===========
Net income........................................................................ $.44 $.50
==== ====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income earnings
----- ----- --------------- ------ --------
Balance, January 1, 2005............................. $3,902.2 $667.8 $2,599.3 $337.3 $297.8
Comprehensive income, net of tax:
Net income...................................... 81.8 - - - 81.8
Change in unrealized appreciation of
investments (net of applicable income tax
benefit of $101.8)............................ (181.9) - - (181.9) -
--------
Total comprehensive loss.................... (100.1)
Stock option and restricted stock plans......... 2.3 - 2.3 - -
Dividends on preferred stock.................... (9.5) - - - (9.5)
-------- ------ -------- ------ ------
Balance, March 31, 2005.............................. $3,794.9 $667.8 $2,601.6 $155.4 $370.1
======== ====== ======== ====== ======
Balance, January 1, 2004............................. $2,817.6 $887.5 $1,642.9 $218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 72.8 - - - 72.8
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $140.5)............................ 252.0 - - 252.0 -
--------
Total comprehensive income.................. 324.8
Stock option and restricted stock plans......... 4.5 - 4.5 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 22.9 22.9 - - -
Dividends on preferred stock.................... (22.9) - - - (22.9)
-------- ------ -------- ------ ------
Balance, March 31, 2004.............................. $3,146.9 $910.4 $1,647.4 $470.7 $118.4
======== ====== ======== ====== ======
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Three months ended
March 31,
----------------------
2005 2004
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 635.3 $ 649.6
Net investment income................................................................. 348.6 358.8
Fee revenue and other income.......................................................... 4.2 7.4
Net sales (purchases) of trading securities........................................... 26.1 (1.6)
Insurance policy benefits............................................................. (450.6) (542.1)
Interest expense...................................................................... (11.6) (25.5)
Policy acquisition costs.............................................................. (107.2) (89.8)
Other operating costs................................................................. (153.0) (159.1)
Taxes................................................................................. 5.9 12.9
--------- ---------
Net cash provided by operating activities........................................... 297.7 210.6
--------- ---------
Cash flows from investing activities:
Sales of investments.................................................................. 3,148.0 2,324.0
Maturities and redemptions of investments............................................. 320.6 634.3
Purchases of investments.............................................................. (4,183.8) (3,395.5)
Change in restricted cash............................................................. .2 16.4
Other................................................................................. (4.8) 4.3
--------- ---------
Net cash used by investing activities .............................................. (719.8) (416.5)
--------- ---------
Cash flows from financing activities:
Payments on notes payable............................................................. (.9) -
Amounts received for deposit products................................................. 402.1 359.6
Withdrawals from deposit products..................................................... (452.6) (453.7)
Investment borrowings................................................................. (6.2) 73.9
Dividends paid on preferred stock..................................................... (9.5) -
Other................................................................................. - (3.6)
--------- ---------
Net cash used by financing activities............................................. (67.1) (23.8)
--------- ---------
Net decrease in cash and cash equivalents......................................... (489.2) (229.7)
Cash and cash equivalents, beginning of period........................................... 776.6 1,228.7
--------- ---------
Cash and cash equivalents, end of period................................................. $ 287.4 $ 999.0
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2004 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 is the successor to
Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"), in
connection with its bankruptcy reorganization which became effective on
September 10, 2003 (the "Effective Date"). 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.
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary for a fair statement of 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 (the "SEC") 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 2005 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, 2004, 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
value of policies in force at the Effective Date, certain investments, assets
and liabilities related to income taxes, 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 former 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.
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.
Our trading security accounts are designed to act as hedges for embedded
derivatives related to our equity-indexed annuity products and 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 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 $858.5 million and
$902.3 million at March 31, 2005 and December 31, 2004, respectively. The change
in the market value of these securities is recognized currently in investment
income (classified as income from policyholder and reinsurer accounts).
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Accumulated other comprehensive income is comprised of the net effect of
unrealized appreciation on our investments. These amounts, included in
shareholders' equity as of March 31, 2005 and December 31, 2004, were as follows
(dollars in millions):
March 31, December 31,
2005 2004
---- ----
Net unrealized appreciation on investments............................................ $279.5 $ 621.6
Adjustment to value of policies inforce at the Effective Date......................... (33.9) (85.7)
Adjustment to cost of policies produced............................................... (3.6) (10.2)
Deferred income tax liability......................................................... (86.6) (188.4)
------ -------
Accumulated other comprehensive income........................................... $155.4 $ 337.3
====== =======
AMORTIZATION OF THE VALUE OF POLICIES INFORCE AT THE EFFECTIVE DATE
The value assigned to the right to receive future cash flows from contracts
existing at August 31, 2003 (the effective date of the reorganization of our
Predecessor) 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. For universal life or
investment products, we amortize these costs using the interest rate credited to
the underlying policies in relation to the established gross profits. For other
products, we amortize these costs using the projected investment earnings rate
in relation to future anticipated premium revenue.
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 included the impact of this adjustment in accumulated other
comprehensive income within shareholders' equity.
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.
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
EARNINGS PER SHARE
A reconciliation of net income and shares used to calculate basic and
diluted earnings per share is as follows (dollars in millions and shares in
thousands):
Three months ended
March 31,
-----------------------
2005 2004
---- ----
Net income................................................................................... $81.8 $ 72.8
Preferred stock dividends.................................................................... (9.5) (22.9)
----- -------
Net income applicable to common stock
for basic earnings per share.......................................................... 72.3 49.9
Effect of dilutive securities:
Preferred stock dividends................................................................. 9.5 -
----- -------
Net income applicable to common stock and assumed conversions for diluted earnings
per share............................................................................. $81.8 $49.9
===== =====
Shares:
Weighted average shares outstanding
for basic earnings per share............................................................ 151,058 100,116
------- -------
Effect of dilutive securities on weighted average shares:
Class B mandatorily convertible preferred stock......................................... 35,027 -
Stock option and restricted stock plans................................................. 679 472
------- -------
Dilutive potential common shares........................................................ 35,706 472
------- -------
Weighted average shares outstanding for diluted earnings per share........................ 186,764 100,588
======= =======
For the three months ended March 31, 2004, equivalent common shares of 44.2
million related to the assumed conversion of convertible exchangeable preferred
stock (which was redeemed in the second quarter of 2004) 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 options and restricted shares is calculated using the
treasury stock method. Under this method we assume the proceeds from the
exercise of the options (or the unrecognized 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).
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR STOCK OPTIONS
We measure compensation cost for our stock option plans using the intrinsic
value method pursuant to Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" and related interpretations ("APB 25"). Under
this method, compensation cost is recorded when the quoted market price at the
grant date exceeds the amount an employee must pay to acquire the stock. When
the Company issues employee stock options with the exercise price equal to or
greater than the market price of our stock on the grant date, no compensation
cost is recorded. Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123") and Statement of
Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation
- - Transition and Disclosure" ("SFAS 148") require disclosures of the pro forma
effects of using the fair value method of accounting for stock options.
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123 (revised 2004) "Share-Based
Payment" ("SFAS 123R"), which revises SFAS 123 and supersedes APB 25. SFAS 123R
provides additional guidance on accounting for share-based payments and will
require all such awards to be measured at fair value with the related
compensation cost recognized in the statement of operations over the related
service period. In April 2005, the SEC delayed the implementation date of SFAS
123R. Conseco will implement SFAS 123R using the modified prospective method on
January 1, 2006. Under this method, the Company will begin recognizing
compensation cost for all awards granted, modified, repurchased or cancelled on
and after January 1, 2006. In addition, we will be required to recognize
compensation cost over the remaining vesting period for the portion of
outstanding awards that are not vested as of January 1, 2006. SFAS 123R also
requires the benefits of tax deductions in excess of recognized compensation
cost to be reported as a financing cash flow rather than as an operating cash
flow, as currently required. The aggregate value of unvested options at March
31, 2005, as determined using the Black-Scholes option valuation model at the
date of grant, was $12.9 million, of which $9.0 million will be recognized as
compensation cost over the remaining vesting period after January 1, 2006. If
compensation cost had been determined based on the fair value at the grant dates
for all awards issued after the Effective Date, the Company's pro forma net
income and pro forma earnings per share would have been as follows (dollars in
millions, except per share amounts):
Three months ended
March 31,
----------------------
2005 2004
---- ----
Net income, as reported ................................................................. $81.8 $72.8
Less stock-based employee compensation expense determined
under the fair value method for all awards, net of
income taxes........................................................................ .6 .3
----- -----
Pro forma net income..................................................................... $81.2 $72.5
===== =====
Earnings per share:
Basic, as reported.................................................................. $.48 $.50
Basic, pro forma .................................................................. .47 .50
Diluted, as reported................................................................ $.44 $.50
Diluted, pro forma.................................................................. .43 .49
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
BUSINESS SEGMENTS
We manage our business through the following: two primary operating
segments, Bankers Life and Conseco Insurance Group, which are defined on the
basis of product distribution; a third segment comprised of other business in
run-off; and corporate operations, which consists of holding company activities
and certain noninsurance businesses.
Operating information by segment was as follows (dollars in millions):
Three months ended
March 31,
-----------------------
2005 2004
---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.................................................................... $ 12.3 $ 12.2
Supplemental health.......................................................... 301.7 292.4
Life......................................................................... 42.2 37.7
Other........................................................................ 3.1 2.8
Net investment income (a)......................................................... 113.5 99.1
Fee revenue and other income (a).................................................. .6 .3
Net realized investment gains (a)................................................. 2.0 11.0
-------- --------
Total Bankers Life revenues.............................................. 475.4 455.5
-------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities.................................................................... 5.6 5.4
Supplemental health.......................................................... 171.6 186.3
Life......................................................................... 96.2 103.8
Other........................................................................ 3.5 4.5
Net investment income (a)......................................................... 157.3 188.1
Fee revenue and other income (a).................................................. .5 1.8
Net realized investment gains (losses) (a)........................................ (2.5) 16.2
-------- --------
Total Conseco Insurance Group
revenues............................................................. 432.2 506.1
-------- --------
Other Business in Run-Off:
Insurance policy income - supplemental health..................................... 91.5 103.3
Net investment income (a)......................................................... 43.2 40.3
Fee revenue and other income (a).................................................. .1 .3
Net realized investment gains (a)................................................. 2.1 2.7
-------- --------
Total Other Business in Run-Off
revenues............................................................. 136.9 146.6
-------- --------
Corporate:
Net investment income............................................................. .5 .2
Fee and other income.............................................................. 3.0 5.0
Net realized investment losses.................................................... - (2.8)
-------- --------
Total corporate revenues................................................. 3.5 2.4
-------- --------
Total revenues........................................................... 1,048.0 1,110.6
-------- --------
(continued on next page)
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended
March 31,
----------------------
2005 2004
---- ----
Expenses:
Bankers Life:
Insurance policy benefits........................................................ $329.4 $306.5
Amortization..................................................................... 46.9 45.7
Interest expense on investment borrowings........................................ .7 .4
Other operating costs and expenses............................................... 37.7 35.5
------ ------
Total Bankers Life expenses................................................. 414.7 388.1
------ ------
Conseco Insurance Group:
Insurance policy benefits........................................................ 255.1 311.9
Amortization..................................................................... 42.0 47.7
Interest expense on investment borrowings........................................ 2.0 .9
Other operating costs and expenses............................................... 69.6 76.3
------ ------
Total Conseco Insurance Group expenses...................................... 368.7 436.8
------ ------
Other Business in Run-Off:
Insurance policy benefits........................................................ 86.5 101.3
Amortization..................................................................... 5.8 4.8
Other operating costs and expenses............................................... 21.0 22.9
------ ------
Total Other Business in Run-Off expenses.................................... 113.3 129.0
------ ------
Corporate:
Interest expense on corporate debt............................................... 12.0 27.8
Other operating costs and expenses............................................... 12.1 16.5
------- ------
Total corporate expenses.................................................... 24.1 44.3
------- ------
Total expenses.............................................................. 920.8 998.2
------ ------
Income (loss) before income taxes:
Bankers Life................................................................ 60.7 67.4
Conseco Insurance Group..................................................... 63.5 69.3
Other Business in Run-Off................................................... 23.6 17.6
Corporate operations........................................................ (20.6) (41.9)
------ ------
Income before income taxes.............................................. $127.2 $112.4
====== ======
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
13
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 a particular
index, such as 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 one-year call options on the applicable indices in an effort to
hedge potential increases to policyholder benefits resulting from increases in
the particular index to which the product's return is linked. We include the
cost of the 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 $10.2
million and $12.0 million in the three months ended March 31, 2005 and 2004,
respectively. These costs are reflected in the change in market value of the
options included in investment income. Net investment income (loss) related to
equity-indexed products before this expense was $(5.8) million and $17.5 million
in the three months ended March 31, 2005 and 2004, respectively. These amounts
were substantially offset by the corresponding charge to insurance policy
benefits. The estimated fair value of the options was $41.2 million and $50.4
million at March 31, 2005 and December 31, 2004, 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 $215.9 million and $236.7
million at March 31, 2005 and December 31, 2004, 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 that 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 March 31, 2005, all of our counterparties were rated "A" or
higher by Standard & Poor's Corporation ("S&P").
Certain of our reinsurance payable balances contain embedded derivatives as
defined in 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". Such derivatives had an
estimated fair value of $25.5 million and $32.1 million at March 31, 2005 and
December 31, 2004, 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.
GUARANTEES
We hold bank loans made to certain former directors and employees that
enabled them to purchase common stock of Old Conseco. These loans, with a
principal amount of $481.3 million, had been guaranteed by our Predecessor. 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 exceed $260 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, the credit
worthiness of the participants and the current status of various legal actions
we have taken to collect the D&O loans. At March 31, 2005, we have estimated
that approximately $43 million of the D&O loan balance (which is included in
other
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 net proceeds from the collection of certain D&O loans in an
aggregate amount not to exceed $30 million. We have established a liability of
$19 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 employment agreements of two of the
Company's former chief executive officers, certain wholly-owned subsidiaries of
the Company are the guarantors of the former executives' nonqualified
supplemental retirement benefits. The liability for such benefits at March 31,
2005 and December 31, 2004 was $24.6 million and $22.0 million, respectively,
and is included in the caption "Other liabilities" in the consolidated balance
sheet.
REINSURANCE
The cost of reinsurance ceded totaled $60.6 million and $64.7 million in
the three months ended March 31, 2005 and 2004, 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
$71.9 million and $82.9 million in the three months ended March 31, 2005 and
2004, 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. Reinsurance premiums
assumed totaled $14.3 million and $18.2 million in the three months ended March
31, 2005 and 2004, respectively.
See the note entitled "Accounting for Derivatives" for a discussion of the
derivatives embedded in the payable related to certain modified coinsurance
agreements.
INCOME TAXES
The components of income tax expense were as follows (dollars in millions):
Three months ended
March 31,
-----------------------
2005 2004
---- ----
Current tax provision.................................................................... $ - $ 1.8
Deferred tax provision................................................................... 45.4 37.8
----- -----
Income tax expense on period income............................................. $45.4 $39.6
===== =====
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Three months ended
March 31,
-----------------------
2005 2004
---- ----
U.S. statutory corporate rate........................................................ 35.0% 35.0%
Other nondeductible expenses......................................................... .6 .3
State taxes.......................................................................... .5 .4
Provision for tax issues and other................................................... (.4) (.5)
---- ----
Effective tax rate.......................................................... 35.7% 35.2%
==== ====
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
March 31, December 31,
2005 2004
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to worthless investment in Conseco Finance Corp........... $ 1,452.4 $ 1,452.4
Other.......................................................................... 107.8 99.9
Capital loss carryforwards........................................................ 375.2 388.6
Deductible temporary differences:
Insurance liabilities.......................................................... 1,547.0 1,598.0
Reserve for loss on loan guarantees............................................ 207.3 207.3
--------- ---------
Gross deferred tax assets.................................................... 3,689.7 3,746.2
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (55.4) (79.7)
Value of policies in force at the Effective Date and cost of policies produced. (735.2) (732.1)
Unrealized appreciation of investments......................................... (86.6) (188.4)
Other.......................................................................... (179.3) (169.4)
--------- ---------
Gross deferred tax liabilities............................................... (1,056.5) (1,169.6)
--------- ---------
Net deferred tax assets before valuation allowance........................... 2,633.2 2,576.6
Valuation allowance................................................................... (1,629.6) (1,629.6)
--------- ---------
Net deferred tax assets...................................................... 1,003.6 947.0
Current income taxes prepaid.......................................................... 14.1 20.2
--------- ---------
Net income tax assets........................................................ $ 1,017.7 $ 967.2
========= =========
Conseco and its affiliates are currently under examination by the Internal
Revenue Service (the "IRS") for tax years ending December 31, 2002 through
December 31, 2003. The outcome of this examination is not expected to have a
material adverse affect on our operating results, but may result in utilization
or adjustment of 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 below.
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
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
deferred tax assets before valuation allowance totaled $2.6 billion at March 31,
2005. In evaluating 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 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 have taken and plan to take in our current and future
tax returns. We evaluate the realizability of our deferred income tax assets and
assess the need for a valuation allowance on an ongoing basis.
As of March 31, 2005, we believe that it is necessary to have a valuation
allowance on a portion of our deferred tax assets. This determination was made
by evaluating each component of the deferred tax assets and assessing the
effects of limitations or issues on such component's ability to be fully
recognized in the future. Two significant issues include whether section 382 of
the Internal Revenue Code (the "Code") applies to limit the net operating losses
related to our previous subsidiary, Conseco Finance Corp. ("CFC"), and whether
such net operating losses are eligible to offset life insurance income without
limitation. We intend to maintain a sufficient valuation allowance against our
deferred tax assets until objective evidence exists to further reduce or
eliminate it.
Based upon our projections of future income that we completed in early
2005, we believe that we will more likely than not recover $1,003.6 million of
our deferred tax assets through reductions of our tax liabilities in future
periods. However, recovery is dependent on achieving our projections of future
taxable income, and failure to do so would result in an increase in the
valuation allowance in a future period. Any future increase in the valuation
allowance would result in additional income tax expense and reduce shareholders'
equity, and such an increase could have a significant impact upon our earnings
in the future. There was no change in our valuation allowance during the first
quarter of 2005.
As of March 31, 2005, we had $4.5 billion of net operating loss
carryforwards and $1.1 billion of capital loss carryforwards (including 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 section 382 Not subject to section 382 Subject to section 382 Not subject to section 382
------------------ ---------------------- -------------------------- ---------------------- --------------------------
2005...................... $ .2 $ - $ - $ -
2006...................... .1 - - -
2007...................... 5.8 - 454.2 -
2008 ..................... .1 - 583.7 -
2009...................... 10.5 - - 34.1
2010...................... 3.5 - - -
2011...................... .5 - - -
2016...................... 29.2 - - -
2017...................... 51.1 - - -
2018...................... 53.9 4,182.3 (a) - -
2019...................... .7 - - -
2020...................... 2.5 22.8 - -
2022...................... .6 - - -
2023...................... 84.0 - - -
2024...................... - 10.0 - -
------ -------- -------- -----
Total...................... $242.7 $4,215.1 $1,037.9 $34.1
====== ======== ======== =====
- -------------
(a) We have taken the position in our tax returns that the $4.1 billion tax
loss on the worthlessness of CFC included in this amount will not be
subject to Section 382 of the Code. Although we believe our position is
consistent with the Code, it is subject to interpretation and remains an
uncertainty with respect to the future utilization of this operating loss
carryforward. If the IRS disagrees with our position, the $4.1 billion tax
loss would be subject to Section 382 of the Code and the maximum
carryforward that could be utilized would be $2.7 billion (subject to our
ability to generate sufficient future taxable income in the relevant
carryforward period). See additional discussion below.
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 Code (and interpretation thereof) and our
ability to generate sufficient future taxable income in the relevant
carryforward period.
The following paragraphs summarize some of the unresolved limitations and
contingencies which exist with respect to the future utilization of our net
operating loss carryforwards, which will cause a reassessment of the need for a
major portion of the valuation allowance when resolved.
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 of the non-life entities. There is no
limitation on 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 Code 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 such
limitation. The IRS has informed the Company that it will address this matter
during its examination of our tax returns for calendar years 2002-2003.
The timing and manner in which the Company will be able to utilize some or
all of its net operating loss carryforwards may be limited by Section 382 of the
Code. Section 382 imposes limitations on a corporation's ability to use its net
operating loss carryforwards when the company undergoes an ownership change.
Because the Company underwent an ownership change pursuant to its
reorganization, this limitation applies to the Company. In order to determine
the amount of this limitation, we must determine the amount of our net operating
loss carryforwards related to the period prior to our emergence from bankruptcy
(such amount will be subject to the 382 limitation) and the amount related to
the period after emergence (such amount will not be subject to the 382
limitation). When the Company filed its 2003 federal income tax return, it
elected to specifically identify transactions in each period and record them in
the period they actually occurred. As a result, we believe the loss related to
CFC will be 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 IRS has informed
the Company that it will address this matter during its examination of our tax
returns for calendar years 2002-2003.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of March 31, 2005 and December 31, 2004 (dollars in millions):
March 31, December 31,
2005 2004
---- ----
$800.0 million secured credit agreement ("Credit Facility")............................. $767.1 $768.0
Unamortized issuance costs.............................................................. (8.7) (9.1)
------ ------
Direct corporate obligations....................................................... $758.4 $758.9
====== ======
On June 22, 2004, we entered into the Credit Facility. The Credit Facility
is a six-year term loan, the proceeds of which were used: (i) to refinance in
full all indebtedness, including accrued interest, under the $1.3 billion credit
agreement (the "Previous Credit Facility"); (ii) to repurchase $106.6 million of
certain affiliated preferred stock; and (iii) for other general corporate
purposes.
We are required to make: (i) a principal payment of $1.1 million on
December 31, 2005; and (ii) quarterly principal payments of $2.0 million
commencing March 31, 2006, and continuing until March 31, 2010. The remaining
principal balance is due on June 22, 2010. The Company made an optional
prepayment of $28.0 million in December 2004. The Company made a mandatory
prepayment of $.9 million (after consideration of the $28.0 million prepayment)
on March 31, 2005, based on the Company's excess cash flows at December 31,
2004, as defined in the Credit Facility. The borrowing bears interest, payable
at least quarterly, based on either a eurodollar rate or a base rate. The
eurodollar rate is equal to
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
LIBOR plus 3.5 percent. The base rate is equal to 2.5 percent plus the greater
of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of America's prime
rate. On March 31, 2005, the interest rate on our Credit Facility was 6.35
percent.
Pursuant to the Credit Facility, as long as the interest coverage ratio (as
defined in the Credit Facility) is less than 4.0:1.0, 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; and (iv) excess cash flows as defined in the Credit Facility. The
Company may make optional prepayments at any time in minimum amounts of $3.0
million. In the event that the Company refinances or otherwise repays in full
the Credit Facility prior to June 22, 2005, we will incur a one percent
prepayment fee on the remaining principal balance of the Credit Facility.
The 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 not more than 25 percent at all times (such ratio was 17
percent at March 31, 2005); (ii) an interest coverage ratio greater than or
equal to 2.0:1.0 for each rolling four quarters ending (or, if less, the number
of full quarters commencing after June 22, 2004) during the period October 1,
2004 through June 30, 2007, and 2.5:1.0 for the four quarters ending September
30, 2007 and for each rolling four quarters thereafter (such ratio exceeded
2.25:1.0 for the three quarters ending March 31, 2005); (iii) EBITDA, as defined
in the Credit Facility, greater than or equal to $725.0 million for each rolling
four quarters ending during the period July 1, 2004 through December 31, 2005,
$775.0 million for each rolling four quarters ending during the period January
1, 2006 through December 31, 2006, and $825.0 million for each rolling four
quarters thereafter (such amount was greater than $990 million for the four
quarters ended March 31, 2005); (iv) an aggregate risk-based capital ratio, as
defined in the Credit Facility, greater than or equal to 240 percent for the
quarter ending March 31, 2005, 245 percent for each quarter ending during the
period June 30, 2005 through March 31, 2006, and 250 percent for each quarter
ending thereafter (such ratio exceeded the minimum risk-based capital
requirements at March 31, 2005); (v) a combined statutory capital and surplus
level, as defined in the Credit Facility of greater than $1,270.0 million
(combined statutory capital and surplus at March 31, 2005 exceeded such
requirement); and (vi) specified investment portfolio requirements (such
investment portfolio requirements were met at March 31, 2005).
The Credit Facility prohibits or restricts, among other things: (i) the
payment of cash dividends on the Company's common 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 Credit Facility). The obligations under our 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
Facility. 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.
RECENTLY ISSUED ACCOUNTING STANDARDS
The FASB issued SFAS 123R in December 2004. SFAS 123R revises SFAS 123
"Accounting for Stock-Based Compensation" and supersedes APB 25. SFAS 123R
provides additional guidance on accounting for share-based payments and will
require all such awards to be measured at fair value with the related
compensation cost recognized in the statement of operations over the related
service period. SFAS 123R is effective for all awards granted, modified,
repurchased or cancelled in the interim period beginning after June 15, 2005 and
requires the recognition of compensation cost over the remaining vesting period
for the portion of outstanding awards that are not vested as of the effective
date. In April 2005, the SEC amended the compliance date to implement SFAS 123R
at the beginning of the next fiscal year, instead of the next reporting period
that begins after June 15, 2005. SFAS 123R also requires the benefits of tax
deductions in excess of recognized compensation cost to be reported as a
financing cash flow rather than as an operating cash flow, as currently
required. The Company's net income would have been reduced by $.6 million in the
quarter ended March 31, 2005, if we had recognized stock-based employee
compensation as determined under the fair value method, net of income taxes.
The FASB issued Statement of Financial Accounting Standards No. 153,
"Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29" ("SFAS
153") in December 2004. SFAS 153 amends prior guidance to eliminate the
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of SFAS 153 are
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005 and shall be applied prospectively. SFAS 153 is not expected
to have a material impact on the Company's consolidated financial statements at
the date of adoption.
In March 2004, the Emerging Issues Task Force issued Emerging Issues Task
Force Topic No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments" ("EITF 03-01"). EITF 03-01 provides
additional guidance for determining whether an impairment of an investment is
other than temporary. EITF 03-01 also includes guidance for accounting for an
investment subsequent to an other-than-temporary impairment and requires certain
disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments. Certain guidance in EITF 03-01 was effective
beginning the quarter ended September 30, 2004; however, such guidance did not
significantly change our procedures for evaluating impairments. The FASB is
currently considering additional guidance, which we will evaluate when
finalized.
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 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 sold
most of its separate account business in 2002. Accordingly, the new guidance
related to separate accounts had 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 persistency
bonus benefits was $311.8 million at March 31, 2005 and $313.2 million at
December 31, 2004. Our annuity products include contracts that offered enhanced
crediting rates or bonus payments. These enhanced rates are considered sales
inducements under SOP 03-01. Such amounts are deferred and amortized in the same
manner as the cost of policies produced. Sales inducements deferred totaled $4.7
million and $3.5 million during the three months ended March 31, 2005 and 2004,
respectively. Amounts amortized totaled $1.0 million and $.3 million during the
three months ended March 31, 2005 and 2004, respectively. The unamortized
balance of deferred sales inducements at March 31, 2005 and December 31, 2004
was $19.5 million and $15.8 million, respectively.
LITIGATION AND OTHER LEGAL PROCEEDINGS
The Company and its subsidiaries are involved in various legal actions in
the normal course of business, in which claims for compensatory and punitive
damages are asserted, some for substantial amounts. Some of the pending matters
have been filed as purported class actions and some actions have been filed in
certain jurisdictions that permit punitive damage awards that are
disproportionate to the actual damages incurred. Although there can be no
assurances, at the present time the Company does not anticipate that the
ultimate liability from either pending or threatened legal actions, after
consideration of existing loss provisions, will have a material adverse effect
on the financial condition, operating results or cash flows of the Company.
Nonetheless, given the large or indeterminate amounts sought in certain of these
actions, and the inherent unpredictability of litigation, it is possible that an
adverse outcome in certain matters could, from time to time, have a material
adverse effect on the Company's consolidated results of operations or cash flows
in particular quarterly or annual periods.
In the cases described below, we have disclosed any specific dollar amounts
sought in the complaints. In our experience, such monetary demands bear little
relation to the ultimate loss, if any, to the Company. However, for the reasons
stated above, it is not possible to make meaningful estimates of the amount or
range of loss that could result from some of these matters at this time. The
Company reviews these matters on an ongoing basis and follows the provisions of
Statement of Financial Accounting Standards No. 5, "Accounting for
Contingencies", when making accrual and disclosure decisions. When assessing
reasonably possible and probable outcomes, the Company bases its decisions on
its assessment of the ultimate outcome following all appeals.
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Securities Litigation
After our Predecessor announced its intention to restructure on August 9,
2002, eight purported securities fraud class action lawsuits were filed in the
United States District Court for the Southern District of Indiana. The
complaints named us as a defendant, along with certain of our 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. 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 complaint seeks an unspecified amount of damages. The
plaintiffs have filed a consolidated class action complaint with respect to the
individual defendants. Our liability with respect to this lawsuit was discharged
in our Predecessor's plan of reorganization and our obligation to indemnify
individual defendants who were not serving as an officer or director on the
Effective Date is limited to $3 million in the aggregate under such 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 such plan. A motion to dismiss was filed on behalf of defendants
Shea, Wendt and Chokel. The motion was heard on November 19, 2004, and we await
a ruling. We believe this lawsuit is without merit and intend to defend it
vigorously; however, the ultimate outcome cannot be predicted with certainty.
Our current estimate of the maximum loss that we could reasonably incur on this
case is approximately $3.0 million (based on our obligation to indemnify
individual defendants under our Predecessor's plan of reorganization). We do not
believe that the potential loss related to the individual defendant who served
as an officer on the Effective Date is material.
Other Litigation
The Company and certain subsidiaries, including principally Conseco Life
Insurance Company ("Conseco Life"), have been named in numerous purported class
action and individual lawsuits alleging, among other things, breach of contract,
fraud and misrepresentation with regard to a change made in the way monthly
deductions are calculated for insurance coverage. These cases relate to life
insurance policies sold primarily under the names "Lifestyle" and "Lifetime".
Approximately 86,500 policies were subject to the change. Many of these
nationwide purported class action lawsuits were filed in Federal courts across
the United States. The Judicial Panel on Multidistrict Litigation consolidated
these lawsuits into the case now referred to as In Re Conseco Life Insurance Co.
Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California).
The complaint seeks unspecified compensatory, punitive and exemplary damages and
specifically alleges, among other things, that the change made in the way
monthly deductions are calculated for insurance coverage enabled Conseco, Inc.
to add $360 million to its balance sheet. On April 26, 2005, the Judge issued an
order certifying a nationwide class on the claims for breach of contract and
injunctive relief. On April 27, 2005, the Judge issued an order certifying a
statewide California class for injunctive and restitutionary relief pursuant to
California statute section 17200 and breach of the duty of good faith and fair
dealing, but denied certification on the claims for fraud and intentional
misrepresentation and fraudulent concealment. Other cases now pending include
purported nationwide class actions in Indiana and California state courts. Those
cases filed in Indiana state courts have been consolidated into the case now
referred to as Alene P. Mangelson, et al. v. Conseco Life Insurance Company,
Cause No. 29D01-0403-PL-211 (Superior Court, Hamilton County, Indiana). Those
cases filed in California state courts have been consolidated and are being
coordinated under the new caption Cost of Insurance Cases, Judicial Council
Coordination Proceeding No. 4384 (Judicial Council of California). On January
25, 2005 an Amended Complaint making similar allegations was filed in the case
captioned William Schwartz v. Jeffrey Landerman, Diann P. Urbanek, Metro
Insurance, Inc., Samuels Jacky Insurance Agency, Conseco Life Insurance Company,
Successor to Philadelphia Life Insurance Company, Case no. GD 00-011432 (Court
of Common Pleas, Allegheny County, Pennsylvania). Additionally, Schwartz filed a
purported nationwide class action captioned William Schwartz and Rebecca R.
Frankel, Trustee of the Robert M. Frankel Irrevocable Insurance Trust v. Conseco
Life Ins. Co. et al., Case No. GD 05-3742 (Court of Common Pleas, Allegheny
County, Pennsylvania). We believe these lawsuits 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 purportedly on
behalf of 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
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Indiana against our Predecessor, our subsidiary Conseco Services, LLC ("Conseco
Services") 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 complaint seeks an
unspecified amount of damages. 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 reached a tentative settlement with the Russell
plaintiffs for $10 million in February 2005, subject to the negotiation of a
final settlement agreement. The proposed class action settlement must also be
approved by the district court after a fairness hearing is conducted. We have
established a liability of $10 million for the cost of the tentative settlement.
The Company will pursue recovery of any settlement in the Russell matter,
from its fiduciary insurance carrier, RLI Insurance Company ("RLI"). However, on
February 13, 2004, RLI filed a declaratory judgment action asking the court to
find no liability under its policy for the claims made in the Russell matter due
to certain releases provided to them pursuant to RLI's agreement to settle a
case involving the Predecessor related to a different policy coverage, RLI
Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No.
1:04-CV-0310DFH-TAB (Southern District, Indiana). On March 15, 2004, RLI filed
an amended complaint adding Conseco Services as an additional defendant. On
March 30, 2004, RLI filed a second amended complaint adding certain individual
plan fiduciaries as defendants. On May 24, 2004, we filed our answer to the
second amended complaint and counterclaims for declaratory judgment and breach
of contract. On September 2, 2004, RLI filed a motion for judgment on all
counterclaims. The court has stayed this matter until the Russell matter is
resolved. We believe RLI's position is without merit because the previous
release is not applicable to the Russell matter. We plan to vigorously pursue
all claims against RLI, but the ultimate outcome of the lawsuit cannot be
predicted with certainty. We expect to ultimately recover a substantial portion
of the $10 million we expect to pay in settlement of the Russell matter from
RLI.
On July 9, 1999, a complaint was filed in the Supreme Court of the State of
New York, County of New York, PRG Planning & Development, LLC v. LateNite Magic,
Inc., Daurio & Russo & Sons Construction Co., Inc., Specialized Audio Visual,
Inc., Farmore Realty, Inc. f/k/a Sweetheart Theatres, Inc., The City of New York
and the State of New York Cause No: 114077/99. The complaint seeks damages in
the amount of $3.9 million with interest thereon from January 20, 1998. This is
a lien foreclosure suit that is the result of an April 1996 lease agreement
entered into by LateNite Magic and Farmore Realty, Inc. to develop a theme
restaurant based on the magic of David Copperfield. A former subsidiary of the
Company, Conseco Variable Insurance Company ("CVIC"), and Conseco Annuity
Assurance Company (now known as Conseco Insurance Company) purchased preferred
stock of LateNite and acquired the right to an assignment of the April 1996
lease. An amended complaint was filed on December 2, 1999 naming CVIC and
Conseco Annuity Assurance Company as co-defendants. The trial in this case
commenced on March 10, 2005. We retained liability for CVIC's involvement in
this litigation in connection with the sale of CVIC. Conseco has established
adequate reserves in the event we are found liable under this lawsuit. The
ultimate outcome of the lawsuit cannot be predicted with certainty.
On February 7, 2003, Conseco Life was named in a purported Texas statewide
class action seeking unspecified damages in the County Court of Cameron County,
Texas, Lawrence Onderdonk and Yolanda Carrizales v. Conseco Life Insurance
Company and Pete Ramirez, III Cause No. 2003-CCL-102-C. On February 12, 2004,
the complaint was amended to allege a purported nationwide class and to name
Conseco Services as an additional defendant. On March 5, 2004, the complaint was
amended a second time naming additional plaintiffs. 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 alleged, among other things, civil
conspiracy to convert the accumulated cash values of the plaintiffs and the
class, and the violation of insurance laws nationwide. The parties have reached
a settlement agreement on a class wide basis which requires a payment which had
been accrued at March 31, 2005. On October 14, 2004, the judge signed an order
preliminarily approving the settlement. The hearing for final approval was held
January 31, 2005 and the final order approving class settlement became effective
March 31, 2005.
On December 10, 2004, an arbitration award was issued by the American
Arbitration Association finding for American Worldwide Insurance, Inc. ("AWI")
and Todd Green ("Green"), individually, and against Conseco Life. The arbitrated
dispute arises from a marketing agreement initially entered into in 1994. AWI
and Green alleged breach of contract and bad faith and sought $4.3 million
actual damages and unspecified punitive damages. The award resulted in total
actual damages of $2.1 million, as well as future payments of $.9 million due on
September 9, 2005, $.8 million due on September 9, 2006,
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
and $.6 million due on September 9, 2007. The panel also found that AWI and
Green failed to prove that either Conseco Life or Conseco Marketing, LLC acted
in bad faith and refused an award of punitive damages. We have filed an
application in Federal court in the case captioned, Conseco Life Insurance
Company and Conseco Marketing, LLC v. American Worldwide Insurance, Inc. and
Todd Green, Cause No. 1:04-CV-2035-DFH-TAB (Southern District, Indiana)
requesting, among other things, to vacate the arbitration award because it is
contrary to applicable law and order a new arbitration proceeding. AWI and Green
have filed a motion in opposition and a motion to confirm the arbitration award.
The issues were fully briefed in April 2005. Our estimate of the ultimate loss
we may incur in this matter is between $1 million and $4.3 million.
On June 27, 2001, two suits against Conseco Life, both purported nationwide
class actions seeking unspecified compensatory and punitive damages, were
consolidated in the U.S. District Court, Middle District of Florida, In Re PLI
Sales Litigation, Cause No. 01-MDL-1404. The complaint alleges, among other
things, fraudulent sales and a "vanishing premium" scheme. Conseco Life filed a
motion for summary judgment against both named plaintiffs, which motion was
granted in June 2002. Plaintiffs appealed to the 11th Circuit Court of Appeals.
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. Conseco
Life filed a summary judgment motion with respect to the remaining claims. This
summary judgment was denied in February 2004. On April 23, 2004, a similar case
was filed. Harold R. Arthur, individually and as Trustee of the Harold A. Arthur
Revocable Living Trust, on behalf of himself and all others similarly situated
v. Conseco Life Insurance Company, Case no. 6:04-CV-587-ORL-31KRS (U.S. District
Court, Middle District of Florida). The case was consolidated with the PLI Sales
Practices Litigation in May 2004. Conseco Life filed a motion for summary
judgment on all of Plaintiff Arthur's claims and the court took that motion
under advisement on February 10, 2005. Briefing continues on class
certification. If no class is certified and if Plaintiff Arthur's claims are not
summarily adjudicated, trial on the individual claims of both plaintiffs will be
set during the June 2005 trial term. Given the uncertainties regarding the
outcome of these proceedings, we are unable to estimate the possible range of
loss that may result from this pending litigation.
On September 27, 2004, Conseco Life was named in a purported nationwide
class action seeking unspecified compensatory damages in the District Court of
Clark County, Nevada, Emma Gilbertson individually and on behalf of others
similarly situated v. Conseco Life Insurance Company f/k/a Philadelphia Life
Insurance Company, Cause No. A492738, alleging breach of contract pertaining to
notice of premium increases. In April 2005, after Conseco Life filed a motion
for summary judgment, the plaintiffs voluntarily dismissed this matter with
prejudice.
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. Given the uncertainties
regarding the outcome of these proceedings, we are unable to estimate the
possible range of loss that may result from this pending litigation.
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 policyholders paying via premium
modes other than annual. On November 10, 2003, the court denied the plaintiff's
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. Given the
uncertainties regarding the outcome of these proceedings, we are unable to
estimate the possible range of loss that may result from this pending
litigation.
In October 1997, an action was filed against CVIC and general agent Glenn
H. Guffey by nine South Carolina agents, who alleged that they had suffered
losses as a result of defendants' breach of contract, fraud and misleading
conduct relating to the sale of Flex II annuities. In the action, Thomas Allen
et al v. Great American Reserve Insurance Company, Glenn H. Guffey and American
Home Assurance Company, Case Number 29C01-9709-CP751 in the Circuit Court of
Hamilton County, Indiana, plaintiffs claim that Mr. Guffey told them that the
annuities would have no initial administrative fees charged to the owner of the
annuity (when in fact they did) and that as a result, they had been selling the
annuities on that
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
basis. Plaintiffs demanded unspecified compensatory and punitive damages, and
allege that they have lost commissions and renewals and that their business
reputations have been damaged as a result of Mr. Guffey's misrepresentations.
They further contend that CVIC should be held liable as it negligently
supervised Mr. Guffey and knew about his fraudulent conduct. Defendants were
granted a Summary Judgment on February 9, 2000, but plaintiffs appealed the
judgment, and the Indiana Supreme Court overturned it on April 2, 2002. Mr.
Guffey has settled with plaintiffs, and the case against CVIC is now set for a
jury trial commencing July 11, 2005. We retained liability for CVIC's
involvement in this litigation in connection with the sale of CVIC. We believe
this action is without merit, and intend to defend it vigorously. The ultimate
outcome of the action cannot be predicted with certainty.
Collection efforts by the Company and Conseco Services 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.,
James S. Adams, Maxwell E. Bublitz, Ngaire E. Cuneo and David R. Decatur. The
specific lawsuits now pending include: Hilbert v. Conseco, Case No. 03CH 15330
(Circuit Court, Cook County, 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-1701-LJM-VSS (Southern District, Indiana); Stephen
C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026
(Superior Court, Hamilton County, Indiana); Conseco Services v. Adams, Case No.
29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton
County, Indiana); Conseco Services v. Cuneo, et al., Case No.
1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray,
Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County,
Indiana); Conseco Inc. v. Adams, et al., Case No. 04 L 012974 (Circuit Court,
Cook County, Illinois); Conseco Inc. v. Cuneo, et al., Case No. 04 C 7469
(Northern District, Illinois). David Decatur filed for bankruptcy on May 12,
2004, Case No. 04-08772-JKC-11 (Southern District, Indiana). Maxwell E. Bublitz
filed for bankruptcy on May 2, 2005, Case No. 05-08168-7 (Southern District,
Indiana).
On October 20, 2004, the judge in the Conseco Services v. Hilbert case
granted partial final summary judgment in favor of Conseco Services in the
amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of appeal.
We filed an objection to Decatur's bankruptcy on December 9, 2004. The Company
and Conseco Services 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 our Predecessor's plan of reorganization, 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 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 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. At March 31, 2005,
we estimated that approximately $43 million, net of collection costs, of the
remaining amounts due under the loan program will be collected and that $19
million will be paid to the former holders of our Predecessor's trust preferred
securities.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other arbitrations and lawsuits, 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.
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Three months ended
March 31,
-----------------------
2005 2004
---- ----
Cash flows from operating activities:
Net income........................................................................... $ 81.8 $ 72.8
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization and depreciation.................................................... 98.1 106.9
Income taxes..................................................................... 51.3 52.5
Insurance liabilities............................................................ 128.0 78.8
Accrual and amortization of investment income.................................... 34.1 31.1
Deferral of policy acquisition costs............................................. (107.2) (89.8)
Net realized investment gains.................................................... (1.6) (27.1)
Net sales (purchases) of trading securities...................................... 26.1 (1.6)
Other............................................................................