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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ -------
Commission File Number 1-9250
Conseco, Inc.
Indiana No. 35-1468632
------------------------ ------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
- -------------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [x] No [ ]
Shares of common stock outstanding as of August 7, 2002: 346,008,013
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
June 30, December 31,
2002 2001
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost: 2002 - $21,370.3;
2001 - $23,127.8)........................................................................... $20,791.9 $22,347.0
Interest-only securities at fair value (amortized cost: 2002 - $177.9; 2001 - $131.3)......... 207.1 141.7
Equity securities at fair value (cost: 2002 - $233.5; 2001 - $257.3).......................... 213.0 227.0
Mortgage loans................................................................................ 1,378.0 1,228.0
Policy loans.................................................................................. 541.3 635.8
Venture capital investment in AT&T Wireless Services, Inc. (cost: 2002 - $26.8; 2001- $39.0).. 51.2 155.3
Other invested assets ........................................................................ 327.4 292.4
--------- ---------
Total investments......................................................................... 23,509.9 25,027.2
Cash and cash equivalents:
Held by the parent company.................................................................... 203.5 152.2
Held by the parent company in segregated accounts............................................. 55.4 54.7
Held by subsidiaries.......................................................................... 1,210.3 2,853.9
Accrued investment income........................................................................ 691.2 688.6
Finance receivables.............................................................................. 3,080.1 3,810.7
Finance receivables - securitized................................................................ 14,529.7 14,198.5
Cost of policies purchased....................................................................... 1,388.9 1,657.8
Cost of policies produced........................................................................ 2,308.7 2,570.2
Reinsurance receivables.......................................................................... 1,466.9 663.0
Income tax assets................................................................................ 55.2 678.1
Goodwill......................................................................................... 600.0 3,695.4
Assets held in separate accounts and investment trust ........................................... 2,107.9 2,376.3
Cash held in segregated accounts for investors................................................... 446.9 550.2
Cash held in segregated accounts related to servicing agreements and securitization
transactions.................................................................................. 951.9 994.6
Other assets..................................................................................... 2,306.9 1,420.9
-------- ---------
Total assets.............................................................................. $54,913.4 $61,392.3
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements
2
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
June 30, December 31,
2002 2001
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products.............................................................. $15,433.9 $15,787.7
Traditional products..................................................................... 7,929.3 8,172.8
Claims payable and other policyholder funds.............................................. 987.4 1,005.5
Liabilities related to separate accounts and investment trust............................ 2,107.9 2,376.3
Liabilities related to certificates of deposit........................................... 2,037.5 1,790.3
Investor payables.......................................................................... 446.9 550.2
Other liabilities.......................................................................... 2,501.3 1,699.3
Investment borrowings...................................................................... 604.9 2,242.7
Notes payable:
Direct corporate obligations............................................................. 4,012.4 4,087.6
Direct finance obligations:
Master repurchase agreements........................................................... 907.4 1,670.8
Credit facility collateralized by retained interests in securitizations................ 506.3 507.3
Other borrowings....................................................................... 9.6 349.8
Related to securitized finance receivables structured as collateralized borrowings....... 14,977.5 14,484.5
--------- ---------
Total liabilities.................................................................... 52,462.3 54,724.8
--------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts......... 1,918.1 1,914.5
Shareholders' equity:
Preferred stock............................................................................ 501.5 499.6
Common stock and additional paid-in capital (no par value, 1,000,000,000 shares
authorized, shares issued and outstanding: 2002 - 346,006,584; 2001 - 344,743,196)....... 3,499.4 3,484.3
Accumulated other comprehensive loss....................................................... (295.9) (439.0)
Retained earnings (deficit)................................................................ (3,172.0) 1,208.1
--------- ---------
Total shareholders' equity........................................................... 533.0 4,753.0
--------- ---------
Total liabilities and shareholders' equity........................................... $54,913.4 $61,392.3
========= =========
The accompanying notes are an integral part
of the consolidated financial statements
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------- ----------------
2002 2001 2002 2001
---- ---- ---- ----
Revenues:
Insurance policy income............................................................ $ 884.5 $1,023.6 $ 1,841.7 $2,052.8
Net investment income:
Insurance and fee-based segment general account assets........................... 408.0 464.7 825.1 913.3
Finance segment assets........................................................... 553.6 555.4 1,113.9 1,116.8
Equity-indexed and separate account products..................................... (135.0) (44.1) (203.6) (120.1)
Venture capital gain (loss) related to investment in AT&T Wireless Services, Inc. (23.7) 50.5 (100.0) 3.4
Other............................................................................ 3.3 6.7 5.7 17.6
Gain on sale of finance receivables................................................ 10.2 6.7 17.4 15.6
Gain on sale of interest in riverboat.............................................. - - - 192.4
Net realized investment losses .................................................... (260.4) (40.3) (290.8) (153.6)
Impairment charge related to retained interests in securitization transactions..... - (33.8) - (41.7)
Fee revenue and other income....................................................... 81.4 112.9 171.8 228.8
--------- -------- --------- --------
Total revenues................................................................. 1,521.9 2,102.3 3,381.2 4,225.3
--------- -------- --------- --------
Benefits and expenses:
Insurance policy benefits.......................................................... 682.5 900.1 1,477.7 1,775.1
Provision for losses............................................................... 250.3 111.0 448.7 226.7
Interest expense................................................................... 372.7 407.0 741.4 826.0
Amortization....................................................................... 256.7 276.2 452.9 428.7
Other operating costs and expenses................................................. 288.9 352.4 622.3 699.3
Special charges.................................................................... 133.0 16.2 202.5 55.8
--------- -------- ---------- --------
Total benefits and expenses.................................................... 1,984.1 2,062.9 3,945.5 4,011.6
--------- -------- --------- --------
Income (loss) before income taxes, minority interest, extraordinary gain (loss)
and cumulative effect of accounting change.................................. (462.2) 39.4 (564.3) 213.7
Income tax expense (benefit):
Tax expense (benefit) on period income......................................... (160.2) 31.0 (191.6) 89.3
Valuation allowance for deferred tax assets.................................... 1,003.0 - 1,003.0 -
--------- -------- --------- --------
Income (loss) before minority interest, extraordinary gain (loss)
and cumulative effect of accounting change................................... (1,305.0) 8.4 (1,375.7) 124.4
Minority interest:
Distributions on Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts, net of income taxes....................................... 29.2 29.1 58.4 61.3
--------- -------- --------- --------
Income (loss) before extraordinary gain (loss) and cumulative effect of
accounting change............................................................ (1,334.2) (20.7) (1,434.1) 63.1
Extraordinary gain (loss) on extinguishment of debt, net of income taxes.............. 1.1 (5.0) 5.1 (4.7)
Cumulative effect of accounting change for goodwill impairment........................ - - (2,949.2) -
---------- --------- --------- --------
Net income (loss).............................................................. (1,333.1) (25.7) (4,378.2) 58.4
Preferred stock dividends............................................................. .9 4.6 1.9 8.5
--------- -------- --------- --------
Net income (loss) applicable to common stock................................... $(1,334.0) $ (30.3) $(4,380.1) $ 49.9
========= ======== ========= ========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------ -------------------
2002 2001 2002 2001
---- ---- ---- ----
Income (loss) per common share:
Basic:
Weighted average shares outstanding................................... 346,005,000 337,773,000 345,607,000 334,454,000
=========== =========== =========== ===========
Income (loss) before extraordinary gain (loss) and cumulative effect
of accounting change............................................... $(3.86) $(.08) $ (4.15) $ .16
Extraordinary gain (loss) on extinguishment of debt................... - (.01) .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ----- ------- -----
Net income (loss)................................................. $(3.86) $(.09) $(12.67) $. 15
====== ===== ======= =====
Diluted:
Weighted average shares outstanding................................... 346,005,000 337,773,000 345,607,000 350,337,000
=========== =========== =========== ===========
Income (loss) before extraordinary gain (loss) and cumulative effect
of accounting change.............................................. $(3.86) $(.08) $ (4.15) $ .15
Extraordinary gain (loss) on extinguishment of debt................... - (.01) .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ----- ------- -----
Net income (loss)................................................. $(3.86) $(.09) $(12.67) $ .14
====== ===== ======= =====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital loss (deficit)
----- ----- --------------- ---- -------
Balance, January 1, 2002............................. $ 4,753.0 $499.6 $3,484.3 $(439.0) $ 1,208.1
Comprehensive loss, net of tax:
Net loss........................................ (4,378.2) - - - (4,378.2)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $82.4)............................. 143.1 - - 143.1 -
---------
Total comprehensive loss.................... (4,235.1)
Issuance of shares for stock options and for
employee benefit plans.......................... 15.1 - 15.1 - -
Payment-in-kind dividends on convertible
preferred stock................................. 1.9 1.9 - - -
Dividends on preferred stock...................... (1.9) - - - (1.9)
--------- ------ -------- ------- ---------
Balance, June 30, 2002............................... $ 533.0 $501.5 $3,499.4 $(295.9) $(3,172.0)
========= ====== ======== ======= =========
Balance, January 1, 2001............................. $4,374.4 $486.8 $2,911.8 $(651.0) $1,626.8
Comprehensive income, net of tax:
Net income...................................... 58.4 - - - 58.4
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $117.0)............................ 204.6 - - 204.6 -
---------
Total comprehensive income.................. 263.0
Issuance of shares pursuant to stock purchase
contracts related to FELINE PRIDES.............. 496.6 - 496.6 - -
Issuance of shares for stock options and for
employee benefit plans.......................... 15.5 - 15.5 - -
Payment-in-kind dividends on convertible
preferred stock................................. 8.5 8.5 - - -
Dividends on preferred stock...................... (8.5) - - - (8.5)
--------- ------ -------- ------- --------
Balance, June 30, 2001............................... $ 5,149.5 $495.3 $3,423.9 $(446.4) $1,676.7
========= ====== ======== ======= ========
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Six months ended
June 30,
-------------------
2002 2001
---- ----
Cash flows from operating activities:
Insurance policy income....................................................................... $ 1,557.9 $ 1,775.6
Net investment income......................................................................... 1,837.1 1,953.4
Fee revenue and other income.................................................................. 158.3 214.8
Insurance policy benefits..................................................................... (1,261.4) (1,396.7)
Interest expense.............................................................................. (726.4) (812.3)
Policy acquisition costs...................................................................... (271.0) (354.1)
Special charges............................................................................... (33.3) (11.8)
Other operating costs......................................................................... (669.4) (777.5)
Taxes......................................................................................... (114.5) (85.4)
---------- -----------
Net cash provided by operating activities................................................... 477.3 506.0
---------- -----------
Cash flows from investing activities:
Sales of investments.......................................................................... 11,498.9 10,301.4
Maturities and redemptions of investments..................................................... 766.8 559.0
Purchases of investments...................................................................... (11,764.7) (10,643.1)
Cash received from the sale of finance receivables, net of expenses........................... 619.6 683.6
Principal payments received on finance receivables............................................ 4,323.7 4,047.0
Finance receivables originated................................................................ (4,423.0) (6,072.5)
Other......................................................................................... (105.0) (83.9)
---------- -----------
Net cash provided (used) by investing activities ........................................... 916.3 (1,208.5)
---------- -----------
Cash flows from financing activities:
Amounts received for deposit products......................................................... 2,304.2 1,943.7
Withdrawals from deposit products............................................................. (2,537.2) (2,245.5)
Issuance of notes payable..................................................................... 4,259.6 6,185.5
Payments on notes payable..................................................................... (5,434.7) (5,970.2)
Ceding commission received on reinsurance transaction......................................... 83.0 -
Change in cash held in restricted accounts for settlement of borrowings....................... 34.5 (4.8)
Investment borrowings......................................................................... (1,637.8) 819.0
Issuance of common and convertible preferred shares........................................... - 4.1
Dividends on preferred shares and distributions on Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts............................ (56.8) (65.6)
---------- -----------
Net cash provided (used) by financing activities.......................................... (2,985.2) 666.2
---------- -----------
Net decrease in cash and cash equivalents................................................. (1,591.6) (36.3)
Cash and cash equivalents, beginning of period................................................... 3,060.8 1,663.6
---------- -----------
Cash and cash equivalents, end of period......................................................... $ 1,469.2 $ 1,627.3
========== ===========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2001 Form 10-K of Conseco,
Inc. ("we", "Conseco" or the "Company").
Conseco is a financial services holding company with subsidiaries operating
throughout the United States. Our insurance subsidiaries develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. Conseco Finance Corp. ("Conseco Finance"), a wholly
owned subsidiary of Conseco, originates, securitizes and services manufactured
housing, home equity, home improvement, retail credit, consumer finance and
floorplan loans. Conseco's operating strategy is to grow its business by
focusing its resources on the development and expansion of profitable products
and strong distribution channels, to seek to achieve superior investment returns
through active asset management and to control expenses.
During 2001, we began the process of non-renewing our major medical lines
of business. These lines of business are referred to herein as the "discontinued
major medical business."
LIQUIDITY ISSUES
As we announced on August 9, 2002, the Company did not make its August 2002
interest payments on its 6.4 percent senior and guaranteed senior notes due in
2003 and 2004 and 8.75 percent senior and guaranteed senior notes due in 2004
and 2006. The failure to make the interest payments on these notes within the
30-day grace period constitutes a default under the notes. If the Company does
not cure the non-payment of interest within 30 days of their occurrence, an
event of default will occur which will give the holders of the notes the right
to accelerate the maturity of all principal and past due interest, which
aggregated $1.1 billion on August 9, 2002. If the maturity of these notes is
accelerated, we would be unable to satisfy these obligations.
The Company is not in compliance with the debt to capitalization ratio we
agreed to maintain pursuant to our bank credit agreement and the guarantees of
bank loans to current and former directors, officers and key employees to
purchase shares of the Company's common stock (the "D&O loans"). We have
received from the relevant lenders a waiver of the covenant violation effective
as of June 30, 2002 through September 9, 2002. The debt to capitalization ratio
is defined as: (1) the sum of (i) the principal amount of all of our
indebtedness, (ii) accrued, unpaid interest and (iii) accrued, unpaid dividends
on Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts; divided by (2) our total capitalization, as defined. This ratio must not
exceed 0.400 to 1.0 as of June 30, 2002 and 0.375 to 1.0 as of September 30,
2002. The ratio was 0.406 to 1.0 as of June 30, 2002. If we are not able to
extend the covenant waiver, the covenant violation gives the lenders the right
to declare all borrowings under the credit agreement and guarantees due and
payable. The aggregate balance due under this facility, including unpaid
interest, was approximately $1.5 billion on August 9, 2002. If the maturity of
the bank debt is accelerated, we would be unable to satisfy these obligations.
If an uncured event of default occurs with respect to a series of notes, it
could result in the acceleration of and immediate maturity of all of our notes
and our credit facility and the guarantees of the D&O loans through
cross-acceleration and cross-default provisions contained in the governing
instruments. At June 30, 2002, such indebtedness totaled $4.6 billion. We would
be unable to satisfy all of our obligations then due and payable under the
credit facility, the guarantee related to the D&O loans and the senior notes.
On August 9, 2002, we announced that, in addition to exercising the 30 day
grace period on bond interest payments as described above, we have engaged
financial and legal advisors to begin discussions with our debt holders with a
goal of restructuring the capital of the parent company. We cannot predict
whether any restructuring will be effected out-of-court or through a Chapter 11
bankruptcy proceeding, nor can we predict how long any restructuring of our debt
will be required to
8
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
implement. If we are unable to achieve a consensual restructuring, we will be
unable to satisfy all of our debt obligations and we will be forced to petition
for relief under the U.S. Bankruptcy Code.
As more fully described in "Liquidity for finance operations" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", absent the waiver, a violation by the Company of the debt to
capitalization ratio covenant under its bank credit agreements would result in
cross-defaults under certain repurchase and other credit facilities utilized by
the finance subsidiary to finance loan inventory and daily operations. We have
received from the relevant lenders a waiver of the covenant violation effective
as of June 30, 2002 through September 9, 2002. These facilities are secured with
finance receivables, retained interests in securitizations and other assets. The
aggregate outstanding balance of these master repurchase agreements and other
facilities was $1.4 billion as of June 30, 2002. The repurchase facilities are
commonly referred to as warehouse facilities. Upon the occurrence of an event
of default under these warehouse facilities, the parties that provide this
financing may exercise various remedies, which vary among the facilities and
include retaining income generated by the financed loans, affecting a permanent
purchase of the financed loans, accelerating repayment of outstanding amounts
and reducing the size of or terminating the facility. The exercise of these
rights by one or more of the providers of these credit facilities would cross
default other credit facilities and would thereupon entitle certain other
warehouse lenders to declare an event of default under their respective credit
facilities and accelerate their respective indebtedness. The finance subsidiary
would pursue waivers in the event that a default occurs (if Conseco is
unsuccessful in extending its waiver of the debt to capitalization ratio
covenant). There can be no assurance that we can obtain such waivers and as such
any exercise of their rights by these providers would have a material adverse
effect on the ability of the finance subsidiary to finance its loan inventory
and to originate new loans. The recent adverse developments concerning the
parent company's liquidity have adversely affected the cost at which our finance
subsidiary can obtain funding in the securitization market and may adversely
affect our access to this market. In addition, our finance subsidiary lenders
have reduced and/or restricted access to available funding facilities. There can
be no assurance that our finance subsidiary will be able to continue to make new
loans and fund its operations.
As more fully described in "Liquidity for insurance and fee-based
operations" within "Management's Discussion and Analysis of Financial Condition
and Results of Operations", our insurance subsidiaries claim-paying ratings were
downgraded by A.M. Best on July 12, 2002 to B++ and the ratings remain "under
review with negative implications". We believe that A.M. Best will soon lower
this rating. The downgrade may cause sales of our insurance products to fall and
policyholder redemptions and lapses to increase. If such activity was unusually
high, it could cause a material adverse impact on our financial results and
liquidity. Also, the recent adverse developments concerning the parent company's
liquidity will make obtaining approvals for dividends from insurance regulatory
authorities more difficult in the future, if we request such approvals.
The accompanying consolidated financial statements have been prepared on a
going concern basis, which assumes continuity of operations and realization of
assets and satisfaction of liabilities in the ordinary course of business. The
financial statements do not include any adjustments that might result from the
outcome of the uncertainties summarized above.
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly Conseco's financial position
and results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2002 presentation. These reclassifications
have no effect on net income or shareholders' equity. Results for interim
periods are not necessarily indicative of the results that may be expected for a
full year.
As described in the note to the consolidated financial statements entitled
"Cumulative Effect of Accounting Change", the Company has completed the goodwill
impairment test required by Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142") and has recorded the
cumulative effect of the accounting change of $2,949.2 million. Pursuant to the
transitional rules of SFAS 142, such effect is reflected in the consolidated
financial statements for the quarter ended March 31, 2002. Accordingly, the
consolidated financial statements of the Company as of March 31, 2002 and for
the three months then ended have been restated to reflect the change.
9
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect various
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions in calculating values for the cost of policies produced, the
cost of policies purchased, interest-only securities, certain investments,
servicing rights, goodwill, liabilities for insurance and asset accumulation
products, liabilities related to litigation, guaranty fund assessment accruals,
liabilities related to guarantees of securitized debt issued in conjunction with
certain sales of finance receivables and liabilities related to guarantees of
bank loans and the related interest loans to certain current and former
directors, officers and key employees, gain on sale of finance receivables,
allowance for credit losses on finance receivables and the reliance on
generating adequate future taxable income to support deferred income tax assets.
If our future experience differs from these estimates and assumptions, our
financial statements could be materially affected.
The accompanying financial statements include the accounts of the Company
and all of its wholly-owned subsidiaries. Our consolidated financial statements
exclude the results of material transactions between us and our consolidated
affiliates, or among our consolidated affiliates.
We follow the requirements of Statement of Financial Accounting Standards
No. 140, "Accounting for the Transfer and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 140") and related authoritative guidance
in determining whether the special purpose entities formed in conjunction with
the securitization of the finance receivables we originate and the
securitization of certain investment portfolios are consolidated. Subsequent to
September 8, 1999, we have structured the securitizations in a manner that
requires the special purpose entities to be consolidated. See "Revenue
Recognition for Sales of Finance Receivables and Amortization of Servicing
Rights." For certain other special purpose entities related to our investment
portfolio, we consider the requirements of EITF Topic D-14 in determining
whether to consolidate such entities. We consolidate such entities if: (i) an
independent third party has not made a substantial capital investment in the
entity; (ii) such independent third party does not control the activities of the
entity; and (iii) the independent party does not retain substantial risks and
rewards of the special purpose entity's assets.
10
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
The FASB issued SFAS 142, in June 2001. Under the new rule, intangible
assets with an indefinite life are no longer amortized in periods subsequent to
December 31, 2001, but are subject to annual impairment tests (or more frequent
under certain circumstances), effective January 1, 2002. The Company has
determined that all of its goodwill has an indefinite life and is therefore
subject to the new rules.
Pursuant to SFAS 142, the goodwill impairment test has two steps. The first
step was required to be completed by June 30, 2002 and the second step, if
necessary, was required to be completed by December 31, 2002. Any resulting
impairment is required under SFAS 142 to be recorded in the quarter ended March
31, 2002. For Conseco, the first step consisted of comparing the estimated fair
value of each of the business units comprising our insurance segment to the
unit's book value. Since all of our goodwill relates to the insurance segment
(which is also a reportable segment), the goodwill impairment test is not
relevant to the finance business. If the estimated fair value exceeds the book
value, the test is complete and goodwill is not impaired. If the fair value is
less than the book value, the second step of the impairment test must be
performed, which compares the implied fair value of the applicable business
unit's goodwill with the book value of that goodwill to measure the amount of
goodwill impairment, if any.
Pursuant to the transitional rules of SFAS 142, we have completed the
two-step impairment test during the second quarter of 2002 and, as a result of
that test, we recorded the cumulative effect of the accounting change for the
goodwill impairment charge of $2,949.2 million for the quarter ended March 31,
2002. The first quarter of 2002 impairment charge is reflected in cumulative
effect of an accounting change in the accompanying consolidated statement of
operations for the six months ended June 30, 2002, and the consolidated
financial statements for the quarter ended March 31, 2002 have been
retroactively restated. Subsequent impairment tests will be performed on an
annual basis in the fourth quarter of each year, or more frequently if
circumstances indicate a possible impairment. Subsequent impairment charges, if
any, would be classified as an operating expense.
The significant factors used to determine the amount of the impairment
included analyses of industry market valuations, historical and projected
performance of our insurance segment, discounted cash flow analyses and the
market value of our capital. The valuation utilized the best available
information, including assumptions and projections we considered reasonable and
supportable. The assumptions we used to determine the discounted cash flows
involve significant judgments regarding the best estimate of future premiums,
expected mortality and morbidity, interest earned and credited rates,
persistency and expenses. The discount rate used was based on an analysis of the
weighted average cost of capital for several insurance companies and considered
the specific risk factors related to Conseco. Pursuant to the guidance in SFAS
142, quoted market prices in active markets are the best evidence of fair value
and shall be used as the basis for measurement, if available. Management
believes that the assumptions and estimates used are reasonable given all
available facts and circumstances. However, if projected cash flows are not
realized in the future, we may be required to recognize additional impairments.
Prior to the adoption of SFAS 142, we determined whether goodwill was
recoverable from projected undiscounted net cash flows for the earnings of our
subsidiaries over the remaining amortization period. If we determined that
undiscounted projected cash flows were not sufficient to recover the goodwill
balance, we would reduce its carrying value with a corresponding charge to
expense or shorten the amortization period. Cash flows considered in such an
analysis were those of the business acquired, if separately identifiable, or the
product line that acquired the business, if such earnings were not separately
identifiable.
11
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Changes in the carrying amount of goodwill for the six months ended June
30, 2002 and 2001, are as follows:
Six months ended
June 30,
----------------
2002 2001
---- ----
Goodwill balance, beginning of period....................................... $ 3,695.4 $3,800.8
Amortization expense........................................................ - (54.9)
Impairment charge........................................................... (2,949.2) -
Reduction of tax valuation contingencies established at acquisition date
for acquired companies.................................................. (146.2) -
Goodwill related to businesses sold......................................... - (35.8)
--------- --------
Goodwill balance, end of period............................................. $ 600.0 $3,710.1
========= ========
12
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
In accordance with SFAS 142, we discontinued the amortization of goodwill
expense effective January 1, 2002. The following information summarizes the
impact of goodwill amortization on income before extraordinary charge, net
income and the respective earnings per share amounts for the periods presented
in our consolidated statement of operations:
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions, except per share data)
Reported income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(1,334.2) $(20.7) $(1,434.1) $ 63.1
Add back: goodwill amortization............................... - 28.4 - 54.9
--------- ------ --------- -------
Adjusted income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(1,334.2) $ 7.7 $(1,434.1) $ 118.0
========= ====== ========= =======
Reported net income (loss) applicable to common stock........... $(1,333.1) $(30.3) $(4,378.2) $ 49.9
Add back: goodwill amortization................................ - 28.4 - 54.9
--------- ------ --------- -------
Adjusted net income (loss) applicable to common stock........... $(1,333.1) $(1.9) $(4,378.2)(a) $ 104.8
========= ===== ========= =======
Basic earnings per share:
Reported income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(3.86) $(.08) $ (4.15) $.16
Add back: goodwill amortization................................ - .08 - .17
------ ----- ------- ----
Adjusted income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change...................... $(3.86) $ - $ (4.15) $.33
====== ===== ======== ====
Reported net income (loss) applicable to common stock........... $(3.86) $(.09) $(12.67) $.15
Add back: goodwill amortization................................ - .08 - .17
------ ----- ------- ----
Adjusted net income (loss) applicable to common stock........... $(3.86) $(.01) $(12.67) $.32
====== ===== ======= ====
Diluted earnings per share:
Reported income (loss) before extraordinary gain (loss)
and cumulative effect of accounting change.................. $(3.86) $(.08) $ (4.15) $.15
Add back: goodwill amortization............................... - .08 - .16
------ ----- ------- ----
Adjusted income (loss) before extraordinary gain (loss)
and cumulative effect of accounting change.................. $(3.86) $ - $ (4.15) $.31
====== ===== ======= ====
Reported net income (loss) applicable to common stock........... $(3.86) $(.09) $(12.67) $.14
Add back: goodwill amortization................................ - .08 - .16
------ ----- ------- ----
Adjusted net income (loss) applicable to common stock........... $(3.86) $(.01) $(12.67) $.30
====== ===== ======= ====
- ------------------
(a) Adjusted net income for the six months ended June 30, 2002, includes
the cumulative effect of the accounting change for goodwill impairment of
$2,949.2 million.
13
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following summarizes the effect of the goodwill impairment charge on
our results of operations for the three months ended March 31, 2002 (dollars in
millions, except per share data):
Net loss, applicable to common stock as reported................ $ (96.9)
Cumulative effect of accounting change.......................... (2,949.2)
---------
Net loss, as adjusted........................................... $(3,046.1)
=========
Net loss per common share:
Basic:
Net loss, as reported..................................... $ (.28)
Cumulative effect of accounting change.................... (8.54)
------
Net loss, as adjusted..................................... $(8.82)
======
Diluted:
Net loss, as reported..................................... $ (.28)
Cumulative effect of accounting change.................... (8.54)
------
Net loss, as adjusted..................................... $(8.82)
======
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value); (ii) "trading"
(which we carry at estimated fair value); and (iii) "held to maturity" (which we
carry at amortized cost). We had no fixed maturity securities in the "trading"
or "held to maturity" categories at June 30, 2002.
Accumulated other comprehensive loss is primarily comprised of unrealized
losses on actively managed fixed maturity investments. Such amounts, included in
shareholders' equity as of June 30, 2002, and December 31, 2001, were as
follows:
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Unrealized losses on investments...................................................... $(524.5) $(816.0)
Adjustments to cost of policies purchased and cost of policies produced............... 67.9 133.9
Deferred income tax benefit........................................................... 167.2 249.6
Other................................................................................. (6.5) (6.5)
------- -------
Accumulated other comprehensive loss............................................. $(295.9) $(439.0)
======= =======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
At December 31, 2001, our venture capital investments consisted of 12.6
million shares of TeleCorp PCS, Inc. ("TeleCorp") a company in the wireless
communication business. In the first quarter of 2002, AT&T Wireless Services,
Inc. ("AWE") acquired TeleCorp. Pursuant to the merger agreement, our shares of
TeleCorp were converted into 11.4 million shares of AWE. Upon the completion of
the merger, there were no restrictions on our ability to sell our interest in
AWE. In the second quarter of 2002, Conseco sold 7.7 million shares of AWE
generating net proceeds of $61.3 million. Our investment in AWE is carried at
estimated fair value, with changes in fair value recognized as investment income
(loss). The Company currently intends to sell its remaining holdings of AWE
common stock.
During the fourth quarter of 2001, the parent company transferred 4.6
million shares of TeleCorp common stock to certain investment trusts. Conseco's
insurance subsidiaries hold substantially all of the economic interests in the
trusts. Pursuant to
14
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
SFAS 140 and other authoritative guidance, the transfer of the shares to the
trust is not a sale and the accounts of the trusts are consolidated with the
accounts of the Company. The parent company received cash of $60.3 million (the
market value of the shares on the date of transfer) in exchange for the shares
transferred to the trusts. After the transfer of the common shares, Conseco
continues to recognize in its consolidated financial statements the change in
the market value of the common shares, with changes in fair value recognized as
investment income (loss).
At June 30, 2002, our holdings of AWE common stock included: 2.7 million
shares valued at $15.1 million (all of which were sold in July 2002 generating
net proceeds of $14.4 million); 4.1 million shares valued at $23.6 million which
are held in the investment trusts described in the previous paragraph; and 1.0
million shares valued at $5.9 million which are held as collateral for a $12.4
million investment borrowing transaction and are subject to a forward sale
contract pursuant to which the Company has agreed to sell between .6 million and
1.0 million shares of AWE common stock for $15.5 million on November 15, 2006.
The number of shares purchased will be based on the $15.5 million purchase price
and the price of AWE common stock at the purchase date. However, such price will
be no lower than $14.9862 per share and no higher than $24.3527 per share
pursuant to the terms of the forward sale contract.
The forward contract is a derivative that is required to be
marked-to-market each period. Since the hedged asset (i.e., a portion of the
shares of AWE which we own) is required to be carried at market value, the hedge
rules of SFAS 133 (as defined under the caption "Accounting for Derivatives")
are not applicable. However, since the value of the derivative will fluctuate in
relation to the change in value of the related AWE common stock, we expect the
forward contract to act as a hedge and reduce earnings volatility associated
with the AWE common stock. At June 30, 2002, the value of the derivative was
$6.5 million. The market values of AWE and many other companies in AWE's
business sector have declined significantly in recent periods. We recognized
venture capital investment gains (losses) of $(23.7) million and $50.5 million
in the second quarters of 2002 and 2001, respectively, related to this
investment. Such venture capital investment gains (losses) were $(100.0) million
and $3.4 million in the first six months of 2002 and 2001, respectively.
FINANCE RECEIVABLES AND RETAINED INTERESTS IN SECURITIZATION TRUSTS
During the first six months of 2002, we completed five securitization
transactions, securitizing $2.3 billion of finance receivables. These
securitizations were structured in a manner that requires them to be accounted
for as secured borrowings, whereby the loans and securitization debt remain on
our balance sheet, rather than as sales, pursuant to SFAS 140. Such accounting
method is referred to as the "portfolio method".
We classify the finance receivables transferred to the securitization
trusts and held as collateral for the notes issued to investors as "finance
receivables-securitized." The average interest rate earned on these receivables
at June 30, 2002, was approximately 12.5 percent. We classify the notes issued
to investors in the securitization trusts as "notes payable related to
securitized finance receivables structured as collateralized borrowings."
We also completed various loan sale transactions. During the first six
months of 2002, we sold $.3 billion of finance receivables which generated net
gains of $17.4 million. We also recognized a loss of $47.3 million related to
the sale of $.4 billion of certain finance receivables sold as part of our cash
raising initiatives in order to meet our debt obligations. See "Special Charges"
elsewhere in the notes to the consolidated financial statements. In the first
six months of 2001, we sold $1.5 billion of receivables including: (i) our
$802.3 million vendor services loan portfolio (which was marked-to-market in the
fourth quarter of 2000 and no additional gain or loss was recognized in the
first six months of 2001); (ii) $568.4 million of high-loan-to-value mortgage
loans; and (iii) $96.4 million of other loans. These sales resulted in net gains
of $15.6 million in the first six months of 2001. The Company entered into a
servicing agreement on the high-loan-to-value mortgage loans sold. Pursuant to
the servicing agreement, the servicing fees payable to the Company are senior to
all other payments of the trust which purchased the loans. The Company also
holds a residual interest in certain other cash flows of the trust. The Company
did not provide any guarantees with respect to the performance of the loans
sold.
15
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following table summarizes our finance receivables - securitized by
business line (there were no such finance receivables related to discontinued
lines):
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................... $ 7,516.7 $ 6,940.4
Mortgage services.................................................................. 5,749.0 5,658.2
Retail credit...................................................................... 818.0 878.9
Consumer finance - closed-end...................................................... 486.5 580.8
Floorplan.......................................................................... 316.3 436.9
--------- ---------
14,886.5 14,495.2
Less allowance for credit losses................................................... 356.8 296.7
--------- ---------
Total finance receivables - securitized.......................................... $14,529.7 $14,198.5
========= =========
16
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following table summarizes our other finance receivables by business
line and categorized as either: (i) a part of our continuing lines; or (ii) a
part of our discontinued lines:
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................... $ 215.4 $ 609.3
Mortgage services.................................................................. 860.4 1,128.9
Retail credit...................................................................... 1,931.5 1,811.1
Consumer finance - closed-end...................................................... 8.6 6.3
-------- --------
3,015.9 3,555.6
Less allowance for credit losses................................................... 102.9 111.6
-------- --------
Net other finance receivables for continuing lines............................... 2,913.0 3,444.0
-------- --------
Discontinued lines.................................................................... 173.8 379.7
Less allowance for credit losses................................................... 6.7 13.0
-------- --------
Net other finance receivables for discontinued lines............................. 167.1 366.7
-------- --------
Total other finance receivables.................................................. $3,080.1 $3,810.7
======== ========
The changes in the allowance for credit losses included in finance
receivables (both securitized and other portfolios) were as follows:
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Allowance for credit losses, beginning of period................ $439.9 $ 312.1 $ 421.3 $ 306.8
Additions to the allowance:
Provision for losses......................................... 158.3 111.0 316.7 226.7
Change in allowance due to purchases and sales of certain
finance receivables........................................ 1.6 2.9 3.9 (5.5)
Credit losses................................................... (133.4) (107.8) (275.5) (209.8)
------ ------- ------- -------
Allowance for credit losses, end of period...................... $466.4 $ 318.2 $ 466.4 $ 318.2
====== ======= ======= =======
The securitizations structured prior to September 8, 1999, met the
applicable criteria to be accounted for as sales. At the time the loans were
securitized and sold, we recognized a gain and recorded our retained interest
represented by the interest-only security. The interest-only security represents
the right to receive, over the life of the pool of receivables: (i) the excess
of the principal and interest received on the receivables transferred to the
special purpose entity over the principal and interest paid to the holders of
other interests in the securitization; and (ii) contractual servicing fees. In
some of those securitizations, we also retained certain lower-rated securities
that are senior in payment priority to the interest-only securities. Such
retained securities (classified as actively managed fixed maturity securities)
had a par value, fair value and amortized cost of $733.9 million, $511.6 million
and $687.8 million, respectively, at June 30, 2002.
17
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The interest-only securities on our balance sheet represent an allocated
portion of the cost basis of the finance receivables in the securitization
transactions accounted for as sales related to transactions structured prior to
September 8, 1999. Our interest-only securities and other retained interests in
those securitization transactions are subordinate to the interests of other
investors. Their values are subject to credit, prepayment, and interest rate
risk on the securitized finance receivables. We determine the discount rate to
value these securities based on our estimates of current market rates of
interest for securities with similar yield, credit quality and maturity
characteristics. We include the difference between estimated fair value and the
amortized cost of the interest-only securities (after adjustments for
impairments required to be recognized in earnings) in "accumulated other
comprehensive loss, net of taxes." We used the following assumptions to adjust
the amortized cost to estimated fair value at June 30, 2002 and December 31,
2001. If actual performance differs from these assumptions, we may be required
to recognize additional impairment charges related to the value of our
interest-only securities and servicing rights.
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
June 30, 2002 housing home improvement equipment Total others Conseco
- ------------- ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Interest-only securities at fair value............ $ 116.0 $ 141.6 $ 7.8 $ 265.4 $(58.3) $207.1
Cumulative principal balance of sold finance
receivables at June 30, 2002................... 16,481.7 4,099.2 966.4 21,547.3
Weighted average stated customer interest rate
on sold finance receivables.................... 9.8% 11.9% 10.5%
Assumptions to determine estimated fair value
of interest-only securities at June 30, 2002:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a)............................ 7.1% 16.5% 18.4%
Expected nondiscounted credit losses as a
percentage of principal balance of
related finance receivables (a)............ 11.3% 7.1% 6.0%
Weighted average discount rate .............. 16.0% 16.0% 16.0%
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
December 31, 2001 housing home improvement equipment Total others Conseco
- ----------------- ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Interest-only securities at fair value............ $ 32.3 $ 155.8 $ 8.8 $ 196.9 $(55.2) $141.7
Cumulative principal balance of sold finance
receivables at December 31, 2001............... 17,732.2 4,947.4 1,210.1 23,889.7
Weighted average stated customer interest rate on
sold finance receivables....................... 9.8% 12.0% 10.6%
Assumptions to determine estimated fair value of
interest-only securities at December 31, 2001:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a)............................ 7.1% 17.4% 18.8%
Expected nondiscounted credit losses as a
percentage of principal balance of related
finance receivables (a).................... 11.7% 7.4% 6.1%
Weighted average discount rate............... 16.0% 16.0% 16.0%
18
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
(a) The valuation of interest-only securities is affected not only by the
projected level of prepayments of principal and net credit losses, but also
by the projected timing of such prepayments and net credit losses. Should
such timing differ materially from our projections, it could have a
material effect on the valuation of our interest-only securities.
Additionally, such valuation is determined by discounting cash flows over
the entire expected life of the receivables sold.
Under current accounting rules (pursuant to EITF Issue No. 99-20
"Recognition of Interest Income and Impairments on Purchased and Retained
Beneficial Interests in Securitized Financial Assets" (" EITF 99-20")) which we
adopted effective July 1, 2000, declines in the value of our interest-only
securities are recognized when: (i) the fair value of the retained beneficial
interests are less than their carrying value; and (ii) the timing and/or amount
of cash expected to be received from the retained beneficial interests have
changed adversely from the previous valuation which determined the carrying
value of the retained beneficial interests. When both occur, the retained
beneficial interests are written down to fair value.
We recognized an impairment charge (net of adjustments to the valuation
allowance associated with our servicing rights) of $41.7 million in the first
six months of 2001 for the interest-only securities that were not performing as
well as expected based on our previous valuation estimates. No such impairment
charge was recognized in the first six months of 2002.
The following table summarizes certain cash flows received from and paid to
the securitization trusts during the three and six month periods ended June 30,
2002 and 2001 (dollars in millions):
Three months Six months
ended June 30, ended June 30,
---------------- --------------
2002 2001 2002 2001
---- ---- ---- ----
Servicing fees received................................................. $ 10.8 $17.9 $ 22.6 $ 42.4
Cash flows from interest-only securities, net........................... (31.3) 1.8 (30.5) 7.9
Cash flows from retained bonds.......................................... 28.0 17.4 52.6 34.9
Servicing advances paid................................................. (69.1) (195.4) (155.4) (399.9)
Repayment of servicing advances......................................... 65.7 193.1 148.8 388.0
We have projected that the adverse manufactured housing default experience
in 2001 and the first half of 2002 will improve over time beginning in the third
quarter of 2002. As a result of these assumptions, we project that payments
related to guarantees issued in conjunction with the sales of certain finance
receivables will exceed the gross cash flows from the interest-only securities
by approximately $55 million during the remainder of 2002 and $65 million in
2003. We project the gross cash flows from the interest-only securities will
exceed the payments related to guarantees issued in conjunction with the sales
of certain finance receivables by approximately $5 million in 2004 and $15
million in 2005 and by approximately $530 million in all years thereafter. These
projected payments are considered in the projected cash flows we use to value
our interest-only securities. There can be no assurance that we will have
adequate liquidity to make such guarantee payments.
Effective September 30, 2001, we transferred substantially all of our
interest-only securities into a securitization trust. The transaction provided a
means to finance a portion of the value of our interest-only securities by
selling some of the cash flows to Lehman Brothers, Inc. and affiliates
(collectively "Lehman"). The transfer was accounted for as a sale in accordance
with SFAS 140. However, no gain or loss was recognized because the aggregate
fair value of the interest retained by the Company and the cash received from
the sale were equal to the carrying value of the interest-only securities prior
to their transfer to the trust. The trust is a special purpose entity and is not
consolidated pursuant to SFAS 140. We received a trust security representing an
interest in the trust equal to 85 percent of the estimated future cash flows of
the interest-only securities held in the trust. Lehman purchased the remaining
15 percent interest. The value of the interest purchased by Lehman was $58.3
million at June 30, 2002. The Company continues to be the servicer of the
finance receivables underlying the interest-only securities transferred to the
trust. Lehman has the ability to accelerate the principal payments related to
their interest after a stated period. Until such time, Lehman is required to
maintain a 15 percent interest in the estimated future cash flows of the trust.
By aggregating the interest-only securities into one structure, the impairment
test for these securities are conducted on a single set of cash flows
representing the Company's 85 percent interest in the trust. Accordingly,
adverse changes in cash flows from one interest-only security are offset by
positive changes in another. The new structure does not avoid an
19
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
impairment charge if sufficient positive cash flows in the aggregate are not
available. Further, increases in cash flows above the adverse cash flows cannot
be recognized in earnings.
The following table summarizes quantitative information about
delinquencies, net credit losses, and components of managed finance receivables:
Principal balance
60 days or more Net credit
Principal balance past due losses
------------------------- --------------------------- ---------------
Six months
June 30, December 31, June 30, December 31, ended June 30,
---------------
2002 2001 2002 2001 2002 2001
---- ---- ---- ---- ---- ----
(Dollars in millions)
Type of finance receivables
Manufactured housing................... $24,608.1 $25,575.1 $614.3 $610.5 $289.7 $277.9
Home equity/home improvement........... 10,859.4 11,851.4 125.7 139.9 124.8 125.5
Consumer............................... 4,011.8 4,198.8 78.7 112.6 123.4 99.4
Commercial............................. 512.6 1,377.0 6.3 16.2 14.8 34.9
--------- --------- ------ ------ ------ ------
Total managed receivables.............. 39,991.9 43,002.3 825.0 879.2 552.7 537.7
Less finance receivables securitized
and repossessed assets............ 21,683.9 24,297.3 406.8 464.9 277.2 327.9
--------- --------- ------ ------ ------ ------
Finance receivables held on balance
sheet before allowance for credit
losses and deferred points and
other, net........................ 18,308.0 18,705.0 $418.2 $414.3 $275.5 $209.8
====== ====== ====== ======
Less allowance for credit losses....... 466.4 421.3
Less deferred points and other, net.... 231.8 274.5
--------- ---------
Finance receivables held on
balance sheet....................... $17,609.8 $18,009.2
========= =========
20
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Activity in the interest-only securities account was as follows:
Six months ended
June 30,
-------------------
2002 2001
---- ----
(Dollars in millions)
Balance, beginning of period................................................................... $141.7 $432.9
Investment income........................................................................... 10.0 31.7
Cash paid (received):
Gross cash received....................................................................... (32.9) (32.2)
Guarantee payments related to clean-up calls (a).......................................... 9.3 14.7
Guarantee payments related to bonds held by others........................................ 26.1 12.6
Guarantee payments related to retained bonds (included in actively managed
fixed maturities)....................................................................... 37.3 11.7
Impairment charge to reduce carrying value.................................................. - (47.8)
Sale of securities related to a discontinued line........................................... - (12.4)
Change in interest purchased by Lehman in conjunction with securitization transaction....... (3.1) -
Change in unrealized appreciation recorded in shareholders' equity.......................... 18.7 47.5
------ ------
Balance, end of period......................................................................... $207.1 $458.7
====== ======
- --------------------
(a) During the first six months of 2002 and 2001, clean-up calls were exercised
for certain securitizations that were previously recognized as sales. The
interest-only securities related to these securitizations had previously
been separately securitized with other interest-only securities in
transactions recognized as sales. The Company holds the residual interests
issued by the securitization trusts. The terms of the residual interests
require the holder to make payments to the securitization trust when a
clean-up call related to an underlying trust (a trust which issued
interest-only securities held by the securitization trust) occurs. These
payments are used to accelerate principal payments to the holders of the
other securities issued by the securitization trusts. During the first six
months of 2002 and 2001, the Company was required to make payments to the
securitization trusts. These payments increased our basis in the retained
interests, as the related liability assumed by the Company (and reflected
in the value of the retained interest) was extinguished.
AMORTIZATION OF THE COST OF POLICIES PURCHASED
The cost assigned to the right to receive future cash flows from contracts
existing at the date of an acquisition is referred to as the cost of policies
purchased which is an intangible asset subject to amortization. We amortize
these costs using the interest rate credited to the underlying policy: (i) in
relation to the estimated gross profits for universal life-type and
investment-type products; or (ii) in relation to future anticipated premium
revenue for other products.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the cost of
policies purchased for the change in amortization that would have been recorded
if actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income (loss)
within shareholders' equity.
The amortization related to the cost of policies purchased was $100.7
million and $144.3 million in the first six months of 2002 and 2001,
respectively. The Company expects to amortize approximately 13 percent of the
December 31, 2001, balance of cost of policies purchased in 2002, 11 percent in
2003, 8 percent in 2004, 10 percent in 2005 and 7 percent in 2006.
21
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
EARNINGS PER SHARE
A reconciliation of income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change and shares used to calculate basic and
diluted earnings per share is as follows:
Three months ended Six months ended
June 30, June 30,
------------------ -------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions
and shares in thousands)
Income (loss) before extraordinary gain (loss) and cumulative
effect of accounting change........................................ $(1,334.2) $(20.7) $(1,434.1) $63.1
Preferred stock dividends............................................. (.9) (4.6) (1.9) (8.5)
--------- ------ --------- -----
Income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change applicable to
common ownership for basic earnings per share.................. (1,335.1) (25.3) (1,436.0) 54.6
Effect of dilutive securities......................................... - - - -
--------- ------ --------- -----
Income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change applicable to
common ownership and assumed conversions for
diluted earnings per share.................................... $(1,335.1) $(25.3) $(1,436.0) $54.6
========= ====== ========= =====
Shares:
Weighted average shares outstanding for basic earnings per share... 346,005 337,773 345,607 334,454
Effect of dilutive securities on weighted average shares:
Stock options...................................................... - - - 13,263
Employee benefit plans............................................. - - - 2,620
Dilutive potential common shares................................. - - - 15,883
--------- ------- ------- -------
Weighted average shares outstanding for diluted earnings
per share...................................................... 346,005 337,773 345,607 350,337
========= ======= ======= =======
There were no dilutive common stock equivalents during the 2002 periods and
the three month period ended June 30, 2001 because of the net loss realized by
the Company during such periods.
22
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and six months ended June 30, 2002 and 2001, because doing so would have
been antidilutive in the periods presented. Such securities could potentially
dilute earnings per share in future periods.
Three months ended Six months ended
June 30, June 30,
------------------- -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Shares in thousands)
Equivalent common shares that were antidilutive during the period:
Stock options....................................................... 3,351 14,147 2,914 -
Employee benefit plans.............................................. 889 3,055 907 -
Assumed conversion of convertible preferred stock................... 28,414 27,305 28,273 27,170
------ ------ ------ ------
Antidilutive equivalent common shares............................. 32,654 44,507 32,094 27,170
====== ====== ====== ======
BUSINESS SEGMENTS
We manage our business operations through two segments, based on the
products offered, in addition to the corporate segment.
Insurance and fee-based segment. Our insurance and fee-based segment
provides supplemental health, annuity and life insurance products to a broad
spectrum of customers through multiple distribution channels, each focused on a
specific market segment. These products are primarily marketed through career
agents, professional independent producers and direct marketing. Fee-based
activities include services performed for other companies, including: (i)
investment management; and (ii) insurance product marketing.
Finance segment. Our finance segment provides a variety of finance products
including: loans for the purchase of manufactured housing, home improvements and
various consumer products, home equity loans, private label credit card
programs, and floorplan financing. These products are primarily marketed through
intermediary channels such as dealers, vendors, contractors and retailers.
Corporate and other segment. Our corporate segment includes certain
investment activities, such as our venture capital investment in AWE, and, prior
to its sale, our ownership interest in the riverboat casino in Lawrenceburg,
Indiana. In addition, the corporate segment includes interest expense related to
the Company's corporate debt, special corporate charges, income (loss) from the
discontinued major medical business and other income and expenses. Corporate
expenses are net of charges to our subsidiaries for services provided by the
corporate operations.
23
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Segment operating information was as follows:
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Revenues:
Insurance and fee-based segment:
Insurance policy income:
Annuities................................................. $ 44.5 $ 32.6 $ 81.1 $ 58.5
Supplemental health....................................... 564.1 555.4 1,137.3 1,111.6
Life...................................................... 133.2 209.0 315.0 416.6
Other..................................................... 28.8 32.6 59.3 66.0
Net investment income (a)................................... 267.4 413.0 613.6 777.8
Fee revenue and other income (a)............................ 25.1 26.3 53.5 52.3
Net investment losses (a)................................... (260.4) (40.3) (290.8) (153.6)
-------- -------- -------- --------
Total insurance and fee-based segment revenues.......... 802.7 1,228.6 1,969.0 2,329.2
-------- -------- -------- --------
Finance segment:
Net investment income:
Interest-only securities (a).............................. 5.1 16.6 10.0 31.7
Manufactured housing...................................... 236.7 210.5 462.1 409.9
Mortgage services......................................... 194.7 191.1 389.8 391.7
Consumer/credit card...................................... 110.0 106.6 221.1 215.5
Commercial................................................ 13.1 35.9 36.9 72.3
Other (a)................................................. - - - 7.3
Gain on sale of finance receivables......................... 10.2 6.7 17.4 15.6
Fee revenue and other income................................ 63.1 87.7 131.2 175.3
Impairment charge related to retained interests in
securitization transactions............................... - (33.8) - (41.7)
-------- -------- -------- --------
Total finance segment revenues.......................... 632.9 621.3 1,268.5 1,277.6
-------- -------- -------- --------
Corporate and other:
Net investment income....................................... 3.3 6.7 5.7 17.6
Venture capital income (loss) related to investment in AWE.. (23.7) 50.5 (100.0) 3.4
Gain on sale of interest in riverboat....................... - - - 192.4
Revenue from the discontinued major medical business........ 118.8 201.0 259.8 416.9
Other income................................................ - - - .9
-------- -------- -------- --------
Total corporate segment revenues........................ 98.4 258.2 165.5 631.2
-------- -------- -------- --------
Eliminations.................................................. (12.1) (5.8) (21.8) (12.7)
-------- -------- -------- --------
Total revenues.......................................... 1,521.9 2,102.3 3,381.2 4,225.3
-------- -------- -------- --------
Expenses:
Insurance and fee-based segment:
Insurance policy benefits................................... 598.7 727.5 1,307.0 1,437.7
Amortization................................................ 239.5 206.3 413.0 357.9
Interest expense on investment borrowings................... 3.7 12.2 11.2 16.7
Other operating costs and expenses.......................... 124.8 148.3 268.8 297.1
Special charges............................................. 42.8 3.6 48.1 12.7
-------- -------- -------- --------
Total insurance and fee-based segment expenses............ 1,009.5 1,097.9 2,048.1 2,122.1
-------- -------- -------- --------
(continued)
24
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Finance segment:
Provision for losses........................................ $ 158.3 $ 111.0 $ 316.7 $ 226.7
Interest expense............................................ 286.0 306.6 575.5 628.2
Special charges............................................. 9.3 2.4 56.5 16.2
Other operating costs and expenses.......................... 148.0 157.4 302.6 320.7
-------- -------- -------- --------
Total finance segment expenses............................ 601.6 577.4 1,251.3 1,191.8
-------- -------- -------- --------
Corporate and other:
Interest expense on corporate debt.......................... 80.2 93.6 155.4 193.5
Provision for losses and expenses related to stock
purchase plan............................................. 100.0 - 140.0 -
Expenses from the discontinued major medical
business.................................................. 118.8 261.8 259.8 485.6
Other corporate expenses, less charges to subsidiaries for
services provided......................................... 5.2 9.3 14.8 6.1
Special charges and other................................... 80.9 28.7 97.9 25.2
-------- -------- -------- --------
Total corporate segment expenses.......................... 385.1 393.4 667.9 710.4
-------- -------- -------- --------
Eliminations.................................................. (12.1) (5.8) (21.8) (12.7)
-------- -------- -------- --------
Total expenses............................................ 1,984.1 2,062.9 3,945.5 4,011.6
-------- -------- -------- --------
Income (loss) before income taxes, minority interest, extraordinary
gain (loss)and cumulative effect of accounting change:
Insurance and fee-based operations.......................... (206.8) 130.7 (79.1) 207.1
Finance operations.......................................... 31.3 43.9 17.2 85.8
Corporate interest expense and other items.................. (286.7) (135.2) (502.4) (79.2)
-------- -------- -------- -------
Income (loss) before income taxes, minority interest,
extraordinary gain (loss) and cumulative effect of
accounting change..................................... $ (462.2) $ 39.4 $ (564.3) $ 213.7
======== ======== ======== =======
- --------------------
(a) It is not practicable to provide additional components of revenue by
product or service.
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return linked to the performance of the Standard &
Poor's 500 Index ("S&P 500 Index") based on a percentage (the participation
rate) over an annual period. At the beginning of each policy year, a new index
period begins. The Company is able to change the participation rate at the
beginning of each index period, subject to contractual minimums. We buy S&P 500
Call Options in an effort to hedge potential increases to policyholder benefits
resulting from increases in the S&P 500 Index to which the product's return is
linked. We include the cost of the S&P 500 Call Options in the pricing of these
products. Policyholder account balances for these annuities fluctuate in
relation to changes in the values of these options. We reflect changes in the
estimated market value of these options in net investment income. Option costs
that are attributable to benefits provided were $52.2 million and $61.5 million
in the first six months of 2002 and 2001, respectively. These costs are
reflected in the change in market value of the S&P 500 Call Options included in
investment income. Net investment income (loss) related to equity-
25
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
indexed products before this expense was $(18.2) million and $5.4 million in the
first six months of 2002 and 2001, respectively. Such amounts were substantially
offset by the corresponding charge to insurance policy benefits. The estimated
fair value of the S&P 500 Call Options was $15.9 million and $49.8 million at
June 30, 2002 and December 31, 2001, respectively. We classify such instruments
as other invested assets. The Company accounts for the options issued to the
policyholder for the estimated life of the annuity contract as embedded
derivatives as defined by Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities", as amended by
Statement of Financial Accounting Standards No. 137, "Deferral of the Effective
Date of FASB Statement No. 133" and Statement of Financial Accounting Standards
No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities" (collectively referred to as "SFAS 138"). The Company records the
change in the fair values of the embedded derivatives in current earnings as a
component of policyholder benefits. The fair value of these derivatives, which
are classified as "liabilities for interest-sensitive products", was $376.2
million and $491.2 million at June 30, 2002 and December 31, 2001, respectively.
In 2001, we entered into interest rate swap agreements to convert the fixed
rate on our senior notes (10.75 percent) to a variable rate based on LIBOR plus
5.7525 percent. In accordance with the requirements of SFAS 138, the change in
the fair value of the interest rate swap and the gain or loss on the hedged
senior notes attributable to the hedged interest rate risk were recorded in
current-period earnings. Because the terms of the interest rate swap agreements
substantially match the terms of the senior notes, the gain or loss on the swap
and the senior notes will generally be equal and offsetting (although the
effective interest rate on our debt would be affected).
At December 31, 2001, "notes payable-direct corporate obligations" was
decreased by $13.5 million, to reflect the estimated fair value of such interest
rate swap agreements. Such interest rate swap agreements were terminated in
April 2002 generating cash proceeds of $3.5 million. Such amount represented
$11.9 million of cash due to the Company pursuant to the terms of the swaps, net
of $8.4 million which represented the fair value of the interest rate swaps on
the date of termination. The $8.4 million will be amortized as additional
interest expense over the remaining life of our senior notes.
The Company entered into a forward sale contract related to a portion of
its venture capital investment in AWE. Such contract is carried at market value,
with the change in such value being recognized as venture capital income (loss).
The value of the derivative fluctuates in value in relation to the AWE common
stock it relates to. See "Venture Capital Investment in AT&T Wireless Services,
Inc." above for additional information.
If the counterparties for the derivatives we hold fail to meet their
obligations, Conseco may have to recognize a loss. Conseco limits its exposure
to such a loss by diversifying among several counterparties believed to be
strong and creditworthy. At June 30, 2002, all of the counterparties were rated
"A" or higher by Standard & Poor's Corporation.
GUARANTEES
In conjunction with certain sales of finance receivables, our finance
subsidiary provided guarantees aggregating approximately $1.4 billion at June
30, 2002. We consider any potential payments related to these guarantees in the
projected net cash flows used to determine the value of our interest-only
securities. If we have to make more payments on these guarantees than
anticipated, or we experience higher than anticipated rates of repayment,
including due to foreclosure or charge-offs, or any adverse changes in our
assumptions used for valuation, we would be required to recognize additional
impairment charges. During the first six months of 2002 and 2001, interest and
principal payments related to such guarantees on bonds held by others totaled
$26.1 million and $12.6 million, respectively. There can be no assurance that we
will have adequate liquidity to make such guarantee payments.
We have guaranteed bank loans totaling $537.3 million to approximately 155
current and former directors, officers and key employees. As described in the
note to the consolidated financial statement entitled "Liquidity Issues", the
Company has violated a debt to capitalization ratio loan covenant which could
result in the immediate acceleration of our obligation pursuant to the Company's
guarantee. We have requested from the relevant lenders a waiver of the covenant
violation effective as of June 30, 2002 through September 9, 2002. There can be
no assuarance that we can obtain such waivers. The funds were used by the
participants to purchase approximately 18.0 million shares of Conseco common
stock in open market or negotiated transactions with independent parties. Such
shares are held by the bank as collateral for the loans. In addition, Conseco
has provided loans to participants for interest on the bank loans totaling
$159.0 million. During the third quarter of 2000, the Company negotiated a new
guarantee with the banks which expires on December 31, 2003, and made it
available to participants who qualified and chose to participate in a new
lending program.
26
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
A key goal of the program is to reduce the balance of each participant's
bank and interest loans to $25 per share of stock purchased through the program.
Such reductions are to occur through cash payments and pay for performance
programs. In order to receive the pay for performance program benefits,
participants in the new program are required to put to the Company, 75 percent
of the value in excess of $25 per share of the shares purchased through this
program, as determined on December 31, 2003. A subsidiary of Conseco has pledged
$55.3 million of cash collateral in conjunction with the guarantee of a portion
of the bank loans. Conseco also granted a security interest in most of its
assets in conjunction with the guarantee of a portion of the bank loans. During
the first six months of 2002, we established a noncash provision in connection
with these guarantees and loans of $140.0 million. Such provision is included as
a component of the provision for losses. At June 30, 2002, the reserve for
losses on the loan guarantees and the liability related to the pay for
performance benefits totaled $560.0 million. At June 30, 2002, the guaranteed
bank loans and interest loans exceeded the value of the collateral held
(primarily the value of the common stock purchased) and the reserve for losses
and the liability related to the pay for performance benefits by approximately
$95 million. All participants have agreed to indemnify Conseco for any loss
incurred on their loans. We regularly evaluate these guarantees and loans in
light of the collateral and the creditworthiness of the participants.
REINSURANCE
In the first quarter of 2002, we completed a reinsurance agreement pursuant
to which we are ceding 80 percent of the inforce traditional life business of
our subsidiary, Bankers Life & Casualty Company, to Reassure America Life
Insurance Company (rated A++ by A.M. Best). The total insurance liabilities
ceded pursuant to the contract are approximately $400 million. The reinsurance
agreement and the related dividends of $110.5 million have been approved by the
appropriate state insurance departments and the dividends have been paid to the
parent company. The ceding commission approximated the amount of the cost of
policies purchased and cost of policies produced related to the ceded business.
On June 28, 2002, we completed a reinsurance transaction pursuant to which
we ceded 100 percent of the traditional life and interest-sensitive life
insurance business of our subsidiary, Conseco Variable Insurance Company, to
Protective Life Insurance Company (rated A+ by A.M. Best). The total insurance
liabilities ceded pursuant to the contract were approximately $470 million. Our
insurance subsidiary received a ceding commission of $49.5 million. We have
requested approval from the appropriate insurance regulators to transfer the
ceding commission to the parent company.
During the second quarter of 2002, our subsidiary (Conseco Direct Life
Insurance Company) ceded a block of graded benefit life insurance policies to an
unaffiliated company pursuant to a modified coinsurance agreement. We received a
ceding commission of $83.0 million. The cost of policies purchased and the cost
of policies produced were reduced by $123.0 million and we recognized a loss of
$39.0 million related to the transaction.
We may complete additional reinsurance transactions in 2002. We have not
been as successful in completing these transactions as we had hoped. Several of
our planned transactions have been delayed, require regulatory approval (which
may be difficult to obtain given recent developments), and will yield less
proceeds than we previously expected. We expect that all reinsurance
transactions completed in 2002 will reduce the income before income taxes of our
insurance segment by approximately $90 million to $100 million for the year
ended December 31, 2002.
The cost of reinsurance ceded totaled $212.0 million and $110.2 million in
the first six months of 2002 and 2001, respectively. We deducted this cost from
insurance policy income. In each case, the ceding Conseco subsidiary is
contingently liable for claims reinsured if the assuming company is unable to
pay. Reinsurance recoveries netted against insurance policy benefits totaled
$196.6 million and $106.2 million in the first six months of 2002 and 2001,
respectively. Reinsurance premiums assumed totaled $45.5 million and $90.2
million in the first six months of 2002 and 2001, respectively.
INCOME TAXES
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities and net operating loss carryforwards. In assessing the
realization of our deferred income tax assets, we consider whether it is more
likely than not that the deferred income tax assets will be realized. The
ultimate realization of our deferred income tax assets depends upon generating
future taxable income during the periods in which our temporary differences
become deductible and before our net operating loss carryforwards expire. We
evaluate the realizability of our deferred income tax assets by assessing the
need for a valuation allowance on a quarterly basis.
27
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
A valuation allowance of $1,003.0 million has been provided for the entire
balance of net deferred income tax assets at June 30, 2002, as we believe the
realization of such assets in future periods is uncertain. We reached this
conclusion after considering the availability of taxable income in prior
carryback years, tax planning strategies, and the likelihood of future taxable
income exclusive of reversing temporary differences and carryforwards.
The Company established valuation contingencies related to certain tax
uncertainties of the insurance companies we acquired on the date of their
acquisition. We have determined that $146.2 million of such valuation
contingencies are no longer necessary because the tax uncertainties no longer
exist. Pursuant to Statement of Financial Accounting Standards Statement No.
109, "Accounting for Income Taxes", the benefit for the reduction of such
valuation contingencies shall be first applied to reduce the goodwill balance
related to the acquisition. Accordingly, in the second quarter of 2002, we
reduced such valuation contingencies (increasing deferred taxes) and reduced
goodwill by $146.2 million.
28
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The components of the Company's income tax assets and liabilities were as
follows:
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Deferred tax assets:
Net operating loss carryforwards................................................ $ 329.0 $ 411.7
Deductible temporary differences:
Actively managed fixed maturities............................................ 208.7 124.9
Interest-only securities..................................................... 38.6 -
Venture capital loss......................................................... 7.1 -
Insurance liabilities........................................................ 980.7 827.5
Allowance for loan losses.................................................... 177.2 148.2
Reserve for loss on loan guarantees.......................................... 193.2 147.0
Unrealized depreciation...................................................... 167.2 247.1
Debt obligations............................................................. 113.2 -
--------- ---------
Total deferred tax assets................................................. 2,214.9 1,906.4
Valuation allowance.......................................................... (1,003.0) -
--------- ---------
Net deferred tax assets................................................... 1,211.9 1,906.4
--------- ---------
Deferred tax liabilities:
Venture capital income....................................................... - (36.7)
Interest-only securities..................................................... - (75.2)
Cost of policies purchased and cost of policies produced..................... (1,075.4) (1,075.6)
Other........................................................................ (136.5) (56.2)
--------- ---------
Total deferred tax liabilities............................................ (1,211.9) (1,243.7)
--------- ---------
Current income taxes prepaid................................................. 55.2 15.4
--------- ---------
Net income tax assets (liabilities)....................................... $ 55.2 $ 678.1
========= =========
At June 30, 2002, Conseco had federal income tax loss carryforwards of
$940.1 million available (subject to various statutory restrictions) for use on
future tax returns. These carryforwards will expire as follows: $2.3 million in
2003; $11.2 million in 2004; $4.9 million in 2005; $.7 million in 2006; $7.9
million in 2007; $7.5 million in 2008; $10.5 million in 2009; $4.6 million in
2010; $5.7 million in 2011; $10.1 million in 2012; $43.9 million in 2013; $6.9
million in 2014; $100.8 million in 2016; $44.4 million in 2017; $66.9 million in
2018; $121.6 million in 2019; and $490.2 million in 2020.
29
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Income tax expense (benefit) was as follows:
For the six months
ended June 30,
------------------
2002 2001
---- ----
(Dollars in millions)
Current tax provision................................................................. $ 105.4 $28.2
Deferred tax provision (benefit)...................................................... (297.0) 61.1
-------- -----
Income tax expense (benefit) on period income....................................... (191.6) 89.3
Valuation allowance................................................................... 1,003.0 -
-------- -----
Total income tax expense...................................................... $ 811.4 $89.3
======== =====
A reconciliation of the U.S. statutory corporate income tax rate to the
effective rate reflected in the consolidated statement of operations is as
follows:
Six months ended
June 30,
----------------
2002 2001
---- ----
U.S. statutory corporate rate.................................................................. (35.0)% 35.0%
Valuation allowance............................................................................ 177.7 -
Nondeductible goodwill amortization............................................................ - 9.2
State taxes.................................................................................... .3 3.7
Provision for tax issues and other............................................................. .8 (6.1)
----- ----
Effective tax rate...................................................................... 143.8% 41.8%
===== ====
30
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CHANGES IN DIRECT CORPORATE OBLIGATIONS
Notes payable, representing direct corporate obligations, were as follows
(interest rates as of June 30, 2002):
June 30, December 31,
2002 2001
---- ----
( Dollars in millions)
$1.5 billion bank credit facility (5.09%).................................... $1,493.3 $1,493.3
8.5% senior notes due 2002................................................... 224.9 302.3
8.5% guaranteed senior notes due 2003 (a).................................... 1.0 -
6.4% senior notes due 2003................................................... 234.1 250.0
6.4% guaranteed senior notes due 2004 (a).................................... 14.9 -
8.75% senior notes due 2004.................................................. 423.7 788.0
8.75% guaranteed senior notes due 2006 (a)................................... 364.3 -
6.8% senior notes due 2005................................................... 99.2 250.0
6.8% guaranteed senior notes due 2007 (a).................................... 150.8 -
9.0% senior notes due 2006................................................... 150.8 550.0
9.0% guaranteed senior notes due 2008 (a).................................... 399.2 -
10.75% senior notes due 2008................................................. 37.6 400.0
10.75% guaranteed senior notes due 2009 (a).................................. 362.4 -
Other........................................................................ 90.4 90.6
-------- --------
Total principal amount.................................................. 4,046.6 4,124.2
Unamortized net discount related to issuance of notes payable ............... (43.4) (42.1)
Mark-to-market adjustment related to hedging transactions (see note
entitled "Accounting for Derivatives")................................ - 5.5
Unamortized fair market value of terminated interest rate swap agreements
(see note entitled "Accounting for Derivatives")...................... 9.2 -
-------- --------
Direct corporate obligations............................................ $4,012.4 $4,087.6
======== ========
- ---------------------------
(a) Such notes were issued pursuant to a debt exchange offer completed in April
2002 as further described in the following paragraphs.
As described in the note to the consolidated financial statements entitled
"Liquidity Issues" the Company is not in compliance with the debt to
capitalization ratio we agreed to maintain pursuant to our bank credit facility
and the guarantees of the D&O loans for which it has obtained a waiver through
September 9, 2002 and has not made certain interest payments on its debt. Such
events could result (after the expiration of the applicable grace period with
respect to the interest payments) in an immediate acceleration of the maturity
of all of our debt. We have received from the relevant lenders a waiver with
respect to the noncompliance with the debt to capitalization ratio to be
effective as of June 30, 2002 through September 9, 2002.
In April 2002, Conseco completed an exchange of approximately $1.3 billion
aggregate principal amount of newly issued guaranteed notes for our senior
unsecured notes held by "qualified institutional buyers," institutional
"accredited investors", or non-U.S. persons in transactions outside the United
States. The bonds which were exchanged have identical principal amounts, but the
new bonds have extended maturities in exchange for an enhanced ranking in the
Company's capital structure. The purpose of the exchange offer was to extend the
maturity profile of the existing notes in order to improve our financial
flexibility and to enhance our future ability to refinance public debt. The new
notes are guaranteed on a senior subordinated basis by CIHC, Incorporated, the
holding company of our principal operating subsidiaries, including the
subsidiaries that engage in our insurance and finance businesses. As a result,
the new notes are structurally senior to the existing notes. The new notes were
not registered under the Securities Act of 1933, as amended, and may not be
offered or sold in the United States absent registration or an exemption from
registration. However, we entered into a registration rights agreement for the
benefit of each exchange participant in which we agreed to file, and have filed,
an exchange offer registration statement with the SEC with respect to the new
notes. As a result of our decision to restructure the Company's capital, we do
not intend to make the registered exchange offer. Accordingly, the affected
notes will accrue additional interest as liquidated damages under the
registration rights agreement. The results of the exchange by issue were as
follows:
31
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Originally Tendered for %
Outstanding Exchange Tendered
----------- ------------ --------
8.50% senior notes due 2002.................. $302,299,000 $ 991,000 -
6.40% senior notes due 2003.................. 250,000,000 14,936,000 6%
8.75% senior notes due 2004.................. 788,000,000 364,294,000 46%
6.80% senior notes due 2005.................. 250,000,000 150,783,000 60%
9.00% senior notes due 2006.................. 550,000,000 399,200,000 73%
10.75% senior notes due 2008................. 400,000,000 362,433,000 91%
Effective March 20, 2002, Conseco reached agreement with the participating
banks in our bank credit facility to modify certain terms and conditions within
the $1.5 billion bank credit agreement (referred to herein as "the amended
credit facility"). The most significant changes in the amended credit facility
include (i) a change in financial covenant requirements; (ii) a change in the
distribution of proceeds on asset sales; (iii) a reduction in the minimum
liquidity requirement at the holding company necessary to pay trust preferred
dividends; and (iv) a provision permitting the Company to exchange up to $2.54
billion aggregate principal amount of newly issued notes guaranteed by our
wholly owned subsidiary, CIHC, Incorporated ("CIHC"). As noted above, the new
notes are structurally senior to the existing notes, but subordinated to the
CIHC guarantee of the bank credit facility. We are currently not in compliance
with a covenant of the amended bank credit agreement for which we have obtained
a waiver through September 9, 2002.
The amended credit facility is due December 31, 2003; however, subject to
the absence of any default, we may further extend its maturity to March 31,
2005, provided that: (i) we pay an extension fee of 3.5 percent of the amount
extended; (ii) cumulative principal payments of at least $200 million have been
paid by September 30, 2002 and at least $500 million by September 30, 2003; and
(iii) the interest coverage ratio for the four quarters ended September 30, 2003
shall be greater than or equal to 2.25:1.0. As described below, the Company has
violated a loan covenant which has caused an event of default. We have received
from the relevant lenders a waiver of the loan covenant violation effective as
of June 30, 2002 through September 9, 2002.
Pursuant to our amended credit facility, we have agreed to the manner in
which any proceeds received from asset sales (including our AWE investment)
occurring after June 30, 2002 (with certain exceptions), would be applied. The
first $219 million of such proceeds may be retained by the Company and will be
available to be used to meet our other debt obligations. The next $313 million
will be applied pro rata to the principal payments on the bank credit facility
and to a segregated cash account to be held as collateral for our guarantee of
certain bank loans to current and former directors, officers and key employees
(the "D&O loans"). The next $250 million will be divided equally between the
Company and to pay pro rata the principal payments on the bank credit facility
and the D&O loans. Proceeds in excess of $915 million and all proceeds during
the period December 31, 2003 through March 31, 2004, will be divided as follows:
(i) 25 percent to be retained by the Company; and (ii) 75 percent to pay pro
rata the principal payments on the bank credit facility and the D&O loans.
Proceeds received after March 31, 2004, are divided equally between the Company
and to pay pro rata the principal payments on the bank credit facility and the
D&O loans. No assurance can be provided as to the timing, proceeds, or other
terms related to any potential asset sale or financing transaction.
Our amended credit facility requires the Company to maintain various
financial ratios and balances, as defined in the agreement. At June 30, 2002, we
were not in compliance with the debt to capitalization covenant in our bank
credit facility but have received a waiver through September 9, 2002 as
described in the note to the consolidated financial statements entitled
"Liquidity Issues". Absent the waiver, the covenant violation gives the lenders
the right to declare all borrowings under the credit agreement due and payable.
The financial ratios and balance we agreed to maintain include: (i) a debt to
capitalization ratio of less than .400:1.0 at June 30, 2002 and decreasing over
time, as defined in the agreement, to 0.300:1.0 at March 31, 2004 and thereafter
(such ratio was .406:1.0 at June 30, 2002); (ii) an interest coverage ratio
greater than 1.25:1.0 for the four quarters ending June 30, 2002 and changing
over time, as defined in the agreement, to 2.50:1.0 for the four quarters ending
June 30, 2004 and thereafter (such ratio was 1.62:1.0 for the four quarters
ended June 30, 2002); (iii) adjusted earnings, as defined in the agreement, of
at least $1,200.0 million for the four quarters ending June 30, 2002 and
increasing over time, as defined in the agreement, to $1,700.0 million for the
four quarters ending September 30, 2004 (the adjusted earnings for the four
quarters ended June 30, 2002 exceeded $1.3 billion); (iv) Conseco Finance
tangible net worth, as defined in the agreement, of at least $1.2 billion at
June 30, 2002; and $1.6 billion at March 31, 2005 (such tangible net worth
approximated $1.4 billion at June 30, 2002); and (v) the ratio of aggregate
total adjusted capital to aggregate authorized control level risk-based capital
(as defined by the National Association of Insurance
32
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Commissioners) with respect to our insurance subsidiaries of at least 250
percent (such ratio was greater than 410 percent at June 30, 2002). Our amended
bank credit facility provides that any charges taken to write off goodwill to
the extent required by SFAS 142 will be excluded from the various financial
ratios and covenants that we are required to meet or maintain.
The amended credit facility reduces the 90-day moving average cash balance
we must maintain at the parent company from $100 million to $50 million. The
Company is required to have at least $50 million of cash on hand immediately
after making a trust preferred dividend payment in addition to the 90-day moving
average requirement. The amended agreement also states that in the event one of
Conseco's significant insurance subsidiaries is rated B or below by A.M. Best,
the Company must take certain actions to generate liquidity and accelerate the
repayment of the bank credit facility. All of our significant insurance
subsidiaries are rated B++ by A.M. Best and the ratings remain under review with
negative implications. We believe that A.M. Best will soon lower our current B++
rating.
The amended credit facility prohibits the payment of cash dividends on our
common stock until the Company has received investment grade ratings on its
outstanding public debt. Such agreement also prohibits the repurchase of our
common stock. The amended credit agreement limits the issuance of additional
debt, contingent obligations, liens, asset dispositions, other restrictive
agreements, affiliate transactions, change in business and modification of terms
of debt or preferred stock, all as defined in the agreements. The obligations
under our credit facility are also guaranteed by CIHC.
The interest rate on the amended credit facility is based on an IBOR rate
plus a margin of 3.25 percent. Borrowings under our bank credit facilities
averaged $1,493.3 million during the first six months of 2002, at a weighted
average interest rate of 4.86 percent.
During the second quarter of 2002, we repurchased: (i) $76.4 million par
value of the 8.5% notes due October 2002 (resulting in an extraordinary gain of
$1.1 million, net of income taxes of $.6 million); and (ii) $1.0 million of the
6.4% notes due February 2003 (resulting in an extraordinary gain of $.1 million,
net of income taxes of $.1 million).
During the first six months of 2001, we repurchased: $64.6 million par
value of the 7.6% senior notes due June 2001 (resulting in an extraordinary gain
of $.3 million, net of income taxes of $.2 million).
Pursuant to the terms of the Mandatory Par Put Remarketed Securities, the
Company elected to redeem the notes at a redemption price defined in the
remarketing agreement. As a result, the Company recognized an extraordinary
charge of $4.6 million (net of an income tax benefit of $2.5 million) in the
second quarter of 2001.
33
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CHANGES IN DIRECT FINANCE OBLIGATIONS (EXCLUDING NOTES PAYABLE RELATED TO
SECURITIZED FINANCE RECEIVABLES STRUCTURED AS COLLATERALIZED
BORROWINGS)
Notes payable (excluding notes payable related to securitized finance
receivables structured as collateralized borrowings) of the finance segment were
as follows (interest rates as of June 30, 2002):
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Master repurchase agreements due on various dates in
2002 and 2003 (2.73%)..................................................... $ 914.0 $1,679.0
Credit facility collateralized by retained interests in securitizations
due 2004 (3.84%).......................................................... 506.3 507.3
Medium term notes due September 2002 (6.50%)................................. 8.2 189.7
10.25% senior subordinated notes due June 2002............................... - 138.2
Other........................................................................ 1.4 22.5
-------- --------
Total principal amount.................................................. 1,429.9 2,536.7
Unamortized net discount and deferred fees................................... (6.6) (8.8)
-------- --------
Direct finance obligations.............................................. $1,423.3 $2,527.9
======== ========
At August 14, 2002, we had $1.4 billion of committed master repurchase
agreements and other facilities with various banking and investment banking
firms for the purpose of financing our consumer and commercial finance loan
production. We have an additional $1.5 billion of uncommitted master repurchase
agreements which require the approval of the lender prior to advancement of
funds. These facilities typically provide financing of a certain percentage of
the underlying collateral and are subject to the availability of eligible
collateral and, in some cases, the willingness of the banking firms to continue
to provide financing. Some of these agreements provide for annual terms which
are extended either quarterly or semi-annually by mutual agreement of the
parties for an additional annual term based upon receipt of updated quarterly
financial information. At June 30, 2002, we had borrowed $1.4 billion under
these agreements. The capacity under these agreements has been reduced to $2.9
billion (of which $1.4 billion is committed) at August 14, 2002 from $3.8
billion (of which $1.9 billion was committed) at June 30, 2002. In addition,
certain of our banks have recently further restricted our borrowing capacity
related to manufactured housing loans within the committed facilities. We are
unable to predict whether we will be able to obtain replacement financing when
our current facilities expire, and there can be no assurance that financing will
be obtainable on favorable terms, if at all. To the extent that we are unable to
arrange any third party or other financing, our loan origination activities
would be adversely affected, which would have a material adverse effect on our
operations, financial results and cash position.
In the first quarter of 2002, we entered into various transactions with
Lehman and its affiliates pursuant to which Lehman extended the terms of Conseco
Finance's: (a) warehouse line from September 2002 to September 2003; (b)
borrowings with respect to approximately $90 million of miscellaneous assets
("Miscellaneous Borrowings") from January 31, 2002 to June 2003; and (c)
residual line from February 2003 to February 2004 under which financing is being
provided on our interest-only securities, servicing rights and retained
interests in other subordinated securities issued by the securitization trusts.
We agreed to an amortization schedule by which the outstanding balance under the
Miscellaneous Borrowings is required to be repaid by June 2003. We also entered
into a revised agreement governing the movement of cash from Conseco Finance to
the parent company. Conseco Finance and Lehman have agreed to amend the
agreement such that Conseco Finance must maintain liquidity (cash and available
borrowings, as defined) of at least: (i) $50 million until March 31, 2003; and
(ii) $100 million from and after April 1, 2003. However, Conseco Finance no
longer must meet a minimum liquidity requirement of $250 million before making
interest, principal, dividend or redemption payments to the parent company.
Pursuant to the new arrangements, Lehman may exchange their existing
warrant to purchase 5 percent of the common stock of Conseco Finance until May
2003 and receive in its place 500,000 shares of Series G Convertible Redeemable
34
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Preferred Stock of Conseco (the "Series G Preferred Stock") at a $100 stated
value per share, having the following general terms:
(a) No dividend;
(b) Convertible to Conseco common stock at $10 per share;
(c) Voting rights on an as converted basis;
(d) Mandatorily redeemable by Conseco in January 2012 at the stated value;
(e) Pari passu with the Series F Preferred Stock of Conseco if, and only
if, a majority of the holders of Conseco's Series E Preferred Stock
and Series F Preferred Stock consent, and otherwise pari passu with
the Series E Preferred Stock and junior to the Series F Preferred
Stock; and
(f) The right to cause Conseco to register the Series G Preferred Stock
within one year after electing to surrender the Warrant in exchange
for the Series G Preferred Stock.
Lehman's warrant permits the holder to purchase 5 percent of Conseco
Finance at a nominal price. The holder of the warrant may cause the warrant and
any stock issued upon its exercise to be purchased for cash at an appraised
value in May 2003. Since the warrant permits cash settlement at fair value at
the option of the holder of the warrant, it has been included in other
liabilities and is measured at fair value, with changes in its value reported in
earnings. The estimated fair value of the warrant at June 30, 2002 is $37.3
million. Pursuant to a modification of the financing agreement, the holder was
given a derivative instrument which permits the conversion of the warrant
(subject to certain terms and conditions) into convertible preferred stock of
Conseco with a stated value of $50 million. The convertible preferred stock is
convertible into Conseco common stock at $10 per share, pays no dividend and is
mandatorily redeemable by Conseco in January 2012 at its stated value. The
derivative is measured at fair value, with changes in its value reported in
earnings. The estimated fair value of the derivative at June 30, 2002 was $.8
million.
The credit facility collateralized by retained interests in securitizations
and two of the master repurchase agreements require Conseco Finance to maintain
various financial ratios, as defined in the agreement. These ratios include: (i)
an adjusted tangible net worth of at least $1.5 billion (such amount was greater
than $1.6 billion at June 30, 2002); (ii) a fixed charge coverage ratio of not
less than 1.0:1.0 for the four quarters ending June 30, 2002, and defined
periods thereafter (such ratio was 1.13:1.0 for the period ended June 30, 2002);
(iii) a ratio of net worth to total managed receivables of not less than 4:100
(such ratio was 4.77:100 at June 30, 2002); and (iv) a ratio of total
non-warehouse debt less finance receivables and certain other assets, as defined
in the agreement, to net worth of less than 1.0:2.0 (such ratio was .38:2.0 at
June 30, 2002). These credit facilities also require Conseco Finance to maintain
liquidity of greater than $50 million. As of June 30, 2002 our liquidity was
$114.2 million.
One of the master repurchase agreements and one of the other facilities
require Conseco Finance to maintain various financial ratios, as defined in the
agreements. These ratios include: (i) an adjusted tangible net worth of at least
$1.95 billion (such amount was greater than $2.0 billion at June 30, 2002); (ii)
a fixed charge coverage ratio of not less than 1.0:1.0 for the four quarters
ending June 30, 2002, and defined periods thereafter (such ratio was 1.15:1.0
for the four quarters ended June 30, 2002); (iii) a ratio of net worth to total
managed receivables of not less than 4:100 (such ratio was 4.77:100 at June 30,
2002); and (iv) a ratio of total non-warehouse debt less finance receivables and
certain other assets, as defined in the agreement, to net worth of less than
1.0:2.0 (such ratio was .38:2.0 at June 30, 2002).
During the first six months of 2002, Conseco Finance repurchased $46.9
million par value of its senior subordinated notes and medium term notes
resulting in an extraordinary gain of $3.9 million (net of income taxes). In
March 2002, Conseco Finance completed a tender offer pursuant to which it
purchased $75.8 million par value of its senior subordinated notes due June
2002. The purchase price was equal to 100 percent of the principal amount of the
notes plus accrued interest. The remaining principal amount outstanding of $34.8
million of the senior subordinated notes was retired at maturity on June 3,
2002.
In April 2002, Conseco Finance completed a tender offer pursuant to which
it purchased $158.5 million par value of its medium term notes due September
2002 and $3.7 million par value of its medium term notes due April 2003. The
purchase price was equal to 100 percent of the principal amount of the notes
plus accrued interest. In June 2002, Conseco Finance tendered for the remaining
$8.2 million par value of its medium term notes due September 2002. Pursuant to
the tender offer $5.5 million par value of the notes was tendered in July. The
purchase price was equal to 101 percent of the principal amount
35
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
of the notes plus accrued interest. The remaining principal amount outstanding
of the medium term notes after giving effect to both tender offers and other
debt repurchases completed prior to the tender offers is $2.7 million due
September 2002.
36
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
NOTES PAYABLE RELATED TO SECURITIZED FINANCE RECEIVABLES STRUCTURED AS
COLLATERALIZED BORROWINGS
Notes payable related to securitized finance receivables structured as
collateralized borrowings were $14,977.5 million at June 30, 2002. The principal
and interest on these notes are paid using the cash flows from the underlying
finance receivables which serve as collateral for the notes. Accordingly, the
timing of the principal payments on these notes is dependent on the payments
received on the underlying finance receivables which back the notes. In some
instances, the Company is required to advance principal and interest payments
even though the payments on the underlying finance receivables which back the
notes have not yet been received. The average interest rate on these notes at
June 30, 2002, was 6.4 percent. The notes payable balance also includes two
securitization transactions securitizing: (i) capitalized expenses related to
the refurbishment of repossessed assets; and (ii) principal and interest
advances. The outstanding liability on these facilities at June 30, 2002 was
$85.0 million.
CHANGES IN MINORITY INTEREST
On February 16, 2001, the trust preferred securities component of the
FELINE PRIDES were retained by the Company (and subsequently retired) as payment
under the stock purchase contract in accordance with their terms and, as a
result, we issued 11.4 million shares of Conseco common stock to the holders of
the FELINE PRIDES. The $496.6 million carrying value of the FELINE PRIDES that
were retired (and used for payment pursuant to the stock purchase contracts) was
transferred from minority interest to common stock and additional paid-in
capital.
CHANGES IN COMMON STOCK
Changes in the number of shares of common stock outstanding were as
follows:
Six months ended
June 30,
----------------
2002 2001
---- ----
(Shares in thousands)
Balance, beginning of period.............................................................. 344,743 325,318
Stock options exercised................................................................ 5 394
Shares issued pursuant to stock purchase contracts related to the FELINE PRIDES........ - 11,351
Shares issued under employee benefit compensation plans................................ 1,259 910
------- -------
Balance, end of period.................................................................... 346,007 337,973
======= =======
In February 2001, the Company issued 11.4 million shares of Conseco common
stock pursuant to stock purchase contracts related to the FELINE PRIDES. This
transaction is discussed in further detail in the note above entitled "Changes
in Minority Interest".
RECENTLY ISSUED ACCOUNTING STANDARDS
The FASB issued Statement of Financial Accounting Standards No. 144,
"Accounting for the Impairment of Long-Lived Assets" ("SFAS 144") in August
2001. This standard addresses the measurement and reporting for impairment of
all long-lived assets. It also broadens the definition of what may be presented
as a discontinued operation in the consolidated statement of operations to
include components of a company's business segments. SFAS 144 requires that
long-lived assets currently in use be written down to fair value when considered
impaired. Long-lived assets to be disposed of are written down to the lower of
cost or fair value less the estimated cost to sell. The Company adopted this
standard on January 1, 2002. We have followed this standard in determining when
it is appropriate to recognize impairments on assets we have decided to sell as
part of our efforts to raise cash.
The FASB issued Statement of Financial Accounting Standards No. 141,
"Business Combinations" ("SFAS 141"), and SFAS 142 in June 2001. Under the new
rules, intangible assets with an indefinite life are no longer amortized in
periods
37
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
subsequent to December 31, 2001, but are subject to annual impairment
tests (or more frequent under certain circumstances), effective January 1, 2002.
The Company adopted SFAS 141 and SFAS 142 effective January 1, 2002 (refer to
the note entitled "Cumulative Effect of Accounting Change" for additional
discussion).
LITIGATION AND OTHER LEGAL PROCEDINGS
We and our subsidiaries are involved on an ongoing basis in lawsuits
(including purported class actions) relating to our operations, including with
respect to sales practices, and we and current and former officers and directors
are defendants in pending class action lawsuits asserting claims under the
securities laws and derivative lawsuits. The ultimate outcome of these lawsuits
cannot be predicted with certainty.
Conseco Finance was served with various related lawsuits filed in the
United States District Court for the District of Minnesota. These lawsuits were
generally filed as purported class actions on behalf of persons or entities who
purchased common stock or options to purchase common stock of Conseco Finance
during alleged class periods that generally run from July 1995 to January 1998.
One action (Florida State Board of Admin. v. Green Tree Financial Corp., et. al,
Case No. 98-1162) was brought not on behalf of a class, but by the Florida State
Board of Administration, which invests and reinvests retirement funds for the
benefit of state employees. In addition to Conseco Finance, certain current and
former officers and directors of Conseco Finance are named as defendants in one
or more of the lawsuits. Conseco Finance and other defendants obtained an order
consolidating the lawsuits seeking class action status into two actions, one of
which pertains to a purported class of common stockholders (In re Green Tree
Financial Corp. Stock Litig., Case No. 97-2666) and the other of which pertains
to a purported class of stock option traders (In re Green Tree Financial Corp.
Options Litig., Case No. 97-2679). Plaintiffs in the lawsuits assert claims
under Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the
Securities Exchange Act of 1934. In each case, plaintiffs allege that Conseco
Finance and the other defendants violated federal securities laws by, among
other things, making false and misleading statements about the current state and
future prospects of Conseco Finance (particularly with respect to prepayment
assumptions and performance of certain loan portfolios of Conseco Finance) which
allegedly rendered Conseco Finance's financial statements false and misleading.
On August 24, 1999, the United States District Court for the District of
Minnesota issued an order dismissing with prejudice all claims alleged in the
lawsuits. The plaintiffs subsequently appealed the decision to the U.S. Court of
Appeals for the 8th Circuit. A three judge panel issued an opinion on October
25, 2001, reversing the United States District Court's dismissal order and
remanding the actions to the United States District Court. Conseco Finance has
moved to dismiss the options lawsuit on the grounds that stock option traders
lack standing under the federal securities laws. The motion was argued on May
24, 2002. The motion was denied by order dated July 29, 2002. Pretrial discovery
in the options lawsuit was stayed pending disposition of the motion to dismiss
but will commence presently. In the other two lawsuits, pretrial discovery
commenced in April 2002. The Company believes that the lawsuits are without
merit and intends to continue to defend them vigorously. The ultimate outcome of
these lawsuits cannot be predicted with certainty.
A total of forty-five suits were filed in 2000 against the Company in the
United States District Court for the Southern District of Indiana. Nineteen of
these cases were putative class actions on behalf of persons or entities that
purchased the Company's common stock during alleged class periods that generally
run from April 1999 through April 2000. Two cases were putative class actions on
behalf of persons or entities that purchased the Company's bonds during the same
alleged class periods. Three cases were putative class actions on behalf of
persons or entities that purchased or sold option contracts, not issued by the
Company, on the Company's common stock during the same alleged class periods.
One case was a putative class action on behalf of persons or entities that
purchased the Company's "FELINE PRIDES" convertible preferred stock instruments
during the same alleged class periods. With four exceptions, in each of these
twenty-five cases two former officers/directors of the Company were named as
defendants. In each case, the plaintiffs asserted claims under Sections 10(b)
(and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Exchange Act
of 1934. In each case, plaintiffs alleged that the Company and the individual
defendants violated the federal securities laws by, among other things, making
false and misleading statements about the current state and future prospects of
Conseco Finance (particularly with respect to performance of certain loan
portfolios of Conseco Finance) which allegedly rendered the Company's financial
statements false and misleading.
Eleven of the cases in the United States District Court for the Southern
District of Indiana were filed as purported class actions on behalf of persons
or entities that purchased preferred securities issued by various Conseco
Financing Trusts, including Conseco Financing Trust V, Conseco Financing Trust
VI, and Conseco Financing Trust VII.
38
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Each of these complaints named as defendants the Company, the relevant trust
(with two exceptions), two former officers/directors of the Company, and
underwriters for the particular issuance (with one exception). One complaint
also named an officer and all of the Company's directors at the time of issuance
of the preferred securities by Conseco Financing Trust VII. In each case,
plaintiffs asserted claims under Section 11 and Section 15 of the Securities Act
of 1933, and eight complaints also asserted claims under Section 12(a)(2) of
that Act. Two complaints also asserted claims under Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934, and one complaint also asserted a claim
under Section 10(b) of that Act. In each case, plaintiffs alleged that the
defendants violated the federal securities laws by, among other things, making
false and misleading statements in Prospectuses and/or Registration Statements
related to the issuance of preferred securities by the Trust involved regarding
the current state and future prospects of Conseco Finance (particularly with
respect to performance of certain loan portfolios of Conseco Finance) which
allegedly rendered the disclosure documents false and misleading.
All of the Conseco, Inc. securities cases were consolidated into one case
in the United States District Court for the Southern District of Indiana,
captioned: "In Re Conseco, Inc. Securities Litigation", Case number
IP00-C585-Y/S (the "securities litigation"). An amended complaint was filed on
January 12, 2001, which asserted claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, and Sections 11, 12(a)(2), and 15 of the
Securities Act of 1933, with respect to common stock and various other
securities issued by the Company and Conseco Financing Trust VII. The Company
filed a motion to dismiss the amended complaint on April 27, 2001. On January
10, 2002, the Company entered into a Memorandum of Understanding (the "MOU") to
settle the litigation for $120 million subject to court approval. Under the MOU,
as amended on February 12, 2002, $106 million was required to be placed in
escrow by March 8, 2002; the remaining $14 million was to be paid in two
installments: $6 million by April 1, 2002, and $8 million by October 1, 2002
(all payments with interest from January 25, 2002). The $106 million due on
March 8, 2002, was not paid, for reasons set forth in the following paragraph,
and the MOU was terminated by the plaintiffs. On April 15, 2002, a new MOU was
executed (the "April 15 MOU"). Pursuant to the April 15 MOU, $95 million was
funded on April 25, 2002, with the remaining $25 million to await the outcome of
the coverage litigation between the Company and certain of its directors' and
officers' liability insurance carriers as described in the next paragraph. Court
approval of the settlement was received on August 7, 2002.
We maintained certain directors' and officers' liability insurance that was
in force at the time the Indiana securities and derivative litigation (the
derivative litigation is described below) was commenced and which, in our view,
applies to the claims asserted in that litigation. The insurers denied coverage
for those claims, so we commenced a lawsuit against them on June 13, 2001, in
Marion County Circuit Court in Indianapolis, Indiana (Conseco, Inc., et al. v.
National Union Fire Insurance Company of Pittsburgh, PA, Royal & SunAlliance,
Westchester Fire Insurance Company, RLI Insurance Company, Greenwich Insurance
Company and Certain Underwriters at Lloyd's of London, Case No.
49C010106CP001467) (the "coverage litigation") seeking, among other things, a
judicial declaration that coverage for those claims exists. The primary
insurance carrier, National Union Fire Insurance Co. of Pittsburgh, PA, has paid
its full $10 million in policy proceeds toward the settlement of the securities
litigation; in return, National Union has been released from the coverage
litigation. The first excess insurance carrier, Royal & SunAlliance ("Royal"),
has paid its full $15 million in policy proceeds toward the settlement, but
reserved rights to continue to litigate coverage. The second excess insurance
carrier, Westchester Fire Insurance Company, has paid its full $15 million in
policy proceeds toward the settlement without a reservation of rights and is
being released from the coverage litigation. The third excess insurance carrier,
RLI Insurance Company ("RLI"), has paid its full $10 million in policy proceeds
toward the settlement, but reserved rights to continue to litigate coverage. The
fourth excess insurance carrier, Greenwich Insurance Company ("Greenwich"), has
paid its full $25 million in policy proceeds toward the settlement without a
reservation of rights and is being released from the coverage litigation. The
final excess carrier, Certain Underwriters at Lloyd's of London ("Lloyd's"),
refused to pay or to escrow its $25 million in policy proceeds toward the
settlement and is continuing to litigate coverage. Under the April 15 MOU, the
settlement of the securities litigation will proceed notwithstanding the
continuing coverage litigation between the Company, Royal, RLI and Lloyd's.
Since the United States District Court for the Southern District of Indiana has
approved the settlement of the securities litigation prior to resolution of the
coverage litigation, $90 million plus accrued interest is available for
distribution to the putative class. The remaining funds, with interest, will be
distributed at the conclusion of the coverage litigation (or, in the case of the
$25 million at issue in the litigation with Lloyd's, on December 31, 2005, if
the litigation with Lloyd's has not been resolved by that date), with such funds
coming either from Lloyd's (if the Company prevails in the coverage litigation)
or from the Company (if the Company does not prevail). We intend to pursue our
coverage rights vigorously. The ultimate outcome cannot be predicted with
certainty. The directors' and officers' liability insurance that was in force at
the time the litigation commenced provides for coverage of $100 million. In
light of that coverage, the Company's best estimate of its exposure in the
litigation is $20 million (i.e., the excess of the $100 million in coverage).
The Company believes such insurance applies to the claims in the securities
litigation. Accordingly, $20
39
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
million is our best estimate of a probable loss at June 30, 2002. Although the
securities litigation has been settled, not all of the insurance carriers have
paid their allocable share of the coverage without any reservation of rights. Of
the $100 million in total coverage, $50 million was paid without reservation of
rights; $25 million was paid under reservations of rights; and $25 million
remains unpaid. We have established an estimated liability of $50 million and
claim for recovery of $50 million at June 30, 2002. Such amounts include: (i)
$25 million related to the two insurers who paid their portion of the settlement
into a fund but reserved their rights to continue to litigate coverage (which
litigation is proceeding); and (ii) $25 million related to the insurer that has
refused to pay. The Company believes that it is probable that the coverage
litigation will result in a determination that the insurers who paid under a
reservation of rights have no valid rights to recoup the payments they have
made, and that the insurer which refused to pay is obligated to do so under its
policy. We believe it is probable that the latter insurer will pay its portion
of the coverage once such determination is made.
Nine shareholder derivative suits were filed in 2000 in the United States
District Court for the Southern District of Indiana. The complaints named as
defendants the current directors, certain former directors, certain non-director
officers of the Company (in one case), and, alleging aiding and abetting
liability, certain banks that allegedly made loans in relation to the Company's
"Stock Purchase Plan" (in three cases). The Company is also named as a nominal
defendant in each complaint. Plaintiffs allege that the defendants breached
their fiduciary duties by, among other things, intentionally disseminating false
and misleading statements concerning the acquisition, performance and proposed
sale of Conseco Finance, and engaged in corporate waste by causing the Company
to guarantee loans that certain officers, directors and key employees of the
Company used to purchase stock under the Stock Purchase Plan. These cases have
now been consolidated into one case in the United States District Court for the
Southern District of Indiana, captioned: "In Re Conseco, Inc. Derivative
Litigation", Case Number IP00655-C-Y/S. An amended complaint was filed on April
12, 2001, making generally the same allegations and allegations of violation of
the Federal Reserve Board's margin rules. Three similar cases have been filed in
the Hamilton County Superior Court in Indiana. Schweitzer v. Hilbert, et al.,
Case No. 29D01-0004CP251; Evans v. Hilbert, et al., Case No. 29D01-0005CP308
(both Schweitzer and Evans name as defendants certain non-director officers);
Gintel v. Hilbert, et al., Case No. 29003-0006CP393 (naming as defendants, and
alleging aiding and abetting liability as to, banks that allegedly made loans in
relation to the Stock Purchase Plan). The cases filed in Hamilton County have
been stayed pending resolution of the derivative suits filed in the United
States District Court. The Company believes that these lawsuits are without
merit and intends to defend them vigorously. The ultimate outcome of these
lawsuits cannot be predicted with certainty.
Conseco Finance is a defendant in two arbitration proceedings in South
Carolina (Lackey v. Green Tree Financial Corporation, n/k/a Conseco Finance
Corp. and Bazzle v. Green Tree Financial Corporation, n/k/a Conseco Finance
Corp.) where the arbitrator, over Conseco Finance's objection, allowed the
plaintiffs to pursue purported class action claims in arbitration. The two
purported arbitration classes consist of South Carolina residents who obtained
real estate secured credit from Conseco Finance's Manufactured Housing Division
(Lackey) and Home Improvement Division (Bazzle) in the early and mid 1990s, and
did not receive a South Carolina specific disclosure form relating to selection
of attorneys and insurance agents in connection with the credit transactions.
The arbitrator, in separate awards issued on July 24, 2000, awarded a total of
$26.8 million in penalties and attorneys' fees. The awards were confirmed as
judgments in both Lackey and Bazzle. These cases have been consolidated into one
case and are currently on appeal before the South Carolina Supreme Court. Oral
argument was heard on March 21, 2002. Conseco Finance has posted appellate
bonds, including $20 million of cash, for these cases. Conseco Finance intends
to vigorously challenge the awards and believes that the arbitrator erred by,
among other things, conducting class action arbitrations without the authority
to do so and misapplying South Carolina law when awarding the penalties. The
ultimate outcome of this proceeding cannot be predicted with certainty.
On January 15, 2002, Carmel Fifth, LLC ("Carmel"), an indirect, wholly
owned subsidiary of the Company, exercised its rights to require 767 Manager,
LLC ("Manager"), an affiliate of Donald J. Trump, to elect within 60 days,
either to acquire Carmel's interests in 767 LLC for $499.4 million, or sell its
interests in 767 LLC to Carmel for $15.6 million (the "Buy/Sell Right"). Such
rights were exercised pursuant to the Limited Liability Company Agreement of 767
LLC. 767 LLC is a Delaware limited liability company that owns the General
Motors Building, a 50-story office building in New York, New York. 767 LLC is
owned by Carmel and Manager. On February 6, 2002, Mr. Trump commenced a civil
action against the Company, Carmel and 767 LLC in New York State Supreme Court,
entitled Donald J. Trump v. Conseco, Inc., et al. Plaintiff claims that the
Company and Carmel breached an agreement, dated July 3, 2001, to sell Carmel's
interests to plaintiff for $295 million on or before September 15, 2001 (the
"July 3rd Agreement"). Specifically, plaintiff claims that the Company and
Carmel improperly refused to accept a reasonable guaranty of plaintiff's payment
obligations, refused to complete the sale of
40
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Carmel's interest before the September 15, 2001 deadline, repudiated an oral
promise to extend the September 15 deadline indefinitely and repudiated the July
3rd Agreement by exercising Carmel's Buy/Sell Right. Plaintiff asserts claims
for breach of contract, breach of the implied covenant of good faith and fair
dealing, promissory estoppel, unjust enrichment and breach of fiduciary duty.
Plaintiff is seeking compensatory and punitive damages of approximately $1
billion and declaratory and injunctive relief blocking Carmel's Buy/Sell Right.
On March 25, 2002, Carmel filed a Demand for Arbitration and Petition and
Statement of Claim with the American Arbitration Association ("AAA") to have the
issues relating to the Buy/Sell Right resolved by arbitration. Manager and Mr.
Trump requested the New York State Supreme Court to stay that arbitration, but
the Court denied Manager's and Trump's request on May 2, 2002, allowing the
arbitration to proceed. In addition, Conseco and Carmel filed a Motion to
Dismiss Mr. Trump's lawsuit on March 25, 2002. The Company believes that Mr.
Trump's lawsuit is without merit and intends to defend it vigorously.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against the Company, Conseco Services, LLC, and two former officers in
the Boone Circuit Court (Inlow et al. v. Conseco, Inc., et al., Cause No.
06C01-0206-CT-244). The heirs assert that unvested options to purchase 756,248
shares of our common stock should have been vested at Mr. Inlow's death. The
heirs further claim that if such options had been vested, they would have been
exercised, and that the resulting shares of common stock would have been sold
for a gain of approximately $30 million based upon a stock price of $58.125 per
share, the highest stock price during the alleged exercise period of the
options. We believe the heirs' claims are without merit and will defend the
action vigorously.
On March 27, 2002, seven holders of our bank debt filed a lawsuit in the
United States District Court for the Northern District of Illinois (AG Capital
Funding Partners LP, et al. v. Conseco, Inc., Case No. 02C2236). They filed a
voluntary dismissal of that action on April 25, 2002, and an order dismissing
the case was entered on April 26, 2002. On April 15, 2002, the same holders
filed an action in the Circuit Court of Cook County, Illinois (AG Capital
Funding Partners LP, et al. v. Conseco, Inc., Case No. 02CH07453). On March 20,
2002, we amended our credit facilities to provide, in part, that in the event of
certain asset sales, we are not obligated to prepay amounts borrowed under the
credit agreement until we have received in excess of $352 million of net
proceeds from those sales. The plaintiff holders assert that 100 percent of the
holders of the bank debt must vote in favor of an amendment of the provisions
relating to the triggering of mandatory prepayments. We believe that the
amendment of the mandatory prepayment provisions of the credit agreement
complied with the terms of the credit agreement, and we believe this lawsuit is
without merit and intend to defend it vigorously. The ultimate outcome of these
proceedings cannot be predicted with certainty. Except with respect to the
mandatory prepayment provisions of the credit agreement, this lawsuit does not
challenge any other portion of the March 20, 2002 amendment to the credit
agreement.
The Company has been notified that the staff of the U.S. Securities and
Exchange Commission has obtained a formal order of investigation in connection
with an inquiry that relates to events in and before the spring of 2000,
including the Company's accounting for its interest-only securities and
servicing rights. These issues were among those addressed in the Company's
write-down and restatement in the spring of 2000, and were the subject of
shareholder class action litigation, which has been recently settled. The
Company is cooperating with the SEC staff in this matter.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits (including purported class actions) related to their
operations. These actions include one action brought by the Texas Attorney
General regarding long term care policies, two purported nationwide class
actions involving claims related to "vanishing premiums," and two purported
nationwide class actions involving claims related to "modal premiums" (the
alleged imposition and collection of insurance premium surcharges in excess of
stated annual premiums). 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 to individually 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.
41
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows:
Six months ended
June 30,
----------------
2002 2001
---- ----
(Dollars in millions)
Cash flows from operating activities:
Net income (loss)......................................................................... $(4,378.2) $ 58.4
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Interest-only securities investment income............................................ (10.0) (31.7)
Cash received from interest-only securities, net...................................... (30.5) 7.9
Servicing income...................................................................... (36.2) (56.4)
Cash received from servicing activities............................................... 22.7 42.4
Provision for losses.................................................................. 448.7 226.7
Gain on sale of finance receivables................................................... (17.4) (15.6)
Amortization and depreciation......................................................... 492.1 454.2
Income taxes.......................................................................... 668.5 (31.5)
Insurance liabilities................................................................. 83.8 101.2
Accrual and amortization of investment income......................................... 121.7 90.2
Deferral of cost of policies produced and purchased................................... (271.0) (354.1)
Gain on sale of interest in riverboat................................................. - (192.4)
Impairment charges.................................................................... - 41.7
Special charges....................................................................... 169.2 44.0
Cumulative effect of change in accounting............................................. 2,949.2 -
Minority interest..................................................................... 89.8 94.3
Net investment losses................................................................. 290.8 153.6
Extraordinary gain on extinguishment of debt.......................................... (8.1) 6.8
Other................................................................................. (107.8) (133.7)
--------- -------
Net cash provided by operating activities........................................... $ 477.3 $ 506.0
========= =======
Six months ended
June 30,
----------------
2002 2001
---- ----
(Dollars in millions)
Non-cash items not reflected in the investing and financing activities sections
of the consolidated statement of cash flows:
Issuance of common stock under stock option and employee benefit plans....................... $ 15.1 $ 11.4
Issuance of convertible preferred shares..................................................... 1.9 8.5
Value of FELINE PRIDES retired and transferred from minority interest to common
stock and additional paid-in capital....................................................... - 496.6
42
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
SPECIAL CHARGES
2002
The following table summarizes the special charges incurred by the Company
during the three and six months ended June 30, 2002, which are further described
in the paragraphs which follow (dollars in millions):
Three months ended Six months ended
June 30, 2002 June 30, 2002
------------- -------------
Loss related to reinsurance transactions and businesses sold to raise cash..... $109.4 $148.7
Costs related to debt modification and refinancing transactions................ 12.4 24.4
Other items.................................................................... 11.2 29.4
------ ------
Special charges before income tax benefit.................................. $133.0 $202.5
====== ======
Loss related to reinsurance transactions and businesses sold to raise cash
We have sold or plan to sell portions of our insurance and financing
businesses to raise cash. We have not been as successful in completing these
transactions as we had hoped. Several of our planned transactions have been
delayed, require regulatory approval (which may be difficult to obtain given
recent developments) and will yield less proceeds than we previously expected.
In July 2002, we entered into an agreement to sell our subsidiary, Conseco
Variable Insurance Company. The completion of the sale is subject to several
contingencies, including buyer financing and various regulatory approvals. The
completion of the sale as of June 30, 2002, was not considered probable. Given
the potential sale, the Company reviewed its current lapse assumptions with
respect to the valuation of the cost of policies purchased and the cost of
policies produced. We concluded that additional amortization of $73.8 million
was required, based on our belief that future lapses will be higher given the
pending sale of this business. If completed at our current estimate of the sales
price ($120 million), we believe the sale will result in an additional loss of
about $70 million.
We completed other asset sales (including the sale of Manhattan National
Life Insurance Company)and reinsurance transactions which resulted in net losses
of $35.6 million and $39.3 million in the second and first quarters of 2002,
respectively. Such amounts include a loss of $47.3 million related to the sale
of $363 million of certain finance receivables. The sales resulted in net cash
flow of $150 million, after the payment of related debt. In addition, we
recognized a loss of $39.0 million in the second quarter of 2002 related to the
reinsurance of a portion of our life insurance business.
Costs related to debt modification and refinancing transactions
In conjunction with the various modifications to borrowing arrangements and
refinancing transactions (including the debt exchange offer completed in April
2002) entered into in the first and second quarters of 2002, we incurred costs
of $24.4 million which are not permitted to be deferred pursuant to GAAP.
Other items
The employment of the Company's chief financial officer was terminated in
the first quarter of 2002. As a result, the vesting provisions associated with
the restricted stock issued to the chief financial officer pursuant to his
employment agreement were accelerated. We recognized a charge of $5.1 million
related to the immediate vesting of such restricted stock in the first quarter
of 2002. We also recognized severance benefits of $1.4 million associated with
the termination of our chief financial officer.
43
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
In addition, other items include expenses incurred: (i) in conjunction with
the transfer of certain customer service and backroom operations to our India
subsidiary; (ii) for severance benefits; and (iii) for other items which are not
individually significant.
SPECIAL CHARGES
2001
The following table summarizes the special charges incurred by the Company
during the second quarter of 2001 and for the first six months of 2001, which
are further described in the paragraphs which follow (dollars in millions):
Three months Six months
ended ended
June 30, June 30,
2001 2001
------------- -----------
Organizational restructuring:
Severance benefits............................................................. $ - $15.3
Office closings and sale of artwork............................................ .3 7.1
Loss related to sale of certain finance receivables............................ 2.2 11.2
Amounts related to discontinued operations........................................ - 8.5
Other items....................................................................... 13.7 13.7
----- -----
Special charges before income tax benefit...................................... $16.2 $55.8
===== =====
Severance benefits
During the first quarter of 2001, Conseco developed plans to change the way
it operates. Such changes were undertaken in an effort to improve the Company's
operations and profitability. The planned changes included moving a significant
number of jobs to India, where a highly-educated, low-cost, English-speaking
labor force is available. Pursuant to GAAP, the Company was required to
recognize the costs associated with most restructuring activities as the costs
are incurred. However, costs associated with severance benefits are required to
be recognized when the costs are: (i) attributable to employees' services that
have already been rendered; (ii) relate to obligations that accumulate; and
(iii) are probable and can be reasonably estimated. Since the severance costs
associated with our planned activities met these requirements, we recognized a
charge of $15.3 million in the first six months of 2001.
Office closings and sale of artwork
In conjunction with our restructuring activities, we decided to close
certain offices, which resulted in the abandonment of certain leasehold
improvements. Further, certain antiques and artwork, formerly displayed in the
Company's executive offices, were sold. We recognized a charge of $7.1 million
related to these assets in the first six months of 2001.
Loss related to the sale of certain finance receivables
During the second quarter of 2001, we recognized a loss of $2.2 million on
the sale of $11.2 million of finance receivables. During the first quarter of
2001, the purchaser of certain credit card receivables returned certain
receivables pursuant to a return of accounts provision included in the sales
agreement. Such returns and the associated losses exceeded the amounts we
initially anticipated when the receivables were sold. We recognized a loss of
$9.0 million related to the returned receivables.
44
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Amounts related to discontinued operations
During the first quarter of 2001, we recognized special charges related to
our discontinued operations of: (i) $6.0 million related to various disputed
reinsurance balances; and (ii) $2.5 million related to reserves for litigation.
SALE OF INTEREST IN RIVERBOAT
In the first quarter of 2001, the Company sold its 29 percent ownership
interest in the riverboat casino in Lawrenceburg, Indiana, for $260 million. We
recognized a net gain on the sale of $192.4 million.
45
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CONDENSED FINANCIAL INFORMATION OF CIHC, INCORPORATED
CIHC has guaranteed the following debt: (i) Conseco's bank credit
facilities which had a principal balance of $1,493.3 million at June 30, 2002;
(ii) up to $250.0 million of certain obligations of Conseco Finance; (iii) up to
$537.3 million of bank loans to certain of our current and former directors,
officers and key employees which were used to purchase shares of Conseco common
stock; and (iv) $1,292.6 million aggregate principal amount of newly issued
notes (the "new notes") which were exchanged in April 2002 for certain
outstanding senior unsecured notes as described in the note entitled "Changes in
Direct Corporate Obligations". The guarantees of the new notes rank junior in
right of payment to CIHC's guarantee of the bank credit facilities, the
guaranteed obligations of Conseco Finance, the guarantee of bank loans to
certain of our current and former directors, officers and key employees and
certain intercompany debt.
The following condensed financial information summarizes the accounts of
CIHC. Such condensed financial information should be read in conjunction with
the consolidated financial statements of Conseco.
ASSETS
June 30,
2002
----
(Dollars in millions)
Cash and cash equivalents............................................. $ .8
Other invested assets................................................. 3.8
Investment in wholly owned subsidiaries
(eliminated in consolidation)..................................... 6,754.6
Notes receivable from Conseco Finance
(eliminated in consolidation)..................................... 273.2
Receivable from subsidiaries (eliminated in consolidation)............ 1,524.6
Other assets.......................................................... 1.3
---------
Total assets................................................ $ 8,558.3
=========
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities:
Notes payable to subsidiaries (eliminated in consolidation)....... $ 1,011.7
Payable to subsidiaries (eliminated in consolidation)............. 296.8
Income taxes...................................................... 175.3
Other liabilities................................................. .9
---------
Total liabilities........................................... 1,484.7
---------
Shareholder's equity:
Preferred stock................................................... 259.5
Common stock and additional paid-in capital....................... 8,718.8
Accumulated other comprehensive loss.............................. (291.0)
Accumulated deficit............................................... (1,613.7)
---------
Total shareholder's equity.................................. 7,073.6
---------
Total liabilities and shareholder's equity.................. $ 8,558.3
=========
46
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Three months ended Six months ended
June 30, 2002 June 30, 2002
------------- -------------
(Dollars in millions)
Revenues:
Net investment income......................................... $ .1 $ .2
Dividends from subsidiaries (eliminated in consolidation)..... 36.0 276.0
Fee and interest income from subsidiaries
(eliminated in consolidation).............................. 33.7 61.8
------- ---------
Total revenues.......................................... 69.8 338.0
------- ---------
Expenses:
Intercompany expenses (eliminated in consolidation)........... 14.2 31.5
Special charges............................................... .3 .3
Operating costs and expenses.................................. .8 1.6
------- ---------
Total expenses.......................................... 15.3 33.4
------- ---------
Income before income taxes, equity in undistributed
earnings of subsidiaries, extraordinary gain and
cumulative effect of accounting change............... 54.5 304.6
Income tax expense................................................ 6.8 10.6
------- ---------
Income (loss) before equity in undistributed earnings
of subsidiaries, extraordinary gain (loss) and
cumulative effect of accounting change............... 47.7 294.0
Equity in undistributed earnings of subsidiaries (net of dividends
from subsidiaries) before extraordinary gain (loss) and
cumulative effect of accounting change (eliminated in
consolidation)................................................ (372.4) (604.9)
------- ---------
Loss before extraordinary gain (loss) and cumulative
effect of accounting change.......................... (324.7) (310.9)
Extraordinary gain (loss) on extinguishment of debt, net of tax,
of subsidiary................................................. (.1) 3.9
Cumulative effect of accounting change, net of tax, of
subsidiaries.................................................. - (2,949.2)
------- ---------
Net loss................................................... (324.8) (3,256.2)
Preferred stock dividends......................................... 6.7 13.3
------- ---------
Loss applicable to common stock............................ $(331.5) $(3,269.5)
======= =========
47
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
SUBSEQUENT EVENTS
NYSE DELISTING
After the issuance of our press release on August 9, 2002, the New York
Stock Exchange ("NYSE") halted trading in our common stock and other listed
securities. On August 12, 2002, the NYSE issued a public announcement of the
suspension of trading. The NYSE also notified the Company on August 12, 2002,
that application to the Securities and Exchange Commission to delist the
securities was pending completion of applicable procedures, including any appeal
by the Company of the NYSE's staff decision.
48
CONSECO, INC. AND SUBSIDIARIES
--------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review Conseco's consolidated results of operations for
the three months and six ended June 30, 2002 and 2001, and significant changes
in our consolidated financial condition. Please read this discussion in
conjunction with the accompanying consolidated financial statements and notes.
Consolidated results and analysis
The net loss applicable to common stock of $1,334.0 million in the second
quarter of 2002, or $3.86 per diluted share, included: (i) net investment losses
(net of related costs, amortization and taxes) of $166.6 million, or 48 cents
per share; (ii) a loss of $15.3 million, or 4 cents per share, related to our
venture capital investment in AWE; (iii) a provision for loss of $65.0 million,
or 19 cents per share, related to the Company's guarantee of bank loans to
directors, officers and key employees to purchase shares of Conseco common
stock; (iv) special charges of $86.5 million, or 25 cents per share, as
summarized in the note to the consolidated financial statements entitled
"Special Charges"; (v) a deferred income tax valuation allowance of $1,003.0
million, or $2.90 per share; and (vi) an extraordinary gain of $1.1 million, or
nil cents per share, related to the early retirement of debt. The net loss
applicable to common stock of $30.3 million in the second quarter of 2001, or 9
cents per diluted share, included: (i) net investment losses (net of related
costs, amortization and taxes) of $22.0 million, or 7 cents per share; (ii)
income of $20.8 million, or 6 cents per share, related to our venture capital
investment in AWE; (iii) an impairment charge of $21.0 million, or 6 cents per
share, related to the Company's interest-only securities and servicing rights;
(iv) special charges and amounts related to discontinued lines of $72.7 million,
or 22 cents per share as summarized in the note to the consolidated financial
statements entitled "Special Charges"; and (v) an extraordinary charge of $5.0
million, or 1 cent per share, related to the early retirement of debt.
The net loss applicable to common stock of $4,380.1 million in the first
six months of 2002, or $12.67 per diluted share, included: (i) net investment
losses (net of related costs, amortization and taxes) of $186.5 million, or 54
cents per share; (ii) a loss of $65.0 million, or 19 cents per share, related to
our venture capital investment in AWE; (iii) a provision for loss of $91.0
million, or 26 cents per share related to the Company's guarantee of bank loans
to directors, officers and key employees to purchase shares of Conseco common
stock; (iv) special charges of $131.7 million, or 38 cents per share as
summarized in the notes to the consolidated financial statements; (v) a deferred
income tax valuation allowance of $1,003.0 million, or $2.90 per share; (vi) an
extraordinary gain of $5.1 million, or 1 cent per share, related to the early
retirement of debt; and (vii) the cumulative effect of an accounting change for
goodwill impairment of $2,949.2 million, or $8.53 per share, related to the
adoption of SFAS 142. The net income applicable to common stock of $49.9 million
in the first six months of 2001, or 14 cents per diluted share, included: (i)
net investment losses (including related costs, amortization and taxes) of $81.1
million, or 23 cents per share; (ii) income of $3.3 million, or 1 cent per
share, related to our venture capital investment in AWE; (iii) the gain on the
sale of our interest in a riverboat of $122.6 million, or 35 cents per share;
(iv) an impairment charge of $26.0 million, or 8 cents per share, related to the
Company's interest-only securities and servicing rights; (v) special charges,
additional amortization and amounts related to discontinued lines of $87.8
million, or 25 cents per share, as summarized in the notes to the consolidated
financial statements; and (vi) an extraordinary charge of $4.7 million, or 1
cent per share, related to the early retirement of debt.
We evaluate performance and determine future earnings goals based on
operating earnings which we define as income before: (i) net investment gains
(losses)(less that portion of amortization of cost of policies purchased and
cost of policies produced and income taxes relating to such gains (losses));
(ii) the venture capital income (loss) related to our investment in AWE; (iii)
the gain on the sale of our interest in a riverboat; (iv) special items not
related to the continuing operations of our businesses (including impairment
charges to reduce the value of interest-only securities and servicing rights,
special charges and the provision for losses related to loan guarantees); (v)
the effect on amortization of the cost of policies purchased and produced of
significant changes in assumptions used to estimate future gross profits of
insurance businesses; (vi) the net income (loss) related to the discontinued
major medical business; and (vii) the effect of accounting changes and
extraordinary gain (loss) on extinguishment of debt. The criteria used by
management to identify the items excluded from operating earnings include
whether the item: (i) relates to other than the continuing operations of our
businesses; (ii) is infrequent; (iii) is material to net income (loss); (iv)
results from restructuring activities; (v) results from a change in the
regulatory environment; and/or (vi) relates to the sale of an investment or the
change in estimated market value of our venture capital investments. The
non-operating items which may occur will vary from period to period and since
these items are determined based on management's discretion, inconsistencies in
the application of the criteria may exist. Operating earnings are determined by
adjusting GAAP net income for the above mentioned items. While these items may
be significant components in understanding and assessing
49
CONSECO, INC. AND SUBSIDIARIES
--------------------
our consolidated financial performance, we believe that the presentation of
operating earnings enhances the understanding of our results of operations by
highlighting net income attributable to the normal, recurring operations of the
business and by excluding events that materially distort trends in net income.
However, operating earnings are not a substitute for net income (loss)
determined in accordance with GAAP.
50
CONSECO, INC. AND SUBSIDIARIES
--------------------
Results of operations by segment for the three and six months ended June
30, 2002 and 2001
The following tables and narratives summarize our operating results by
business segment.
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Operating earnings from continuing operations before taxes
and goodwill amortization:
Insurance and fee-based segment operating earnings....... $ 92.3 $231.6 $ 256.0 $434.8
Finance segment operating earnings....................... 40.6 80.1 73.7 143.7
--------- ------ --------- ------
Subtotal................................................. 132.9 311.7 329.7 578.5
--------- ------ --------- ------
Holding company activities:
Corporate expenses, less charges to subsidiaries for
services provided........................................ (5.2) (9.3) (14.8) (.8)
Interest and dividends, net of corporate investment income. (122.8) (138.2) (241.4) (290.5)
Allocation of interest to finance segment.................. - 1.9 - 7.4
--------- ------- --------- ------
Operating earnings from continuing operations
before taxes and goodwill amortization................. 4.9 166.1 73.5 294.6
Taxes ....................................................... (3.6) (68.1) (32.3) (115.8)
--------- ------ --------- ------
Operating earnings from continuing operations before
goodwill amortization.................................. 1.3 98.0 41.2 178.8
Goodwill amortization......................................... - (28.4) - (55.2)
--------- ------ --------- ------
Operating earnings from continuing operations
applicable to common stock............................. 1.3 69.6 41.2 123.6
--------- ------ --------- ------
Non-operating items, net of tax:
Deferred income tax valuation allowance.................... (1,003.0) - (1,003.0) -
Loss related to reinsurance transactions and businesses
sold to raise cash....................................... (71.2) (1.6) (96.7) (7.5)
Net realized losses........................................ (166.6) (22.0) (186.5) (81.1)
Provision for losses related to loan guarantees............ (65.0) - (91.0) -
Venture capital income (loss) related to our investment
in AT&T Wireless Services, Inc........................... (15.3) 20.8 (65.0) 3.3
Costs related to debt modification and refinancing
transactions............................................. (8.1) - (15.9) -
Discontinued lines and other non-recurring items........... (7.2) (71.1) (19.1) (80.3)
Gain on sale of interest in riverboat...................... - - - 122.6
Impairment charge related to interest-only securities...... - (21.0) - (26.0)
Extraordinary gain (loss) on extinguishment of debt ....... 1.1 (5.0) 5.1 (4.7)
Cumulative effect of accounting change..................... - - (2,949.2) -
--------- ------ --------- ------
Total non-operating items, net of tax.................... (1,335.3) (99.9) (4,421.3) (73.7)
--------- ------ --------- ------
Net income (loss) applicable to common stock.................. $(1,334.0) $(30.3) $(4,380.1) $ 49.9
========= ====== ========= ======
51
CONSECO, INC. AND SUBSIDIARIES
--------------------
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2001 Annual Report on
Form 10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements.
The following updates the Critical Accounting Policies discussion for
recent developments related to investments, goodwill, and income taxes.
Investments
At June 30, 2002, the carrying value of our investment portfolio was $23.5
billion. The accounting risks associated with these assets relate to the
recognition of income, our determination of other-than-temporary impairments and
our estimation of fair values.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments. We consider anticipated prepayments on
mortgage-backed securities in determining estimated future yields on such
securities.
When we sell a security (other than trading securities or venture capital
investments), we report the difference between the sale proceeds and amortized
cost (determined based on specific identification) as an investment gain or
loss.
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value. For the first six months of 2002, the Company recorded $266.4
million of writedowns of fixed maturities, equity securities, and other invested
assets as a result of conditions that caused us to conclude a decline in fair
value of the investments was other than temporary. The facts and circumstances
resulting in the other-than-temporary losses are described in "Investments with
Other-Than-Temporary Losses" included in this Management's Discussion and
Analysis of Financial Condition and Results of Operations.
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time. At June 30, 2002, our accumulated other comprehensive loss
included unrealized losses on investments of $524.5 million; we consider all
such declines in estimated fair value to be temporary. Our assessments of the
potential other-than-temporary losses related to investments in our
below-investment grade portfolio (or equity-type securities) at June 30, 2002
are described in "Investments with Unrealized Losses" included in this
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
Estimated fair values for our investments are determined based on estimates
from nationally recognized pricing services, broker-dealer market makers, and
internally developed methods. Our internally developed methods require us to
make judgments about the security's credit quality, liquidity and market spread.
We seek to closely match the estimated duration of our invested assets to
the expected duration of our liabilities. When the estimated durations of assets
and liabilities are similar, exposure to interest rate risk is minimized because
a change in the value of assets should be largely offset by a change in the
value of liabilities. A mismatch of the durations of invested assets and
liabilities could have a significant impact on our results of operations and
financial position.
For more information on our investment portfolio and our critical
accounting policies related to investments, see "Investments" included in this
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
52
CONSECO, INC. AND SUBSIDIARIES
--------------------
Goodwill
As more fully described in the note to our consolidated financial
statements entitled "Cumulative Effect of Accounting Change", the Company
recorded an impairment charge to goodwill of $2,949.2 million in the first
quarter of 2002 as a result of adopting SFAS 142.
The significant factors used to determine the amount of the impairment
included analyses of industry market valuations, historical and projected
performance of our insurance segment, discounted cash flow analyses and the
market value of our common stock. The valuation utilized the best available
information, including assumptions and projections we consider reasonable and
supportable. The assumptions we used to determine the discounted cash flows
involve significant judgments regarding the best estimate of future premiums,
expected mortality and morbidity, interest earned and credited rates,
persistency and expenses. The discount rate used was based on an analysis of the
weighted average cost of capital for several other insurance companies and
considered the specific risk factors related to Conseco. Pursuant to the
guidance in SFAS 142, quoted market prices in active markets are the best
evidence of fair value and shall be used as the basis for measurement, if
available. Management believes that the assumptions and estimates used are
reasonable given all available facts and circumstances. However, if projected
cash flows are not realized in the future, we may be required to recognize
additional impairments. Subsequent impairment tests will be performed on an
annual basis, or more frequently if circumstances indicate a possible
impairment. Subsequent impairments, if any, would be classified as an operating
expense.
Income Taxes
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities and net operating loss carryforwards. In assessing the
realization of our deferred income tax assets, we consider whether it is more
likely than not that the deferred income tax assets will be realized. The
ultimate realization of our deferred income tax assets depends upon generating
future taxable income during the periods in which our temporary differences
become deductible and before our net operating loss carryforwards expire. We
evaluate the recoverability of our deferred income tax assets by assessing the
need for a valuation allowance on a quarterly basis.
A valuation allowance of $1,003.0 million has been provided for the entire
net deferred income tax asset balance at June 30, 2002, as we believe the
realization of such asset in future periods is uncertain. We reached this
conclusion after considering the availability of taxable income in prior
carryback years, tax planning strategies, and the likelihood of future taxable
income exclusive of reversing temporary differences and carryforwards. This
conclusion was greatly influenced by recent unfavorable developments affecting
the Company such as rating downgrades that decrease the Company's likelihood to
generate adequate future taxable income to realize the tax benefits.
The Company established valuation contingencies related to certain tax
uncertainties of the insurance companies we acquired on the date of their
acquisition. We have determined that $146.2 million of such valuation
contingencies are no longer necessary because the tax uncertainties no longer
exist. Pursuant to Financial Accounting Standards Board Statement No. 109,
"Accounting for Income Taxes", the benefit for the reduction of such valuation
contingencies shall be first applied to reduce the related goodwill balances
related to the acquisition. Accordingly, in the second quarter of 2002, we
reduced such valuation contingencies (increasing deferred taxes) and goodwill
balances by $146.2 million.
53
CONSECO, INC. AND SUBSIDIARIES
--------------------
Insurance and fee-based operations
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Premiums and asset accumulation product collections:
Annuities............................................................ $ 330.9 $ 410.4 $ 722.0 $ 818.0
Supplemental health.................................................. 596.2 577.8 1,206.3 1,183.7
Life................................................................. 157.3 220.5 371.5 444.2
--------- --------- --------- ---------
Collections on insurance products from continuing operations..... 1,084.4 1,208.7 2,299.8 2,445.9
Major medical........................................................ 102.2 195.4 237.0 404.9
--------- --------- --------- ---------
Total collections on insurance products.......................... 1,186.6 1,404.1 2,536.8 2,850.8
Deposit type contracts............................................... 82.0 37.5 163.8 100.1
Mutual funds......................................................... 38.0 120.5 126.5 231.8
--------- --------- --------- ---------
Total premiums and asset accumulation product collections........ $ 1,306.6 $ 1,562.1 $ 2,827.1 $ 3,182.7
========= ========= ========= =========
Average liabilities for insurance and asset accumulation products
(excluding discontinued major medical business):
Annuities:
Mortality based.................................................. $ 306.9 $ 423.2 $ 321.2 $ 427.3
Equity-linked.................................................... 2,232.3 2,629.7 2,343.9 2,631.2
Deposit based.................................................... 8,820.8 8,744.6 8,827.7 8,801.4
Separate accounts and investment trust liabilities............... 2,252.0 2,437.5 2,323.5 2,463.1
Health............................................................. 5,337.2 5,065.2 5,305.4 5,024.1
Life:
Interest sensitive............................................... 4,017.4 4,315.9 4,017.5 4,302.8
Non-interest sensitive........................................... 2,215.3 2,677.3 2,197.7 2,665.5
--------- --------- --------- ---------
Total average liabilities for insurance and asset
accumulation products, net of reinsurance ceded.............. $25,181.9 $26,293.4 $25,336.9 $26,315.4
========= ========= ========= =========
Revenues:
Insurance policy income.............................................. $ 770.6 $ 829.6 $ 1,592.7 $ 1,652.7
Net investment income:
General account invested assets.................................... 402.4 457.1 817.2 897.9
Equity-indexed products based on the change in
value of the S&P 500 Call Options................................ (54.4) (29.4) (70.5) (56.1)
Separate account assets............................................ (80.6) (14.7) (133.1) (64.0)
Fee revenue and other income......................................... 25.1 26.3 53.5 52.3
--------- --------- --------- ---------
Total revenues (a)............................................... 1,063.1 1,268.9 2,259.8 2,482.8
--------- --------- --------- ---------
Expenses:
Insurance policy benefits............................................ 569.2 601.1 1,181.3 1,211.4
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.................................... 135.0 142.1 274.0 288.2
Equity-indexed products based on S&P 500 Index..................... (24.9) (1.0) (15.2) 2.1
Separate account liabilities....................................... (80.6) (14.7) (133.1) (64.0)
Amortization related to operations................................... 243.6 149.3 416.8 296.5
Interest expense on investment borrowings............................ 3.7 12.2 11.2 16.7
Other operating costs and expenses................................... 124.8 148.3 268.8 297.1
--------- --------- --------- ---------
Total benefits and expenses (a).................................. 970.8 1,037.3 2,003.8 2,048.0
--------- --------- -------- ---------
Operating income before goodwill amortization,
income taxes and minority interest............................. 92.3 231.6 256.0 434.8
Goodwill amortization................................................... - (28.4) - (55.2)
Net investment losses, including related costs and
amortization......................................................... (256.3) (33.9) (287.0) (124.8)
Special charges and additional amortization............................. (42.8) (38.6) (48.1) (47.7)
--------- --------- -------- ---------
Income (loss) before income taxes, minority interest, extraordinary gain
(loss) and cumulative effect of
accounting change.............................................. $ (206.8) $ 130.7 $ (79.1) $ 207.1
========= ========= ========= ========
(continued)
54
CONSECO, INC. AND SUBSIDIARIES
--------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- ------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Ratios:
Investment income, net of interest credited on annuities and
universal life products and interest expense on investment
borrowings, as a percentage of average liabilities for
insurance and asset accumulation products (b)............... 4.45% 4.48% 4.53% 4.47%
Operating costs and expenses (excluding amortization of cost
of policies produced and cost of policies purchased) as a
percentage of average liabilities for insurance and asset
accumulation products....................................... 1.98% 2.26% 2.12% 2.26%
Health loss ratios:
All health lines:
Insurance policy benefits................................... $445.8 $434.7 $917.1 $885.4
Loss ratio.................................................. 75.19% 73.92% 76.64% 75.18%
Medicare Supplement:
Insurance policy benefits................................... $164.0 $161.9 $329.8 $329.6
Loss ratio.................................................. 65.75% 66.29% 65.97% 67.56%
Long-Term Care:
Insurance policy benefits................................... $200.2 $178.8 $417.1 $376.4
Loss ratio.................................................. 90.32% 82.25% 92.79% 86.09%
Interest-adjusted loss ratio................................ 68.59% 63.37% 71.64% 67.58%
Specified Disease:
Insurance policy benefits................................... $61.0 $68.5 $126.6 $127.2
Loss ratio.................................................. 65.53% 72.98% 67.35% 68.19%
Other:
Insurance policy benefits................................... $20.6 $25.5 $43.6 $52.2
Loss ratio.................................................. 71.58% 78.24% 73.49% 79.04%
- --------------------
(a) Revenues exclude net investment gains (losses); benefits and expenses
exclude amortization related to realized gains and goodwill amortization.
(b) Investment income includes income from general account assets only.
Average insurance liabilities exclude liabilities related to separate
accounts, investment trust and reinsurance ceded.
General: As more fully described in "Liquidity for insurance and fee-based
operations" within "Management's Discussion and Analysis of Financial Condition
and Results of Operations", our insurance subsidiaries claim-paying ratings were
downgraded by A.M. Best on July 12, 2002 to B++ and the ratings remain "under
review with negative implications". We believe that A.M. Best will soon lower
this rating. The downgrade may cause sales of our insurance products to fall and
policyholder redemptions and lapses to increase. If such activity was unusually
high, it could cause a material adverse impact on our financial results and
liquidity. Also, the recent adverse developments concerning the parent company's
liquidity will make obtaining approvals for dividends from insurance regulatory
authorities more difficult in the future, if we request such approvals.
Conseco's insurance subsidiaries develop, market and administer annuity,
supplemental health, individual life insurance and other insurance products. We
distribute these products through a career agency force, professional
independent producers and direct response marketing. This segment excludes our
discontinued major medical business.
Liabilities for insurance products are calculated using management's best
judgments of mortality, morbidity, lapse rates, investment experience and
expense levels that are based on the Company's past experience and standard
actuarial tables.
55
CONSECO, INC. AND SUBSIDIARIES
--------------------
Collections on insurance products from continuing operations were $1.1
billion in the second quarter of 2002, down 10 percent from 2001. Collections on
insurance products from continuing operations were $2.3 billion in the first six
months of 2002, down 6.0 percent from 2001. Sales of our equity-indexed products
were adversely affected by the recent performance of the stock market. See
"Premium and Asset Accumulation Product Collections" for further analysis.
Average liabilities for insurance and asset accumulation products, net of
reinsurance receivables, were $25.2 billion in the second quarter of 2002, down
4.2 percent from 2001. Average liabilities for insurance and asset accumulation
products, net of reinsurance receivables, were $25.3 billion in the first six
months of 2002, down 3.7 percent from 2001. The decrease in such liabilities is
primarily due to ceding approximately $870 million of insurance liabilities
pursuant to reinsurance agreements entered into during the first quarter of
2002. See the notes to the consolidated financial statements under the caption
"Reinsurance" for additional discussion of these reinsurance transactions.
Insurance policy income is comprised of: (i) premiums earned on policies
which provide mortality or morbidity coverage; and (ii) fees and other charges
made against other policies. See "Premium and Asset Accumulation Product
Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on separate account assets related to variable annuities; and the income
(loss), cost and change in the fair value of S&P 500 Call Options related to
equity-indexed products) was $402.4 million in the second quarter of 2002, down
12 percent from the same period in 2001 and was $817.2 million in the first six
months of 2002, down 9.0 percent from 2001. The average balance of general
account invested assets in the second quarter of 2002 decreased 3.7 percent to
$24.5 billion compared to the same period in 2001. The yield on these assets was
6.6 percent in 2002 and 7.2 percent in 2001. The average balance of general
account invested assets decreased by .1 percent in the first six months of 2002
to $25.0 billion compared to the same period in 2001. The yield on these assets
decreased by .5 percentage points to 6.5 percent during the first six months of
2002. The decrease reflects general decreases in investment interest rates
between periods. Net investment income and the average balance of general
account invested assets both reflect the transfer of a portion of our investment
portfolio to reinsurers pursuant to recent agreements. See the notes to the
consolidated financial statements under the caption "Reinsurance" for additional
discussion of reinsurance transactions.
Net investment income related to equity-indexed products based on the
change in value of the S&P 500 Call Options represents the change in the
estimated fair value of our S&P 500 Index Call Options which are purchased in an
effort to cover certain benefits accruing to the policyholders of our
equity-indexed products. Our equity-indexed products are designed so that the
investment income spread earned on the related insurance liabilities should be
more than adequate to cover the cost of the S&P 500 Call Options and other costs
related to these policies. Option costs that are attributable to benefits
provided were $27.4 million and $29.9 million in the second quarters of 2002 and
2001, respectively; and $52.2 million and $61.5 million in the first six months
of 2002 and 2001, respectively. These costs are reflected in the change in
market value of the S&P 500 Call Options included in the investment income
amounts. Net investment income (loss) related to equity-indexed products before
this expense was $(27.0) million and $.5 million in the second quarters of 2002
and 2001, respectively; and $(18.2) million and $5.4 million in the first six
months of 2002 and 2001, respectively. Such amounts were substantially offset by
the corresponding charge (credit) to amounts added to policyholder account
balances for equity-indexed products of $(24.9) million and $(1.0) million in
the second quarters of 2002 and 2001, respectively; and $(15.2) million and $2.1
million in the first six months of 2002 and 2001, respectively. Such income and
related charge fluctuated based on the value of options embedded in the
Company's equity-indexed annuity products policyholder account balance subject
to this benefit and to the performance of the S&P 500 Index to which the returns
on such products are linked.
Net investment income (loss) from separate account assets is offset by a
corresponding charge (credit) to amounts added to policyholder account balances
for separate account liabilities. Such income (loss) and related charge (credit)
fluctuated in relationship to total separate account assets and the return
earned on such assets.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. In the three and six months ended June 30, 2002,
this amount includes $7.0 million and $13.2 million, respectively, of affiliated
fee revenue earned by our subsidiary in India. Such revenue is eliminated in
consolidation. Excluding such affiliated income, this amount decreased in the
2002 periods primarily as a result of a decrease in the market value of
investments managed for others, upon which these fees are based.
56
CONSECO, INC. AND SUBSIDIARIES
--------------------
Insurance policy benefits fluctuated as a result of the factors summarized
in the explanations for loss ratios related to specific products which follow.
Loss ratios are calculated by taking the related insurance product's: (i) policy
benefits; divided by (ii) policy income.
The loss ratio for Medicare supplement products has been within the range
we expect it to be in during the 2002 and 2001 periods. Governmental regulations
generally require us to attain and maintain a loss ratio, after three years, of
not less than 65 percent.
The loss ratios for long-term care products increased in 2002, reflecting
the effects of the asset accumulation phase of these products. The net cash
flows from our long-term care products generally result in the accumulation of
amounts in the early years of a policy (accounted for as reserve increases)
which will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, during the asset accumulation phase of these
policies, the loss ratio will increase, but the increase in the change in
reserve will be partially offset by investment income earned on the assets which
have accumulated. The interest-adjusted loss ratio for long-term care products
is calculated by taking the insurance product's (i) policy benefits less
interest income on the accumulated assets which back the insurance liabilities;
divided by (ii) policy income. This ratio has been within the range we expect it
to be in during the 2002 and 2001 periods.
The loss ratio for our specified disease policies increased in the second
quarter of 2001 due to unfavorable claims experience. Our general expectation is
for this loss ratio to be approximately 65 percent.
The loss ratios on our other products will fluctuate due to the smaller
size of these blocks of business. The loss ratios on this business have
generally been within our expectations.
Amounts added to policyholder account balances for annuity products
decreased by 5.0 percent in the second quarter of 2002 to $135.0 million and by
4.9 percent in the first six months of 2002 to $274.0 million, as compared to
the same periods in the prior year. This decrease is primarily due to a smaller
block of this type of annuity business in force, on the average, between
periods. The weighted average crediting rates for these annuity liabilities was
4.4 percent and 4.5 percent for the first six months of 2002 and 2001,
respectively.
Amounts added to equity-indexed products and separate account liabilities
correspond to the related investment income accounts described above.
Amortization related to operations includes amortization of: (i) the cost
of policies produced; and (ii) the cost of policies purchased. Amortization
generally fluctuates in relationship to the total account balances subject to
amortization.
During the second quarter of 2002, we changed the lapse assumptions used to
determine the amortization of the cost of policies produced and the cost of
policies purchased related to certain universal life products and our
equity-indexed annuities to reflect our current estimates of future lapses.
These changes resulted in additional amortization of $74 million. For certain
universal life products, we changed the ultimate lapse assumption from: (i) a
range of 6 percent to 7 percent; to (ii) a tiered assumption based on the level
of funding of the policy of a range of 2 percent to 10 percent. Our
equity-indexed annuity lapses in recent periods have exceeded our estimates. The
values surrendered in the second quarter of 2002 totaled $100.7 million. We
believe lapses have increased due to equity market performance and intense
replacement activity by a small group of our competitors. Accordingly, we
increased the expected future lapse rates on these products to reflect our
current belief that lapses on these policies will continue to be higher than
expected for the next several years.
Interest expense on investment borrowings increased along with our
investment borrowing activities. Average investment borrowings were $1,441.0
million during the first six months of 2002 compared to $729.4 million during
the same period of 2001. The weighted average interest rates on such borrowings
were 1.6 percent and 4.6 percent during the first six months of 2002 and 2001,
respectively.
Other operating costs and expenses decreased in 2002 consistent with our
cost cutting programs and the current business plans for the segment. The
decreased expenses are reflected in the improved ratio of operating expenses
(excluding amortization of cost of policies produced and cost of policies
purchased) as a percentage of average liabilities for insurance and asset
accumulation products (1.98 percent and 2.12 percent for the three and six
months ended June 30, 2002, respectively, compared to 2.26 percent for both the
three and six months ended June 30, 2001).
57
CONSECO, INC. AND SUBSIDIARIES
--------------------
Net investment gains (losses), including related costs and amortization
fluctuate from period to period. During the first six months of 2002, we
recognized net investment losses of $290.8 million, compared to $153.6 million
during the comparable period of 2001. During the first six months of 2002, we
recorded $266.4 million of writedowns of fixed maturity securities, equity
securities and other invested assets as a result of conditions which caused us
to conclude a decline in fair value of the investment was other than temporary.
During the first six months of 2001, we decided to sell several securities to
enhance the yield and other characteristics of our portfolio. In accordance with
GAAP, we were required to recognize a writedown when it was determined that a
loss would occur upon the planned sale of a security. Accordingly, we recorded
$125.4 million of investment writedowns during the first six months of 2001
related to the investment restructuring activities and as a result of changes in
conditions related to other investments which caused us to conclude that a
decline in the fair value of the investments was other than temporary. The facts
and circumstances resulting in the other-than-temporary losses are described in
"Investments with Other-Than-Temporary Losses" included in this Management's
Discussion and Analysis of Financial Condition and Results of Operations.
When we sell securities at a gain (loss) and reinvest the proceeds at a
different yield, we increase (reduce) the amortization of cost of policies
purchased and cost of policies produced in order to reflect the change in future
yields. Sales of fixed maturity investments resulted in an increase (reduction)
in the amortization of the cost of policies purchased and the cost of policies
produced of $(4.2) million and $6.4 million in the second quarters of 2002 and
2001, respectively, and $(3.9) million and $28.8 million in the first six months
of 2002 and 2001, respectively.
Special charges in 2002 include: (i) losses of $39.0 million on reinsurance
transactions entered into as part of our cash raising initiatives (all
recognized in the second quarter of 2002); and (ii) other items totaling $9.1
million ($3.8 million of which was recognized in the second quarter of 2002)
primarily related to severance benefits and costs incurred with the transfer of
certain customer service and backroom operations to our India subsidiary.
Special charges in the six months ended June 30, 2001, included: (i) severance
benefits of $9.1 million which were recognized in the first quarter of 2001; and
(ii) other items totaling $3.6 million which were recognized in the second
quarter of 2001. These charges are described in greater detail in the note to
the accompanying consolidated financial statements entitled "Special Charges".
Additional amortization in the insurance segment represents the
amortization of the cost of policies produced and cost of policies purchased as
a result of changes in our assumptions used to estimate the future gross profits
of our variable annuity business. The cost of policies produced and the cost of
policies purchased are amortized in relation to the estimated gross profits to
be earned over the life of our annuity products. As a result of economic
developments, actual experience of our products and changes in our expectations,
we changed our investment yield assumptions used in calculating the estimated
gross profits to be earned on our annuity products. Such changes resulted in
additional amortization of the cost of policies produced and cost of policies
purchased of $35.0 million during the three and six months ended June 30, 2001.
58
CONSECO, INC. AND SUBSIDIARIES
--------------------
Finance operations
Three months ended Six months ended
June 30, June 30,
------------------- ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Contract originations:
Manufactured housing..................................... $ 325.2 $ 648.2 $ 658.8 $ 1,162.3
Mortgage services........................................... 709.4 712.6 1,374.1 1,276.3
Retail credit............................................ 915.4 1,159.7 1,645.5 1,808.1
Consumer finance - closed-end............................ 4.5 - 4.7 -
Floorplan................................................ 64.1 561.3 450.7 1,024.1
Discontinued............................................. 6.5 13.5 14.8 66.7
--------- --------- --------- ----------
Total.................................................. $ 2,025.1 $ 3,095.3 $ 4,148.6 $ 5,337.5
========= ========= ========= ==========
Sales of finance receivables:
Manufactured housing..................................... $ 3.1 $ - $ 4.8 $ -
Mortgage services........................................ 190.1 49.6 366.5 664.8
Floorplan................................................ - - 126.8 -
Discontinued lines....................................... 84.0 - 173.8 802.3
--------- --------- --------- ---------
Total.................................................. $ 277.2 $ 49.6 $ 671.9 $ 1,467.1
========= ========= ========= =========
Managed receivables (average):
Manufactured housing..................................... $24,840.5 $26,036.0 $25,085.2 $26,132.0
Mortgage services........................................ 11,088.4 12,663.8 11,346.1 12,895.8
Retail credit............................................ 2,677.8 2,068.1 2,672.3 1,943.8
Consumer finance - closed-end............................ 1,260.5 1,801.0 1,324.2 1,881.3
Floorplan................................................ 553.2 1,264.1 700.3 1,336.7
Discontinued lines....................................... 315.7 627.6 387.8 795.9
--------- --------- --------- ---------
Total.................................................. $40,736.1 $44,460.6 $41,515.9 $44,985.5
========= ========= ========= =========
Revenues:
Net investment income:
Finance receivables and other.......................... $ 554.5 $ 544.1 $ 1,109.9 $ 1,096.7
Interest-only securities............................... 5.1 16.6 10.0 31.7
Gain on sales of finance receivables..................... 10.2 6.7 17.4 15.6
Fee revenue and other income............................. 63.1 87.7 131.2 175.3
--------- --------- ---------- ---------
Total revenues......................................... 632.9 655.1 1,268.5 1,319.3
--------- --------- --------- ---------
Expenses:
Provision for losses..................................... 158.3 111.0 316.7 226.7
Finance interest expense................................. 286.0 306.6 575.5 628.2
Other operating costs and expenses....................... 148.0 157.4 302.6 320.7
--------- --------- ---------- ---------
Total expenses......................................... 592.3 575.0 1,194.8 1,175.6
--------- --------- --------- ---------
Operating income before special charges, impairment
charges and income taxes............................. 40.6 80.1 73.7 143.7
Special charges............................................. 9.3 2.4 56.5 16.2
Impairment charges.......................................... - 33.8 - 41.7
--------- --------- --------- ---------
Income before income taxes............................. $ 31.3 $ 43.9 $ 17.2 $ 85.8
========= ========= =========== =========
59
CONSECO, INC. AND SUBSIDIARIES
--------------------
General: As more fully described in "Liquidity for finance operations"
within "Management's Discussion and Analysis of Financial Condition and Results
of Operations", the recent adverse developments concerning the parent company's
liquidity have adversely affected our finance subsidiary's ability to access the
securitization market. In addition, our finance subsidiary's lenders have
reduced and/or restricted access to available funding facilities and an event of
default under our bank-credit agreement would result in cross-defaults under our
finance subsidiary's credit facility. There can be no assurance that our finance
subsidiary will be able to continue to make new loans and fund its operations.
Conseco's finance subsidiaries provide financing for manufactured housing, home
equity, home improvements, consumer products and equipment, and provide consumer
and commercial revolving credit. Finance products include both fixed-term and
revolving loans and leases. Conseco also markets physical damage and other
credit protection relating to the loans it services. Certain amounts have been
reclassified for the change in presentation of accrued finance charges and fees
at the time the related principal balance is charged-off. Effective January 1,
2002, to conform to standard industry practices as well as to maintain
consistency with the Company's closed-end products, accrued interest and fees
were charged against the related income at the time of charge-off. This change
only impacts the retail credit business area. This change in presentation has no
impact on the consolidated balance sheet and does not impact the consolidated
statements of operations or cash flows in total. Any effects on net interest
margin, other income and provision for losses are not material to the
consolidated financial statements.
Our securitization transactions are being structured to include provisions
that entitle the Company to repurchase assets transferred to the special purpose
entity when the aggregate unpaid principal balance reaches a specified level.
Until these assets are repurchased, however, the assets are the property of the
special purpose entity and are not available to satisfy the claims of creditors
of the Company. In addition, our securitization transactions are structured so
that the Company, as servicer for the loans, is able to exercise significant
discretion in making decisions about the serviced portfolio. Pursuant to SFAS
140, such securitization transactions are accounted for as secured borrowings
whereby the loans and securitization debt remain on the balance sheet, rather
than as sales. Under the portfolio method (the accounting method required for
our securitizations which are structured as secured borrowings), we recognize:
(i) earnings over the life of new loans as interest revenues are generated; (ii)
interest expense on the securities which are sold to investors in the loan
securitization trusts; and (iii) provisions for losses.
The risks associated with our finance business become more acute in any
economic slowdown or recession. Periods of economic slowdown or recession may be
accompanied by decreased demand for consumer credit and declining asset values.
In the home equity mortgage and manufactured housing businesses, any material
decline in real estate values reduces the ability of borrowers to use home
equity to support borrowing and increases the loan-to-value ratios of loans
previously made, thereby weakening collateral coverage and increasing the size
of losses in the event of a default. Delinquencies, foreclosures and losses
generally increase during economic slowdowns or recessions. For our finance
customers, loss of employment, increases in cost-of-living or other adverse
economic conditions would impair their ability to meet their payment
obligations. Higher industry inventory levels of repossessed manufactured homes
may affect recovery rates and result in future impairment charges and provision
for losses. In addition, in an economic slowdown or recession, our servicing and
litigation costs increase. Any sustained period of increased delinquencies,
foreclosures, losses or increased costs would adversely affect our financial
condition and results of operations.
Loan originations in the second quarter of 2002 were $2.0 billion, down 35
percent from 2001. Loan originations in the first six months of 2002 were $4.1
billion, down 22 percent from 2001. We recently decided to no longer originate
certain lines of business in order to manage our growth consistent with our
current business plan in addition to applying stricter credit standards for new
originations. However, second quarter originations were still about 5 percent
below our current plan.
Sales of finance receivables in the first six months of 2002 and 2001
include the sale of $.3 billion and $1.5 billion, respectively, of finance
receivables, on which we recognized gains of $17.4 million and $15.6 million,
respectively. These sales are further explained below under "Gain on sale of
finance receivables". We also sold $.4 billion of certain other finance
receivables in the first six months of 2002 as part of our cash raising
arrangements which are explained below under "Special Charges".
Managed receivables include finance receivables recorded on our
consolidated balance sheet and those managed by us but applicable to holders of
asset-backed securities sold in securitizations structured in a manner that
resulted in gain-on-sale revenue. Average managed receivables decreased to $40.7
billion in the second quarter of 2002, down 8.4 percent from the same period in
2001, and to $41.5 billion in the first six months of 2002, down 7.7 percent
from the same period in 2001. The decrease reflects the recent decreases in loan
originations described above.
60
CONSECO, INC. AND SUBSIDIARIES
--------------------
Net investment income on finance receivables and other consists of: (i)
interest earned on finance receivables; and (ii) interest income on short-term
and other investments. Such income increased by 1.9 percent, to $554.5 million,
in the second quarter of 2002, and by 1.2 percent, to $1,109.9 million in the
first six months of 2002, as compared to the same periods in 2001. At June 30,
2002, on-balance sheet finance receivables increased 4.4 percent to $17.6
billion as compared to June 30, 2001. The weighted average yields earned on
finance receivables and other investments were 11.0 percent and 12.1 percent
during the second quarters of 2002 and 2001, respectively, and such weighted
average yields were 10.9 percent and 12.3 percent during the first six months of
2002 and 2001, respectively. The effect of the increase in average on-balance
sheet finance receivables was substantially offset by the decrease in average
yield. The average yield decreased due to the decrease in prime interest rates
and change in product mix of the portfolio. Future interest earned on finance
receivables should increase as our average on-balance sheet finance receivables
increase.
Net investment income on interest-only securities is the income recognized
on the interest-only securities we retain after we sell finance receivables.
Such income decreased by 69 percent, to $5.1 million, in the second quarter of
2002, and by 68 percent, to $10.0 million in the first six months of 2002, as
compared to the same periods in 2001. The decrease is consistent with the change
in the average balance of interest-only securities. The weighted average yields
earned on interest-only securities were 12.1 percent and 14.1 percent during the
first six months of 2002 and 2001, respectively. As a result of the change in
the structure of our securitizations, our securitizations are accounted for as
secured borrowings and we do not recognize gain-on-sale revenue or additions to
interest-only securities from such transactions. Accordingly, future investment
income accreted on the interest-only security will decrease, as cash remittances
from the prior gain-on-sale securitizations reduce the interest-only security
balances. In addition, the balance of the interest-only securities was reduced
by $264.8 million during 2001 (of which $41.7 million was incurred in the first
six months of 2001) due to impairment charges. Impairment charges are further
explained below.
Gain on sales of finance receivables in the first six months of 2002
resulted from the sale of $.3 billion of finance receivables which generated net
gains of $10.2 million and $17.4 million in the three and six months ended June
30, 2002, respectively. In the first six months of 2001, we sold $1.5 billion of
receivables including: (i) our $802.3 million vendor services loan portfolio
(which was marked-to-market in the fourth quarter of 2000 and no additional gain
or loss was recognized in the first six months of 2001); (ii) $568.4 million of
high-loan-to-value mortgage loans; and (iii) $96.4 million of other loans. These
sales resulted in net gains of $6.7 million and $15.6 million in the three and
six months ended June 30, 2001, respectively. The Company entered into a
servicing agreement on the high-loan-to-value mortgage loans sold. Pursuant to
the servicing agreement, the servicing fees payable to the Company are senior to
all other payments of the trust which purchased the loans. The Company also
holds a residual interest in certain other cash flows of the trust. The Company
did not provide any guarantees with respect to the performance of the loans
sold.
Fee revenue and other income includes servicing income, commissions earned
on insurance policies written in conjunction with financing transactions and
other income from late fees. Such income decreased by 28 percent, to $63.1
million, in the second quarter of 2002, and by 25 percent, to $131.2 million in
the first six months of 2002, as compared to the same periods in 2001. Such
decrease is primarily due to decreases in commission income as a result of
reduced origination activities and the termination of sales of single premium
credit life insurance. In addition, as a result of the change in the structure
of our securitizations, we no longer record an asset for servicing rights at the
time of our securitizations, nor do we record servicing fee revenue; instead,
the entire amount of interest income is recorded as investment income. The
amount of servicing income (which is net of the amortization of servicing assets
and liabilities) was $19.3 million and $29.6 million in the second quarters of
2002 and 2001, respectively, and $36.2 million and $56.4 million in the first
six months of 2002 and 2001, respectively. We expect servicing income to decline
in future periods as the managed receivables in these securitizations are paid
down.
Provision for losses related to finance operations increased by 43 percent,
to $158.3 million, in the second quarter of 2002, and by 40 percent, to $316.7
million in the first six months of 2002, as compared to the same periods in
2001. These amounts relate to our on-balance sheet receivables. The increase is
principally due to an increase in delinquencies which was expected due to the
aging of our on-balance sheet portfolio, and to a lesser extent, the increase in
loans held on our balance sheet. At June 30, 2002, on-balance sheet finance
receivables increased 4.4 percent to $17.6 billion as compared to June 30, 2001.
At June 30, 2002 and 2001, the 60-days-and-over delinquencies as a percentage of
on-balance sheet finance receivables were 2.31 percent and 1.70 percent,
respectively (such delinquency ratio was 2.19 percent at December 31, 2001).
Under the portfolio method, we estimate an allowance for credit losses based
upon our assessment of current and historical loss experience, loan portfolio
trends, the value of collateral, prevailing economic and business conditions,
and other relevant factors. Increases in our allowance for credit losses are
recognized as expense based on our current assessments of such factors. For
loans previously recorded as sales, the anticipated discounted credit losses
over
61
CONSECO, INC. AND SUBSIDIARIES
--------------------
the expected life of the loans were reflected through a reduction in the
gain-on-sale revenue recorded at the time of securitization or through
impairment charges when assessments of estimated losses have changed.
Our credit losses as a percentage of related loan balances for our
on-balance sheet portfolio have been increasing over the last several quarters
(2.14 percent, 2.26 percent, 2.36 percent, 2.53 percent and 2.61 percent for the
quarters ended June 30, 2001, September 30, 2001, December 31, 2001, March 31,
2002 and June 30, 2002, respectively). We believe such increases reflect: (i)
the natural increase in delinquencies in some of our products as they age into
periods at which we have historically experienced higher delinquencies; (ii) the
increase in retail credit receivables which typically experience higher credit
losses; (iii) economic factors which have resulted in an increase in defaults;
and (iv) a decrease in the manufactured housing recovery rates when repossessed
properties are sold given current industry levels of repossessed assets.
Delinquencies on loans held in our loan portfolio and our ability to
recover collateral and mitigate loan losses can be adversely impacted by a
variety of factors, many of which are outside our control. When loans are
delinquent and the Company forecloses on the loan, its ability to sell
collateral to recover or mitigate its losses is subject to the market value of
such collateral. In manufactured housing, those values may be affected by the
available inventory of manufactured homes on the market, a factor over which we
have no control. It is also dependent upon demand for new homes, which is tied
to economic factors in the general economy. In addition, repossessed collateral
is generally in poor condition, which reduces its value.
Recently, many consumer lenders have stopped or significantly scaled back
their consumer finance operations in the manufactured housing sector. These
lenders began to foreclose on collateral pledged to secure loans at a more
aggressive rate. The Company is facing increased competition from such lenders
in disposing of collateral pledged to secure its loans. Often collateral is in
similar forms. There is a limited number of collateral buyers and the exiting
consumer lenders may be willing to sell their foreclosed collateral at prices
significantly below fair market value. As a result, collateral recovery rates
for the Company may fall further, which could have a material adverse effect on
the financial position and results of our operations.
At June 30, 2002, the Company had a total of 17,970 unsold manufactured
housing properties (11,679 of which relate to our off-balance sheet
securitizations) in repossession, compared to 13,607 properties (10,133 of which
relate to our off-balance sheet securitizations) at June 30, 2001. We reduce the
value of repossessed property to our estimate of net realizable value upon
repossession. We liquidated 12,127 managed manufactured housing units at an
average loss severity rate (the ratio of the loss realized to the principal
balance of the foreclosed loan) of 58 percent in the first six months of 2002
compared to 13,280 units at an average loss severity rate of 57 percent in the
first six months of 2001. The loss severity rate related to our on-balance sheet
manufactured housing portfolio was 51 percent in the first six months of 2002,
compared to 48 percent in the first six months of 2001. We believe the higher
average severity rate in 2002 related to our on-balance sheet manufactured
housing portfolio is consistent with the aging of such portfolio. The higher
industry levels of repossessed manufactured homes which we believe existed in
the marketplace at June 30, 2002, may adversely affect recovery rates,
specifically wholesale severity, as other lenders (including lenders who have
exited the manufactured home lending business) have acted to more quickly
dispose of repossessed manufactured housing inventory. Additionally, the higher
level of repossessed inventory that currently exists in the marketplace may make
it more difficult for us to liquidate our inventory at or near historical
recovery rates. In order to maintain recovery levels, we may decide to hold
inventory longer, potentially causing our repossessed inventory level to
temporarily grow. We believe that our severity rates are positively impacted by
our use of retail channels to dispose of repossessed inventory (where the
repossessed units are sold through: (i) Company-owned sales lots; or (ii) our
dealer network); thus, we rely less on the wholesale channel (through which
recovery rates are typically lower). We intend to continue to focus on the
retail channel in an effort to maximize our recovery rates.
The Company believes that its historical loss experience has been favorably
affected by various loss mitigation policies. Under one such policy, the Company
works with the defaulting obligor and its dealer network to find a new buyer who
meets our underwriting standards and is willing to assume the defaulting
obligor's loan. Under other loss mitigation policies, the Company may permit
qualifying obligors (obligors who are currently unable to meet the obligations
under their loans, but are expected to be able to meet them in the future under
modified terms) to defer scheduled payments or the Company may reduce the
interest rate on the loan, in an effort to avoid loan defaults.
Due to the prevailing economic conditions in 2001 and 2002, the Company
increased the use of the aforementioned mitigation policies. Based on past
experience, we believe these policies will reduce the ultimate losses we
recognize. If we apply loss mitigation policies, we generally reflect the
customer's delinquency status as not being past due. Accordingly, the loss
mitigation policies favorably impact our delinquency ratios. We attempt to
appropriately reserve for the effects of these
62
CONSECO, INC. AND SUBSIDIARIES
--------------------
loss mitigation policies when establishing loan loss reserves. These policies
are also considered when we determine the value of our retained interests in
securitization trusts (including interest-only securities). Loss mitigation
policies were applied to 2.7 percent of average managed accounts in the second
quarter of 2002, compared to 1.5 percent, 2.9 percent, 3.1 percent and 3.0
percent of average managed accounts during the second, third and fourth quarters
of 2001 and the first quarter of 2002, respectively.
Finance interest expense decreased by 6.7 percent, to $286.0 million, in
the second quarter of 2002, and by 8.4 percent, to $575.5 million in the first
six months of 2002, as compared to the same periods in 2001. Such decrease was
the net result of: (i) lower average borrowing rates partially offset by (ii)
increased borrowings to fund the increased finance receivables. Our average
borrowing rate decreased to 6.1 percent in the second quarter of 2002 from 7.3
percent in the second quarter of 2001. Our average borrowing rate during the
first six months of 2002 was 6.1 percent compared to 7.4 percent during the
first six months of 2001. The decrease in average borrowing rates in 2002 as
compared to the same period in 2001 is primarily due to the decrease in the
general interest rate environment between periods and the repurchase of our
public debt.
Other operating costs and expenses include the costs associated with
servicing our managed receivables, and non-deferrable costs related to
originating new loans. Such expenses decreased by 6.0 percent, to $148.0
million, in the second quarter of 2002, and by 5.6 percent, to $302.6 million in
the first six months of 2002, as compared to the same periods in 2001. Such
costs have decreased as we have begun to realize the benefits from our cost
saving initiatives.
Special charges in the finance segment for the 2002 periods include: (i)
the loss of $45.7 million related to the sales of certain finance receivables of
$363.0 million (such assets were sold as part of our cash raising initiatives
which generated free cash flow in excess of $150 million in order to meet our
debt obligations) and $1.6 million of additional loss related to receivables
required to be repurchased from the purchaser of the vendor services receivables
pursuant to the repurchase clauses in the agreements; (ii) a $7.0 million fee
paid pursuant to amended financing arrangements; and (iii) restructuring and
other charges of $2.2 million. Special charges recorded for the 2001 periods
include: (i) the loss related to the sale of certain finance receivables of
$11.2 million ($2.2 million of which was recognized in the second quarter of
2001); and (ii) severance benefits of $5.0 million. These charges are described
in greater detail in the note to the accompanying financial statements entitled
"Special Charges".
Impairment charges represent reductions in the value of our retained
interests in securitization trusts (including interest-only securities and
servicing rights) recognized as a loss in the statement of operations. We carry
interest-only securities at estimated fair value, which is determined by
discounting the projected cash flows over the expected life of the receivables
sold using current prepayment, default, loss and interest rate assumptions. We
consider any potential payments related to the guarantees of certain lower rated
securities issued by the securitization trusts in the projected cash flows used
to determine the value of our interest-only securities. When declines in value
considered to be other than temporary occur, we reduce the amortized cost to
estimated fair value and recognize a loss in the statement of operations. The
assumptions used to determine new values are based on our internal evaluations.
Under current accounting rules (pursuant to EITF 99-20) which we adopted
effective July 1, 2000, declines in the value of our interest-only securities
are recognized when: (i) the fair value of the security is less than its
carrying value; and (ii) the timing and/or amount of cash expected to be
received from the security has changed adversely from the previous valuation
which determined the carrying value of the security. When both occur, the
security is written down to fair value. The assumptions used to determine new
values for our interest-only securities are based on our internal evaluations
and consultation with external advisors having significant experience in valuing
these securities. Although we believe our methodology is reasonable, many of the
assumptions and expectations underlying our determination may prove wrong, in
which case there may be an adverse effect on our financial results.
We recognized an impairment charge (net of adjustments to the valuation
allowance associated with our servicing rights) of $33.8 million in the second
quarter of 2001 for the interest-only securities that were not performing as
well as expected based on our previous valuation estimates. Such impairment
charge for the first six months of 2001 was $41.7 million.
63
CONSECO, INC. AND SUBSIDIARIES
--------------------
The credit quality of managed finance receivables was as follows:
June 30, December 31,
2002 2001
---- ----
60-days-and-over delinquencies as a percentage of managed finance
receivables at period end:
Manufactured housing.................................................... 2.57% 2.45%
Mortgage services (a)................................................... 1.21 1.23
Retail credit........................................................... 2.40 3.39
Consumer finance - closed-end........................................... .75 1.08
Floorplan............................................................... 1.17 .58
Discontinued lines...................................................... 2.68 3.50
Total................................................................. 2.13% 2.10%
Net credit losses incurred during the last twelve months as a percentage of
average managed finance receivables during the period:
Manufactured housing.................................................... 2.23% 2.14%
Mortgage services....................................................... 2.08 1.95
Retail credit........................................................... 6.40 6.65
Consumer finance - closed-end........................................... 3.05 2.50
Floorplan............................................................... 1.21 1.00
Discontinued lines...................................................... 7.30 5.73
Total................................................................. 2.51% 2.35%
Repossessed collateral inventory as a percentage of managed finance receivables
at period end (b):
Manufactured housing.................................................... 2.97% 2.45%
Mortgage services (c)................................................... 4.67 4.07
Retail credit........................................................... .14 .13
Consumer finance - closed-end........................................... 1.00 1.03
Floorplan............................................................... 1.32 .69
Discontinued lines...................................................... 1.73 4.20
Total................................................................. 3.16% 2.68%
- --------------------
(a) 60-days-and-over delinquencies exclude loans in the process of foreclosure.
(b) Ratio of: (1) outstanding loan principal balance related to the repossessed
inventory (before writedown) to: (2) total receivables. We writedown the
value of our repossessed inventory to estimated realizable value at the
time of repossession.
(c) Repossessed collateral inventory includes loans in the process of
foreclosure.
64
CONSECO, INC. AND SUBSIDIARIES
--------------------
The credit quality of on-balance sheet finance receivables was as follows:
June 30, December 31,
2002 2001
---- ----
60-days-and-over delinquencies as a percentage of on-balance sheet
finance receivables at period end:
Manufactured housing.................................................... 3.44% 3.08%
Mortgage services (a)................................................... 1.05 .94
Retail credit........................................................... 2.40 3.39
Consumer finance - closed-end........................................... .91 1.33
Floorplan............................................................... 1.17 .58
Discontinued lines...................................................... 2.16 2.72
Total................................................................. 2.31% 2.19%
Net credit losses incurred during the last twelve months as a percentage of
average on-balance sheet finance receivables during the period:
Manufactured housing.................................................... 2.05% 1.87%
Mortgage services....................................................... 1.79 1.53
Retail credit........................................................... 6.40 6.65
Consumer finance - closed-end........................................... 2.67 2.02
Floorplan............................................................... 1.21 1.00
Discontinued lines...................................................... 5.64 4.66
Total................................................................. 2.61% 2.36%
Repossessed collateral inventory as a percentage of on-balance sheet finance
receivables at period end (b) (c):
Manufactured housing.................................................... 3.32% 2.41%
Mortgage services (d)................................................... 4.23 3.50
Retail credit........................................................... .14 .13
Consumer finance - closed-end........................................... 1.12 1.15
Floorplan............................................................... 1.32 .69
Discontinued lines...................................................... .35 2.92
Total................................................................. 3.06% 2.37%
- --------------------
(a) 60-days-and-over delinquencies exclude loans in the process of foreclosure.
(b) Ratio of: (1) outstanding loan principal balance related to the repossessed
inventory (before writedown) to: (2) total receivables.
(c) Although the ratio is calculated using the outstanding loan principal
balance related to the repossessed inventory, the repossessed inventory is
written down to net realizable value at the time of repossession or
completed foreclosure.
(d) Repossessed collateral inventory includes loans in the process of
foreclosure.
65
CONSECO, INC. AND SUBSIDIARIES
--------------------
Corporate operations
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Corporate operations:
Interest expense on corporate debt, net of investment
income on cash and cash equivalents..................... $ (76.9) $(88.7) $(149.7) $(187.6)
Allocation of interest expense to the finance segment..... - 1.8 - 7.3
Investment income......................................... - - - 4.4
Other items............................................... (5.2) (9.4) (14.8) (5.3)
------- ------ ------- -------
Operating loss before non-operating items, income
taxes and minority interest......................... (82.1) (96.3) (164.5) (181.2)
Provision for losses and expense related to stock purchase
plan.................................................... (100.0) - (140.0) -
Venture capital gain (loss) related to investment in
AWE, net of related expenses............................ (23.7) 32.0 (100.0) 5.1
Discontinued major medical business....................... - (20.7) - (28.6)
Gain on sale of interest in riverboat..................... - - - 192.4
Special charges and additional amortization............... (80.9) (50.2) (97.9) (66.9)
------- ------ ------ ------
Loss before income taxes and minority interest........ $(286.7) $(135.2) $(502.4) $(79.2)
======= ======= ======= ======
Interest expense on corporate debt, net of investment income on cash and
cash equivalents has decreased as a result of the repayment of debt and lower
interest rates. Amounts allocated to the finance segment have decreased as
Conseco Finance has repaid debt owed to the parent. The average debt outstanding
was $4.1 billion and $4.7 billion in the first six months of 2002 and 2001,
respectively. The average interest rate on such debt was 7.6 percent and 8.5
percent in the first six months of 2002 and 2001, respectively.
Investment income includes the income from our investment in a riverboat
casino (prior to its sale in the first quarter of 2001) and miscellaneous other
income.
Other items include general corporate expenses, net of amounts charged to
subsidiaries for services provided by the corporate operations.
Provision for losses and expense related to stock purchase plan represents
the non-cash provision we established in connection with: (i) our guarantees of
bank loans to approximately 155 current and former directors, officers and key
employees and our related loans for interest; and (ii) the liability related to
the pay for performance benefits related to the loan program. The funds from the
bank loans were used by the participants to purchase approximately 18.0 million
shares of Conseco common stock. In the six months ended June 30, 2002, we
increased our reserve by $140.0 million in connection with these guarantees and
loans. We determine the reserve based upon the value of the collateral held by
the banks (primarily the purchased stock). At June 30, 2002, the reserve for
losses on the loan guarantees and the liability related to the pay for
performance benefits totaled $560.0 million. The outstanding balance on the bank
loans was $537.3 million. In addition, Conseco has provided loans to
participants for interest on the bank loans totaling $159.0 million.
Venture capital gain (loss) relates to our investment in TeleCorp, a
company in the wireless communication business. In the first quarter of 2002,
AWE acquired TeleCorp. Pursuant to the merger agreement, our shares of TeleCorp
were converted into 11.4 million shares of AWE. This transaction is described in
greater detail in the note to the accompanying financial statements entitled
"Venture Capital Investment in AT&T Wireless Services, Inc." Our investment in
AWE is carried at estimated fair value, with changes in fair value recognized as
investment income. The market values of AWE and many other companies in this
sector have declined significantly in recent periods.
66
CONSECO, INC. AND SUBSIDIARIES
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The discontinued major medical business includes individual and group major
medical health insurance products. These lines of business had losses of $20.7
million and $28.6 million in the three and six months ended June 30, 2001. These
lines of business did not incur additional losses in 2002.
Gain on sale of interest in riverboat represents the gain recognized in the
first quarter of 2001 as a result of our sale of our 29 percent ownership
interest in the riverboat casino in Lawrenceburg, Indiana, for $260 million.
Special charges in corporate operations for 2002 include: (i) an impairment
charge of $73.9 million (recognized in the second quarter of 2002) associated
with the value of an insurance company which we have entered into an agreement
to sell; (ii) $17.4 million related to debt modification and refinancing
transactions (of which $12.4 million was recognized in the second quarter of
2002); (iii) other items totaling $18.6 million (of which $6.6 million was
recognized in the second quarter of 2002); partially offset by (iv) net gains of
$12.0 million related to the sale of certain non-core assets (all of which was
recognized in the second quarter of 2002). Special charges in corporate
operations for 2001 include: (i) amounts related to office closings and the sale
of artwork totaling $6.8 million; (ii) amounts related to our discontinued
operations totaling $8.5 million; and (iii) other items totaling $11.6 million.
These charges are described in greater detail in the note to the accompanying
consolidated financial statements entitled "Special Charges".
Additional amortization in the corporate operations represents
unrecoverable cost of policies produced and cost of policies purchased related
to the major medical business we are not renewing. The additional amortization
recognized was $40.0 million in the three and six months ended June 30, 2001.
PREMIUM AND ASSET ACCUMULATION PRODUCT COLLECTIONS
In accordance with GAAP, insurance policy income as shown in our
consolidated statement of operations consists of premiums earned for policies
that have life contingencies or morbidity features. For annuity and universal
life contracts without such features, premiums collected are not reported as
revenues, but as deposits to insurance liabilities. We recognize revenues for
these products over time in the form of investment income and surrender or other
charges.
Agents, insurance brokers and marketing companies who market our products
and prospective purchasers of our products use the ratings of our insurance
subsidiaries as an important factor in determining which insurer's products to
market or purchase. Ratings have the most impact on our annuity and
interest-sensitive life insurance products. On July 12, 2002, A.M. Best lowered
the financial strength ratings of our primary insurance subsidiaries from "A-
(excellent)" to "B++ (very good)" and the ratings remain "under review with
negative implications." We believe that A.M. Best will soon lower this rating.
As a result of the A.M. Best downgrade, sales of our insurance products could
fall and policyholder redemptions and lapses could increase. If such activity is
unusually high, it could cause a material and adverse impact on our financial
results and liquidity. In addition, the rating downgrade could cause defections
among our sales force of agents and/or increases in the commissions we must pay
them. The effect of the recent ratings downgrade is further discussed in the
section entitled "Liquidity and Capital Resources" which follows.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the severity, and the interest rate earned on our investment
of premiums. In setting premium rates, we consider historical claims
information, industry statistics, premiums charged by competitors and other
factors. If our actual claims experience proves to be less favorable than we
assumed and we are unable to raise our premium rates, our financial results will
be adversely affected. We generally cannot raise our premiums in any state
unless we first obtain the approval of the insurance regulator in that state. We
review the adequacy of our premium rates regularly and file requests for rate
increases on our products when we believe existing premium rates are too low. It
is possible, due to additional regulatory review, that we may not be able to
obtain approvals for premium rate increases in a timely manner from currently
pending requests or requests filed in the future. If we are unable to raise our
premium rates because we do not receive rate increase approvals in a timely
manner from one or more states, our financial results will be adversely
affected. If we are successful in obtaining regulatory approval to raise premium
rates due to unfavorable actual claims experience, the increased premium rates
may reduce the volume of our new sales and cause existing policyholders to allow
their policies to lapse. This would reduce our premium income in future periods.
Increased lapse rates also could require us to expense all or a portion of the
cost of policies produced or the cost of policies purchased relating to lapsed
policies in the period in which those policies lapse, adversely affecting our
financial results in that period.
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CONSECO, INC. AND SUBSIDIARIES
--------------------
Total premiums and accumulation product collections were as follows:
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2002 2001(a) 2002 2001(a)
---- ------- ---- ------
(Dollars in millions)
Premiums collected by our insurance subsidiaries:
Annuities:
Equity-indexed (first-year)................................ $ 58.7 $ 90.8 $ 123.4 $ 176.2
Equity-indexed (renewal)................................... 7.6 9.7 17.6 21.2
-------- -------- -------- --------
Subtotal - equity-indexed annuities...................... 66.3 100.5 141.0 197.4
-------- -------- -------- --------
Other fixed (first-year)................................... 187.6 190.4 381.2 378.8
Other fixed (renewal)...................................... 10.3 11.4 20.2 20.8
-------- -------- -------- --------
Subtotal - other fixed annuities......................... 197.9 201.8 401.4 399.6
-------- -------- -------- --------
Variable (first-year)...................................... 50.8 88.5 142.0 181.5
Variable (renewal)......................................... 15.9 19.6 37.6 39.5
-------- -------- -------- --------
Subtotal - variable annuities............................ 66.7 108.1 179.6 221.0
-------- -------- -------- --------
Total annuities.......................................... 330.9 410.4 722.0 818.0
-------- -------- -------- --------
Supplemental health:
Medicare supplement (first-year)........................... 40.8 27.6 84.0 53.4
Medicare supplement (renewal).............................. 206.0 208.9 424.7 438.5
-------- -------- -------- --------
Subtotal - Medicare supplement........................... 246.8 236.5 508.7 491.9
-------- -------- -------- --------
Long-term care (first-year)................................ 25.4 27.0 50.7 53.7
Long-term care (renewal)................................... 201.8 191.2 402.2 390.0
-------- -------- -------- --------
Subtotal - long-term care................................ 227.2 218.2 452.9 443.7
-------- -------- -------- --------
Specified disease (first-year)............................. 9.7 10.7 19.4 21.0
Specified disease (renewal)................................ 83.2 82.2 166.6 166.9
-------- -------- -------- --------
Subtotal - specified disease............................. 92.9 92.9 186.0 187.9
-------- -------- -------- --------
Other health (first-year).................................. 3.6 3.1 7.1 5.9
Other health (renewal)..................................... 25.7 27.1 51.6 54.3
-------- -------- -------- --------
Subtotal - other health.................................. 29.3 30.2 58.7 60.2
-------- -------- -------- --------
Total supplemental health................................ 596.2 577.8 1,206.3 1,183.7
-------- -------- -------- --------
Life insurance:
First-year................................................. 24.7 31.9 53.7 60.6
Renewal.................................................... 132.6 188.6 317.8 383.6
-------- -------- -------- --------
Total life insurance..................................... 157.3 220.5 371.5 444.2
-------- -------- -------- --------
Collections on insurance products from continuing
operations............................................. 1,084.4 1,208.7 2,299.8 2,445.9
-------- -------- -------- --------
Individual and group major medical:
Individual (first-year).................................... 4.3 32.1 13.9 71.3
Individual (renewal)....................................... 23.1 66.5 58.7 129.9
-------- -------- -------- --------
Subtotal - individual.................................... 27.4 98.6 72.6 201.2
-------- -------- -------- --------
Group (first-year)......................................... .1 9.3 .4 14.9
Group (renewal)............................................ 74.7 87.5 164.0 188.8
-------- -------- -------- --------
Subtotal - group......................................... 74.8 96.8 164.4 203.7
-------- -------- -------- --------
Total major medical...................................... 102.2 195.4 237.0 404.9
-------- -------- -------- --------
Total first-year premium collections on insurance products 405.7 511.4 875.8 1,017.3
Total renewal premium collections on insurance products.... 780.9 892.7 1,661.0 1,833.5
-------- -------- -------- --------
Total collections on insurance products.................. $1,186.6 $1,404.1 $2,536.8 $2,850.8
======== ======== ======== ========
Mutual funds (excludes variable annuities)...................... $ 38.0 $ 120.5 $ 126.5 $ 231.8
======== ======== ======== ========
Deposit type contracts.......................................... $ 82.0 $ 37.5 $ 163.8 $ 100.1
======== ========= ========= ========
CONSECO, INC. AND SUBSIDIARIES
--------------------
- ---------------
(a) Certain amounts related to deposit type contracts have been reclassified to
a separate category, to conform to the 2002 presentation.
Annuities include equity-indexed annuities, other fixed annuities and
variable annuities sold through both career agents and professional independent
producers.
We introduced our first equity-indexed annuity product in 1996. The
accumulation value of these annuities is credited with interest at an annual
guaranteed minimum rate of 3 percent (or, including the effect of applicable
sales loads, a 1.7 percent compound average interest rate over the term of the
contracts). These annuities provide for potentially higher returns based on a
percentage of the change in the S&P 500 Index during each year of their term. We
purchase S&P 500 Call Options in an effort to hedge increases to policyholder
benefits resulting from increases in the S&P 500 Index. Total collected premiums
for this product were $66.3 million in the second quarter of 2002 compared with
$100.5 million in the second quarter of 2001 and were $141.0 million in the
first six months of 2002 compared with $197.4 million in the first six months of
2001. The decrease can be attributed to the general stock market performance
which has made other investment products more attractive.
Other fixed rate annuity products include single-premium deferred annuities
("SPDAs"), flexible-premium deferred annuities ("FPDAs") and single-premium
immediate annuities ("SPIAs"), which are credited with a declared rate. The
demand for traditional fixed-rate annuity contracts has increased as such
products became more attractive than equity-indexed or variable annuity products
due to the general stock market performance. SPDA and FPDA policies typically
have an interest rate that is guaranteed for the first policy year, after which
we have the discretionary ability to change the crediting rate to any rate not
below a guaranteed rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products decreased by 1.9 percent, to
$197.9 million, in the second quarter of 2002; and increased by .5 percent, to
$401.4 million in the first six months of 2002, as compared to the same periods
in 2001.
Variable annuities offer contract holders the ability to direct premiums
into specific investment portfolios; rates of return are based on the
performance of the portfolio. Our profits on variable annuities come from the
fees charged to contract holders. Variable annuity collected premiums decreased
by 38 percent, to $66.7 million in the second quarter of 2002, and by 19
percent, to $179.6 million in the first six months of 2002. The decreases in
2002 can be attributed to the general stock market performance, which has made
other investment products more attractive, and to our announcement that we
planned to sell this business.
Supplemental health products include Medicare supplement, long-term care,
specified disease and other insurance products distributed through a career
agency force and professional independent producers. Our profits on supplemental
health policies depend on the overall level of sales, the length of time the
business remains in force, investment yields, claim experience and expense
management.
Collected premiums on Medicare supplement policies increased by 4.4 percent
to $246.8 million, in the second quarter of 2002, and by 3.4 percent, to $508.7
million in the first six months of 2002, as compared to the same periods in
2001. Sales of Medicare supplement policies have been affected by increased
premium rates and sales volume.
Premiums collected on long-term care policies increased by 4.1 percent to
$227.2 million, in the second quarter of 2002, and by 2.1 percent, to $452.9
million in the first six months of 2002, as compared to the same periods in
2001. Such sales have been affected by increased premium rates and sales volume.
Premiums collected on specified disease policies during the 2002 periods
were comparable to the same periods in 2001.
Other health products include disability income, dental and various other
health insurance products. The disability income and dental products are
marketed to school systems located in nearly all states. The other health
insurance products are generally not being actively marketed. Premiums
collected, in total, in the 2002 periods were comparable to the same periods in
2001. The other health products continue to be profitable.
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CONSECO, INC. AND SUBSIDIARIES
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Life products are sold through career agents, professional independent
producers and direct response distribution channels. Life premiums collected
decreased by 29 percent, to $157.3 million in the second quarter of 2002, and by
16 percent, to $371.5 million in the first six months of 2002, as compared to
the same periods in 2001. Such decreases are primarily a result of the
reinsurance agreements we entered into during 2002.
We sell our insurance products through three primary distribution channels
- - career agents, independent producers and direct marketing. Our career agency
force sells primarily Medicare Supplement and long-term care insurance policies,
senior life insurance and annuities. These agents visit the customer's home
which permits one-on-one contacts with potential policyholders and promotes
strong personal relationships with existing policyholders. Our independent
producer distribution channel consists of a general agency and insurance
brokerage distribution system comprised of independent licensed agents doing
business in all fifty states, the District of Columbia, and certain
protectorates of the United States. Independent producers are a diverse network
of independent agents, insurance brokers and marketing organizations. Our direct
marketing distribution channel is engaged primarily in the sale of "graded
benefit life" insurance policies which are sold directly from the Company to the
policyholder.
Individual and group major medical products include major medical health
insurance products sold to individuals and groups. In the second half of 2001,
we began the process of non-renewing a large portion of our major medical
business. In early 2002, we decided to non-renew all inforce individual and
small group business and discontinue new sales. Group premiums decreased by 23
percent, to $74.8 million, in the second quarter of 2002, and by 19 percent, to
$164.4 million in the first six months of 2002, as compared to the same periods
in the prior year. Individual health premiums collected in the second quarter of
2002 decreased by 72 percent, to $27.4 million, and by 64 percent, to $72.6
million in the first six months of 2002, as compared to the same periods in the
prior year. These premiums will decrease substantially during the remainder of
2002 and subsequent periods.
Mutual fund sales decreased 68 percent to $38.0 million in the second
quarter of 2002, and by 45 percent, to $126.5 million in the first six months of
2002, as compared to the same periods in the prior year. Mutual fund sales have
been adversely affected by the recent performance of the stock market and as a
result of our decreased marketing efforts.
Deposit type contracts include guaranteed interest contracts, supplemental
contracts without life contingencies and other deposit funds. Amounts collected
from deposit type contracts increased by 119 percent, to $82.0 million, in the
second quarter of 2002, and by 64 percent, to $163.8 million in the first six
months of 2002, as compared to the same periods in the prior year. Such amounts
often fluctuate from period-to-period.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between June 30, 2002 and
December 31, 2001, reflect: (i) our net loss for the six months ended June 30,
2002, including the effect of establishing a valuation allowance for deferred
tax assets; (ii) the cumulative effect of an accounting change recognizing an
impairment of our goodwill balance; (iii) our origination of finance
receivables; (iv) the transfer of finance receivables to securitization trusts
and sale of notes to investors in transactions accounted for as secured
borrowings; (v) changes in the fair value of actively managed fixed maturity
securities and interest-only securities; and (vi) various financing and
reinsurance transactions (described in the notes to the accompanying
consolidated financial statements).
In accordance with GAAP, we record our actively managed fixed maturity
investments, interest-only securities, equity securities and certain other
invested assets at estimated fair value with any unrealized gain or loss
(excluding impairment losses which are recognized through earnings), net of tax
and related adjustments, recorded as a component of shareholders' equity. At
June 30, 2002, we decreased the carrying value of such investments by $524.5
million as a result of this fair value adjustment. The fair value adjustment
resulted in a $816.0 million decrease in carrying value at year-end 2001.
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CONSECO, INC. AND SUBSIDIARIES
--------------------
Total capital shown below excludes debt of the finance segment used to fund
finance receivables.
June 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Total capital, excluding accumulated other comprehensive loss:
Corporate notes payable................................................ $ 4,012.4 $ 4,087.6
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts..................................... 1,918.1 1,914.5
Shareholders' equity:
Preferred stock..................................................... 501.5 499.6
Common stock and additional paid-in capital......................... 3,499.4 3,484.3
Retained earnings (accumulated deficit)............................. (3,172.0) 1,208.1
--------- ---------
Total shareholders' equity, excluding accumulated
other comprehensive loss...................................... 828.9 5,192.0
---------- ---------
Total capital, excluding accumulated other comprehensive
loss.......................................................... 6,759.4 11,194.1
Accumulated other comprehensive loss....................................... (295.9) (439.0)
--------- ---------
Total capital.................................................... $ 6,463.5 $10,755.1
========= =========
Corporate notes payable decreased during the first six months of 2002
primarily due to: (i) open market repurchases of our 8.5% notes due 2002;
partially offset by (ii) the increase in unamortized fair market value of
terminated interest rate swap agreements (see note entitled "Accounting for
Derivatives").
Shareholders' equity, excluding accumulated other comprehensive loss,
decreased by $4.4 billion in the first six months of 2002, to $.8 billion. The
significant component of the decrease was our net loss of $4,378.2 million. The
accumulated other comprehensive loss decreased by $143.1 million, principally
related to the decrease in the unrealized losses of our insurance companies'
investment portfolio.
Book value per common share outstanding decreased to $.09 at June 30, 2002,
from $12.34 at December 31, 2001. Such change was primarily attributable to our
net loss for the six months ended June 30, 2002, including the effect of
establishing a valuation allowance for deferred tax assets and the cumulative
effect of an accounting change recognizing an impairment of our goodwill
balance. Excluding accumulated other comprehensive loss, book value per common
share outstanding was $0.95 at June 30, 2002, and $13.61 at December 31, 2001.
Goodwill (representing the excess of the amounts we paid to acquire
companies over the fair value of net assets acquired in transactions accounted
for as purchases) was $600.0 million at June 30, 2002 and $3,695.4 million at
December 31, 2001. Goodwill as a percentage of shareholders' equity was 113
percent and 78 percent at June 30, 2002 and December 31, 2001, respectively.
Goodwill as a percentage of total capital, excluding accumulated other
comprehensive loss, was 8.9 percent at June 30, 2002 and 33 percent at December
31, 2001. Amortization of goodwill totaled $54.9 million during the first six
months of 2001.
The FASB issued SFAS 142 in June 2001. Under the new rule, intangible
assets with an indefinite life are no longer amortized in periods subsequent to
December 31, 2001, but are subject to annual impairment tests (or more frequent
under certain circumstances), effective January 1, 2002. The Company has
determined that all of its goodwill has an indefinite life and is therefore
subject to the new rules.
Pursuant to SFAS 142, the goodwill impairment test has two steps. The first
step was required to be completed by June 30, 2002 and the second step, if
necessary, was required to be completed by December 31, 2002. Any resulting
impairment is required, under SFAS 142 to be recorded in the quarter ended March
31, 2002. For Conseco, the first step consisted of
71
CONSECO, INC. AND SUBSIDIARIES
--------------------
comparing the estimated fair value of the business units comprising our
insurance segment (since all of our goodwill relates to the insurance segment,
the goodwill impairment test is not relevant to the finance business) to the
unit's book value. If the estimated fair value exceeds the carrying amount, the
test is complete and goodwill is not impaired. If the fair value is less than
the carrying value, the second step of the impairment test must be performed,
which compares the implied fair value of the applicable business unit's goodwill
with the carrying amount of that goodwill to measure the amount of goodwill
impairment, if any.
Pursuant to the transitional rules of SFAS 142, we have completed the
two-step impairment test during the second quarter of 2002 and, as a result of
that test, we recorded an impairment charge of $2,949.2 million for the quarter
ended March 31, 2002. The first quarter 2002 impairment charge is reflected in
cumulative effect of an accounting change in the accompanying consolidated
statement of operations for the six months ended June 30, 2002. Subsequent
impairment tests will be performed on an annual basis, or more frequently if
circumstances indicate a possible impairment. Subsequent impairments, if any,
would be classified as an operating expense.
The significant factors used to determine the amount of the impairment
included analyses of industry market valuations, historical and projected
performance of our insurance segment, discounted cash flow analyses and the
market value of our common stock. The valuation utilized the best available
information, including reasonable and supportable assumptions and projections.
The assumptions we used to determine the discounted cash flows involve
significant judgments regarding the best estimate of future premiums, expected
mortality and morbidity, interest earned and credited rates, persistency and
expenses. The discount rate used was based on an analysis of the weighted
average cost of capital for several insurance companies and considered the
specific risk factors related to Conseco. Pursuant to the guidance in SFAS 142,
quoted market prices in active markets are the best evidence of fair value and
shall be used as the basis for measurement, if available. Management believes
that the assumptions and estimates used are reasonable given all available facts
and circumstances. However, if projected cash flows are not realized in the
future, we may be required to recognize additional impairments.
72
CONSECO, INC. AND SUBSIDIARIES
--------------------
The following table summarizes certain financial ratios as of and for the
six months ended June 30, 2002, and as of and for the year ended December 31,
2001:
June 30, December 31,
2002 2001
---- ----
Book value per common share:
As reported.................................................................................. $ .09 $12.34
Excluding accumulated other comprehensive income (loss) (a).................................. .95 13.61
Excluding goodwill and accumulated other comprehensive income (loss) (a)..................... (.79) 2.89
Ratio of earnings to fixed charges:
As reported.................................................................................. (h) (f)
Excluding interest added to policyholder account balances.................................... (h) (f)
Excluding interest added to policyholder account balances
and interest expense on direct third party debt of Conseco Finance (b)..................... (h) (f)
Ratio of operating earnings to fixed charges (c):
As reported.................................................................................. 1.10X 1.26X
Excluding interest expense on direct third party debt of Conseco Finance (b)................. 1.44X 2.09X
Ratio of earnings to fixed charges, preferred dividends and distributions on
Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts:
As reported................................................................................ (i) (g)
Excluding interest added to policyholder account balances.................................. (i) (g)
Excluding interest added to policyholder account balances
and interest expense on direct third party debt of Conseco Finance (b)................... (i) (g)
Ratio of operating earnings to fixed charges, preferred dividends and
distributions on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts (c):
As reported................................................................................ (j) 1.12X
Excluding interest expense on direct third party debt of Conseco Finance (b)............... (j) 1.37X
Rating agency ratios (a) (d) (e):
Corporate debt to total capital.............................................................. 59% 37%
Corporate debt and Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts to total capital...................................................... 88% 54%
- ---------------------
(a) Excludes accumulated other comprehensive income (loss).
(b) We include these ratios to assist you in analyzing the impact of interest
expense on debt related to finance receivables and other investments (which
is generally offset by interest earned on finance receivables and other
investments financed by such debt). Such ratios are not intended to, and do
not, represent the following ratios prepared in accordance with GAAP: the
ratio of earnings and operating earnings to fixed charges; and the ratio of
earnings and operating earnings to fixed charges, preferred dividends and
distributions on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts.
(c) Such ratios exclude the following items from earnings: (i) net investment
gains (losses)(less that portion of amortization of cost of policies
purchased and cost of policies produced and income taxes relating to such
gains (losses)); (ii) the venture capital income (loss) related to our
investment in AWE; (iii) the gain on the sale of our interest in a
riverboat; (iv) special items not related to the continuing operations of
our businesses (including impairment charges to reduce the value of
interest-only securities and servicing rights, special charges and the
provision for losses related to loan guarantees); (v) the effect on
amortization of the cost of policies purchased and produced of significant
changes in assumptions used to estimate future gross profits of insurance
businesses; and (vi) the net income (loss) related to the discontinued
major medical business. Operating earnings are determined by adjusting GAAP
net income for the above mentioned items.
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CONSECO, INC. AND SUBSIDIARIES
--------------------
While these items may be significant components in understanding and
assessing our consolidated financial performance, we believe that the
presentation of operating earnings enhances the understanding of our
results of operations by highlighting net income attributable to the
normal, recurring operations of the business and by excluding events that
materially distort trends in net income.
These ratios are not intended to, and do not, represent the following
ratios prepared in accordance with GAAP: the ratio of earnings to fixed
charges; and the ratio of earnings to fixed charges, preferred dividends
and distributions on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts.
(d) Excludes the direct debt of the finance segment used to fund finance
receivables and investment borrowings of the insurance segment.
(e) These ratios are calculated in a manner discussed with rating agencies.
(f) For such ratios, adjusted earnings were $419.4 million less than fixed
charges. Adjusted earnings for the year ended December 31, 2001, included:
(i) special and impairment charges of $488.8 million; and (ii) provision
for losses related to loan guarantees of $169.6 million, as described in
greater detail in the notes to the accompanying consolidated financial
statements.
(g) For such ratios, adjusted earnings were $623.1 million less than fixed
charges. Adjusted earnings for the year ended December 31, 2001, included:
(i) special and impairment charges of $488.8 million; and (ii) provision
for losses related to loan guarantees of $169.6 million, as described in
greater detail in the notes to the accompanying consolidated financial
statements.
(h) For such ratios, adjusted earnings were $564.3 million less than fixed
charges. Adjusted earnings for the six months ended June 30, 2002,
included: (i) special charges of $202.5 million; and (ii) provision for
losses related to loan guarantees of $140.0 million, as described in
greater detail in the notes to the accompanying consolidated financial
statements.
(i) For such ratios, adjusted earnings were $657.1 million less than fixed
charges. Adjusted earnings for the six months ended June 30, 2002,
included: (i) special charges of $202.5 million; and (ii) provision for
losses related to loan guarantees of $140.0 million, as described in
greater detail in the notes to the accompanying consolidated financial
statements.
(j) For such ratios, adjusted earnings were $17.4 million less than fixed
charges.
Liquidity for insurance and fee-based operations
Our insurance operating companies generally receive adequate cash flow from
premium collections and investment income to meet their obligations. Life
insurance and annuity liabilities are generally long-term in nature.
Policyholders may, however, withdraw funds or surrender their policies, subject
to any applicable surrender and withdrawal penalty provisions. We seek to
balance the duration of our invested assets with the estimated duration of
benefit payments arising from contract liabilities.
An important competitive factor for life insurance companies is the ratings
they receive from nationally recognized rating organizations. Agents, insurance
brokers and marketing companies who market our products and prospective
purchasers of our products use the ratings of our insurance subsidiaries as one
factor in determining which insurer's products to market or purchase. Ratings
have the most impact on our annuity and interest-sensitive life insurance
products. Insurance financial strength ratings are opinions regarding an
insurance company's financial capacity to meet the obligations of its insurance
policies in accordance with their terms. They are not directed toward the
protection of investors. Such ratings are not recommendations to buy, sell or
hold securities.
On July 12, 2002, A.M. Best lowered the financial strength ratings of our
primary insurance subsidiaries from A- (excellent) to "B++ (very good)." A.M.
Best has not updated its rating of the financial strength rating of our primary
insurance subsidiaries since our most recent developments relating to our
financial conditions. We expect A.M. Best to further lower our rating in the
near future. A.M. Best ratings for the industry currently range from "A++
(Superior)" to "F (In Liquidation)" and some companies are not rated. An "A++"
ranking indicates superior overall performance and a strong ability to meet
obligations to policyholders over a long period of time. The "B++" rating is
assigned to companies which have, on balance,
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CONSECO, INC. AND SUBSIDIARIES
--------------------
very good balance sheet strength, operating performance and business profile,
when compared to the standards established by A.M. Best, and have a good ability
in A.M.Best's opinion to meet their ongoing obligations to policyholders. The
rating reflects A.M. Best's concern that the parent company will not be able to
meet its obligations on its 8.5% senior notes. Standard & Poor's has given our
insurance subsidiaries a claims paying ability rating of "B+". Rating categories
from "BB" to "CCC" are classified as "vulnerable" claims-paying ability ratings,
and pluses and minuses show the relative standing within a category. In Standard
& Poor's view an insurer rated "B" currently has the capacity to meet its
financial commitments but adverse business conditions could lead to insufficient
ability to meet financial commitments.
A.M. Best and Standard & Poor's each reviews its ratings from time to time.
As a result of the A.M. Best downgrade, or a decision by Standard and Poor's to
downgrade our claims-paying ability, sales of our insurance products could fall
and policyholder redemptions and lapses could increase, which could cause a
material and adverse impact on our financial results and liquidity. In addition,
these ratings decreases could cause defections among our sales force of agents
or increases in the commissions we must pay them.
Should rating agencies continue to downgrade the ratings of our primary
insurance subsidiaries, there is a possibility that state insurance departments
or regulatory agencies will be prompted to take increasingly stronger actions in
connection with mandates to protect the insurance policies of consumers in their
jurisdictions. These protective measures would result in greater supervision and
control over our insurance subsidiaries' business and financial affairs
including, among other possible actions, restrictions on their ability to pay
dividends to the parent company.
Our insurance subsidiaries experienced increased lapse rates on annuity
policies during the first six months of 2002. We believe that the diversity of
our investment portfolio and the concentration of investments in high-quality,
liquid securities provide sufficient liquidity to meet foreseeable cash
requirements. Although there is no present need or intent to dispose of such
investments, our life insurance subsidiaries could readily liquidate portions of
their investments, if such a need arose. In addition, investments could be used
to facilitate borrowings under reverse-repurchase agreements or dollar-roll
transactions. Such borrowings have been used by the life insurance companies
from time to time to increase their return on investments and to improve
liquidity. The availability of reverse-repurchase agreements and dollar-roll
transactions is dependent on counter parties' willingness to enter into the
transactions, and, consequently, no assurance can be given that such
transactions will be available in the future.
Liquidity for finance operations
Our finance operations require cash to originate finance receivables. Our
primary sources of cash are: (i) the collection of receivable balances; (ii)
proceeds from the issuance of debt, certificates of deposit and securitizations
and sales of loans; and (iii) cash provided by operations. During 2001 and the
first six months of 2002, the finance segment significantly slowed the
origination of finance receivables. This strategy allowed the finance segment to
reduce the amount of cash required for new loan originations, to transfer cash
to the parent company and to reduce its outstanding debt.
The liquidity needs of our finance operations could increase in the event
of an extended economic slowdown or recession. Loss of employment, increases in
cost-of-living or other adverse economic conditions could impair the ability of
our customers to meet their payment obligations. Higher industry levels of
repossessed manufactured homes may affect recovery rates and result in decreased
cash flows. In addition, in an economic slowdown or recession, our servicing and
litigation costs would generally increase. Any sustained period of increased
delinquencies, foreclosures, losses or increased costs would have an adverse
effect on our liquidity.
The most significant source of liquidity for our finance operations has
been our ability to finance the receivables we originate in the secondary
markets through loan securitizations. Under certain securitization structures,
we have provided a variety of credit enhancements, which have taken the form of
corporate guarantees (although we have not provided such guarantees during 2001
and the first six months of 2002), and have also included bank letters of
credit, surety bonds, cash deposits and over-collateralization or other
equivalent collateral. When choosing the appropriate structure for a
securitization of loans, we analyze the cash flows unique to each transaction,
as well as its marketability and projected economic value. The structure of each
securitized transaction depends, to a great extent, on conditions in the
fixed-income markets at the time the transaction is completed, as well as on
cost considerations and the availability and effectiveness of the various
enhancement methods.
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CONSECO, INC. AND SUBSIDIARIES
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During the first six months of 2002, we completed seven transactions,
securitizing $2.3 billion of finance receivables. Such securitizations were
generally executed under favorable market conditions although our retained
spreads decreased from the fourth quarter of 2001. Adverse changes in the
securitization market could impair our ability to originate, purchase and sell
loans or other assets on a favorable or timely basis and could have an adverse
effect on our liquidity.
The market for securities backed by receivables is a cost-effective source
of funds. Conditions in the credit markets during certain prior periods resulted
in less-attractive pricing of certain lower-rated securities typically included
in loan securitization transactions. As a result, we chose to hold certain
securities rather than sell them to securitization trusts.
Conditions in the markets for loan securitizations and loan sales change
from time to time. Changes in market conditions could affect the interest rate
spreads we earn on the loans we originate and the cash provided by our finance
operations. We adjust interest rates on our lending products to strive to
maintain our targeted spread in the current interest rate environment.
We believe that our August 9, 2002 announcement regarding the parent
company's bond interest and debt holder discussions (see the note to
consolidated financial statements entitled "Liquidity Issues" and the section
entitled "Liquidity of Conseco (parent company)" in this "Management's
Discussion and Analysis of Financial Condition and Results of Operations") may
adversely affect the cost at which we can obtain funding in the securitization
market and may adversely affect our access to this market. Adverse pricing or
diminished access to the securitization market could impair our ability to
originate, purchase and sell loans or other assets on a favorable or timely
basis. Any such impairment could have a material adverse effect upon our
business and results of operations. The securitization market is sensitive to
the credit ratings of Conseco Finance in connection with our securitization
program. Factors considered by the rating agencies in assigning such ratings
include current and anticipated credit enhancement levels, quality of the
current and expected servicing, as well as additional factors associated with
each distinct asset type. Market participants' concerns with Conseco Finance's
limited financial flexibility, as reflected by Conseco Finance's current senior
unsecured ratings, may have an adverse effect on the pricing of future
securitization transactions. In addition, several securitization transactions
have had ratings actions that have either lowered the original ratings or placed
on credit watch certain debt classes. These rating actions could have an adverse
effect on Conseco Finance's access to the securitization market in the future or
the cost of such access. In addition, the securitization market for certain
types of assets is relatively undeveloped and may be more susceptible to market
fluctuations or other adverse changes than more developed capital markets.
Although we have alternative sources of funding, principally warehouse and bank
credit facilities as well as loan sales, these alternatives may not be
sufficient for us to continue to originate loans.
At August 14, 2002, we had $1.4 billion of committed master repurchase
agreements and other facilities with various banking and investment banking
firms for the purpose of financing our consumer and commercial finance loan
production. We have an additional $1.5 billion of uncommitted master repurchase
agreements which require the approval of the lender prior to advancement of
funds. If we are unable to securitize our finance receivables or otherwise sell
our receivables, our capacity under these facilities would have to increase for
our loan originations to continue. These facilities typically provide financing
of a certain percentage of the underlying collateral and are subject to the
availability of eligible collateral and, in many cases, the willingness of the
banking firms to continue to provide financing. Some of these agreements provide
for annual terms which are extended either quarterly or semi-annually by mutual
agreement of the parties for an additional annual term based upon receipt of
updated quarterly financial information. At June 30, 2002, we had borrowed $1.4
billion under these agreements. The capacity under these agreements has been
reduced to $2.9 billion (of which $1.4 billion is committed) at August 14, 2002
from $3.8 billion (of which $1.9 billion was committed) at June 30, 2002. In
addition, certain of our banks have recently further restricted our borrowing
capacity related to manufactured housing loans within the committed facilities.
We are unable to predict whether we will be able to obtain replacement financing
when our current facilities expire, and there can be no assurance that financing
will be obtainable on favorable terms, if at all. To the extent that we are
unable to arrange any third party or other financing, our loan origination
activities would be adversely affected, which would have a material adverse
effect on our operations, financial results and cash position.
Absent the waiver, the Company's violation of the debt to capitalization
ratio covenant under its bank credit agreements would result in cross-defaults
under certain repurchase and other credit facilities utilized by the finance
subsidiary to finance loan inventory and daily operations. The repurchase
facilities are commonly referred to as warehouse facilities. Pursuant to the
resulting events of default under these warehouse facilities, the parties that
provide this financing may exercise various remedies, which vary among the
facilities and include retaining income generated by the financed loans,
effecting a permanent purchase of the
76
CONSECO, INC. AND SUBSIDIARIES
--------------------
financed loans, accelerating repayment of outstanding amounts and reducing
the size of or terminating the facility. The exercise of these rights by one or
more of the providers of these credit facilities would cross-default other
credit facilities and would thereupon entitle certain other warehouse lenders to
declare an event of default under their respective credit facilities and
accelerate their respective indebtedness. The aggregate outstanding balance of
these master repurchase agreements and other facilities was $1.4 billion as of
June 30, 2002. The finance subsidiary would pursue waivers in the event that a
default occurs if Conseco is unsuccessful in extending its waivers of the debt
to capitalization ratio covenant. There can be no assurance that we can obtain
such waivers and as such any exercise of their rights by these providers would
have a material adverse effect on the ability of the finance subsidiary to
finance its loan inventory and to originate new loans.
During the first six months of 2002, Conseco Finance repurchased $46.9
million par value of its senior subordinated notes and medium term notes
resulting in an extraordinary gain of $3.9 million (net of income taxes). In
March 2002, Conseco Finance completed a tender offer pursuant to which it
purchased $75.8 million par value of its senior subordinated notes due June
2002. The purchase price was equal to 100 percent of the principal amount of the
notes plus accrued interest. The remaining principal amount outstanding of $34.8
million of the senior subordinated notes after the tender offer and other debt
repurchases completed prior to the tender offer was retired at maturity on June
3, 2002.
In April 2002, Conseco Finance completed a tender offer pursuant to which
it purchased $158.5 million par value of its medium term notes due September
2002 and $3.7 million par value of its medium term notes due April 2003. The
purchase price was equal to 100 percent of the principal amount of the notes
plus accrued interest. In June 2002, Conseco Finance commenced a tender offer
for the remaining $8.2 million par value of its medium term notes due September
2002. Pursuant to the tender offer $5.5 million par value of the notes was
tendered in July. The purchase price was equal to 101 percent of the principal
amount of the notes plus accrued interest. The remaining principal amount
outstanding of the medium term notes after giving effect to both tender offers
and other debt repurchases completed prior to the tender offers is $2.7 million
due September 2002.
We continually investigate and pursue alternative and supplementary methods
to finance our lending operations. In late 1998, we began issuing certificates
of deposit through our bank subsidiaries. At June 30, 2002, we had $2.0 billion
of such deposits outstanding which are recorded as liabilities related to
certificates of deposit. The average annual rate paid on these deposits was 3.8
percent during the first six months of 2002. We use the proceeds from the
issuance of the certificates of deposit to fund the origination of certain
consumer/credit card finance receivables. To the extent that we are unable to
issue certificates of deposit, our loan origination activities would be
adversely affected, which would have a material adverse effect on our
operations, financial results and cash position.
Our finance segment generated cash flows from operating activities, as
determined in accordance with Statement of Financial Accounting Standards
Statement No. 95, "Statement of Cash Flows", of $310.0 million during the first
six months of 2002, compared to $196.9 million in the first six months of 2001.
We have projected that the adverse manufactured housing default experience
in 2001 and the first half of 2002 will improve over time beginning in the third
quarter of 2002. As a result of these assumptions, we project that payments
related to guarantees issued in conjunction with the sales of certain finance
receivables will exceed the gross cash flows from the interest-only securities
by approximately $55 million during the remainder of 2002 and $65 million in
2003. We project the gross cash flows from the interest-only securities to
exceed the payments related to guarantees issued in conjunction with the sales
of certain finance receivables by approximately $5 million in 2004 and $15
million in 2005 and by approximately $530 million in all years thereafter. These
projected payments are considered in the projected cash flows we use to value
our interest-only securities. There can be no assurance that we will have
adequate liquidity to make such guarantee payments. We intend to continue to
make the required payments related to these guarantees. If we are unable to make
the required guarantee payments, bond holders would have the right to terminate
the servicing agreements with the Company.
In the first quarter of 2002, we entered into various transactions with
Lehman pursuant to which Lehman extended the terms of Conseco Finance's: (a)
warehouse line of $1.2 billion from September 2002 to September 2003, (b)
borrowings with respect to approximately $90 million of miscellaneous assets
("Miscellaneous Borrowings") from January 31, 2002 to June 2003, and (c)
residual line of $.6 billion from February 2003 to February 2004 under which
financing is being provided on our interest-only securities, servicing rights
and retained interests in other subordinated securities issued by the
securitization trusts. We agreed to an amortization schedule by which the
outstanding balance under the Miscellaneous Borrowings is required to be paid by
June 2003. We also entered into a revised agreement governing the movement of
cash from Conseco Finance to the parent company. Conseco Finance and Lehman have
agreed to amend the agreement such that Conseco Finance must maintain
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CONSECO, INC. AND SUBSIDIARIES
--------------------
liquidity (i.e., cash and available borrowings, as defined) of at least: (i) $50
million until March 31, 2003; and (ii) $100 million from and after April 1,
2003. However, Conseco Finance no longer must meet a minimum liquidity
requirement of $250 million before making interest, principal, dividend or
redemption payments to the parent company.
Liquidity of Conseco (parent company)
At December 31, 2001, the Company's required debt service payments for 2002
totaled $654 million (as summarized in note 2 to our December 31, 2001 financial
statements). Our optional debt service payments (which could be made at the
Company's discretion or on the occurrence of certain asset sales) totaled $323
million.
We expected to have $682 million of cash from operations and completed
transactions during 2002 to service our mandatory debt payments. We also
anticipated an additional $318 million from transactions planned or in process.
Developments affecting the Company's December 31, 2001 liquidity plan
include the following: (i) payment of optional trust preferred dividends in May
and July ($44 million); (ii) decreases in the market value of our AWE venture
capital investment from that assumed in our liquidity plan ($18 million); and
(iii) reduced cash flow from our finance operations ($50 million). These adverse
developments were somewhat offset by increased cash flow from insurance
operations and sales of certain other non-core assets which provided positive
cash flow of $45.4 million. During the second quarter of 2002 we completed the
sale of Manhattan National Life and a reinsurance contract with another of our
insurance subsidiaries, which provided net cash flow to our insurance
subsidiaries of $98 million. We have not requested regulatory approval to
dividend these proceeds to the parent company.
On July 12, 2002, A.M. Best downgraded the ratings of our insurance
companies. Additionally, as a result of the net loss applicable to common stock
for the six months ended June 30, 2002 of $4,380.1 million, including the
goodwill impairment and the establishment of a deferred tax valuation reserve,
our shareholders' equity has been reduced to $533.0 million. We believe the
reduction in the shareholders' equity negatively impacts our A.M. Best ratings
prospects and other capital market ratings prospects. The net loss for the
second quarter of 2002, including the establishment of the deferred tax
valuation reserve, resulted in our not meeting the debt to capitalization ratio
covenant in our bank credit agreement and the guarantees of the D&O loans for
which we have waivers through September 9, 2002. All of these developments have
made it more difficult to obtain regulatory approvals of certain transactions
and/or dividend payments from our insurance companies and have contributed to
our decision to pursue the restructuring of our capital.
As discussed in the note to the consolidated financial statements entitled
"Liquidity Issues", the Company did not make its August 2002 interest payments
on its 6.4 percent senior and guaranteed senior notes due in 2003 and 2004 and
8.75 percent senior and guaranteed senior notes due in 2004 and 2006. The
failure to make the interest payments on these notes within the 30-day grace
period constitutes a default under the notes. If the Company does not cure the
non-payment of interest within 30 days of their occurrence, an event of default
will occur which will give the holders of the notes the right to accelerate the
maturity of all principal and past due interest, which aggregated $1.1 billion
on August 9, 2002. If the maturity of these notes is accelerated, we would be
unable to satisfy these obligations.
The Company is not in compliance with the debt to capitalization ratio we
agreed to maintain pursuant to our bank credit agreement and the guarantees of
the D&O loans. We have received from the relevant lenders a waiver of the
covenant violation effective as of June 30, 2002 through September 9, 2002. The
debt to capitalization ratio is defined as: (1) the sum of (i) the principal
amount of all of our indebtedness, (ii) accrued, unpaid interest and (iii)
accrued, unpaid dividends on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts; divided by (2) our total capitalization, as
defined. This ratio must not exceed 0.400 to 1.0 as of June 30, 2002 and 0.375
to 1.0 as of September 30, 2002. The ratio was 0.406 to 1.0 as of June 30, 2002.
If we are not able to extend the covenant waiver, the covenant violation gives
the lenders the right to declare all borrowings under the credit agreement and
guarantees of the D&O loans due and payable. The aggregate balance due under
this facility, including unpaid interest, was approximately $1.5 billion on
August 9, 2002. If the maturity of the bank debt is accelerated, we would be
unable to satisfy these obligations.
If an uncured event of default occurs with respect to a series of notes, it
could result in the acceleration of and immediate maturity of all of our notes
and our credit facility and our guarantee of bank loans to current and former
directors, officers and key employees to purchase shares of the Company's common
stock (the "D&O loans") through cross-acceleration and cross-default provisions
contained in the governing instruments. At June 30, 2002, such indebtedness
totaled $4.6 billion. We would be unable to satisfy all of our obligations then
due and payable under the credit facility, the guarantee related to the D&O
loans and the senior notes.
On August 9, 2002, we announced that, in addition to exercising the 30 day
grace period on bond interest payments as described above, we have engaged
financial and legal advisors to begin discussions with our debt holders with a
goal of restructuring the capital of the parent company. If such negotiations
are not successful, we will be unable to satisfy all of our debt obligations.
We have substantial indebtedness. At June 30, 2002, the par value of our
notes payable was $4.0 billion and the par value of Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts was $1.9
billion. We have a recent history of net losses. For the first six months of
2002, on a consolidated basis, we had a net loss applicable to common stock of
$4,380.l million and interest expense of $741.4 million. For the year ended
December 31, 2001, on a consolidated basis we had a net loss applicable to
common stock of $418.7 million and interest expense of $1,609.2 million. For the
year ended December 31, 2000, on a consolidated basis, we had a net loss
applicable to common stock
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CONSECO, INC. AND SUBSIDIARIES
--------------------
of $1,202.2 million and interest expense of $1,453.1 million. Our earnings
before fixed charges, preferred stock dividends and distributions on
Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts were inadequate to cover fixed charges by $657.1 million, $623.1 million
and $1,602.4 million for the six months ended June 30, 2002, and the years ended
December 31, 2001 and 2000, respectively.
We are a holding company with no business operations of our own. We depend
on our operating subsidiaries for cash to make principal and interest payments
on our debt (including payments to subsidiary trusts to be used for
distributions on Company-obligated mandatorily redeemable preferred securities),
to pay administrative expenses and income taxes. The cash we receive from our
subsidiaries consists of fees for services provided, tax sharing payments,
dividends and surplus debenture interest and principal payments. A deterioration
in any of our significant subsidiaries' financial condition, earnings or cash
flows could limit such subsidiary's ability to pay cash dividends or make other
payments to us, which in turn, would limit our ability to meet our debt service
requirements and satisfy other parent company financial obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid from earned surplus of the insurance company for any
12-month period in amounts equal to the greater of (or in a few states, the
lesser of): (i) net gain from operations for the prior year; or (ii) 10 percent
of surplus as of the end of the preceding year. Any dividends in excess of these
levels require the approval of the director or commissioner of the applicable
state insurance department. During the first six months of 2002, our insurance
subsidiaries paid dividends to Conseco totaling $240.0 million. There can be no
assurance that regulatory authorities will continue to approve dividends from
our insurance subsidiaries, if we request such approvals. Given the recent
adverse developments concerning the parent company's liquidity, obtaining
approval for dividends will become more difficult in the future.
In the first quarter of 2002, we amended the credit agreement related to
our $1.5 billion bank credit facility including the changes described below:
(i) Financial covenants in the credit agreements require us to maintain
various financial ratios and balances. These requirements were relaxed
in the amended agreement. In addition, such agreements were amended so
that the charge taken to write off goodwill under SFAS 142 is excluded
from the various financial ratios and covenants that we are required
to meet or maintain. See the note to the consolidated financial
statements entitled "Changes in Direct Corporate Obligations" for
further information on such ratios and covenants.
(ii) The manner in which the proceeds from certain asset sales will be used
was changed to allow us to make payments on our 2002 obligations prior
to making any principal payments under the bank credit agreement. The
first $352 million of such proceeds may be retained by the Company and
will be available to be used to meet our other debt obligations. The
next $313 million will be applied pro rata to the principal payments
on the bank credit facility and to a segregated cash account to be
held as collateral for our guarantee of certain bank loans to current
and former directors, officers and key employees (the "D&O loans").
The next $250 million will be divided equally between the Company and
to pay pro rata the principal payments on the bank credit facility and
the D&O loans. Proceeds in excess of $915 million and all proceeds
during the period December 31, 2003 through March 31, 2004, will be
divided as follows: (i) 25 percent to be retained by the Company; and
(ii) 75 percent to pay pro rata the principal payments on the bank
credit facility and the D&O loans. Proceeds received after March 31,
2004, are divided equally between the Company and to pay pro rata the
principal payments on the bank credit facility and the D&O loans. No
assurance can be provided as to the timing, proceeds, or other terms
related to any potential asset sale or financing transaction.
As further described in the notes to the consolidated financial statements
under the caption "Litigation", seven holders of our bank debt have challenged
the validity of the amendment to the credit agreement that changes provisions
related to mandatory prepayments.
The $1.5 billion bank credit facility is due December 31, 2003; however,
subject to the absence of any default, the Company may further extend its
maturity to March 31, 2005, provided that: (i) Conseco pays an extension fee of
3.5 percent of the amount extended; (ii) cumulative principal payments of at
least $200 million have been paid by September 30, 2002 and at
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CONSECO, INC. AND SUBSIDIARIES
--------------------
least $500 million by September 30, 2003; and (iii) our interest coverage ratio
for the four quarters ended September 30, 2003 is greater than or equal to 2.25
to 1. As described below, the Company has violated a loan covenant which has
caused an event of default.
We agreed to a number of covenants and other provisions that restrict our
ability to borrow money and pursue some operating activities without the prior
consent of the lenders under the credit agreements. Those provisions restrict
our ability to use the proceeds of asset sales. We agreed to meet or maintain
various financial ratios and balances. Our ability to meet these financial tests
and maintain ratings may be affected by events beyond our control. Our credit
agreements also limit our ability to issue additional debt, incur additional
contingent obligations, grant liens, dispose of assets, enter into transactions
with affiliates, make certain investments, including in existing and new
businesses, change our businesses, and modify our outstanding debt and preferred
stock. These provisions represent significant restrictions on the manner in
which we may operate our business. As more fully described above, at June 30,
2002, we were not in compliance with the debt to capitalization covenant in our
bank credit facility. We have received from the relevant lenders a waiver of the
covenant violation effective as of June 30, 2002 through September 9, 2002. (See
notes entitled "Liquidity Issues" and "Changes in Direct Corporate
Obligations".) If we are not able to extend the waiver of the covenant
violation, the lenders could declare all outstanding borrowings, accrued
interest and fees to be due and payable. If that occurs, we believe we would not
have sufficient liquidity to repay our bank indebtedness in full or any of our
other debts.
In the first quarter of 2002, we entered into various transactions with
Lehman which are described above under "Liquidity for finance operations". We
also entered into a revised agreement governing the movement of cash from
Conseco Finance to the parent company. Conseco Finance and Lehman have agreed to
amend the agreement such that Conseco Finance must maintain liquidity (i.e.,
cash and available borrowings, as defined) of at least: (i) $50 million until
March 31, 2003; and (ii) $100 million from and after April 1, 2003.
We have taken a number of actions over the past two years to reduce parent
company debt and increase the efficiency of our business operations. However,
our results for future periods are subject to numerous uncertainties. Our future
debt service requirements (including principal maturities) will exceed cash
flows available to the parent from the operations of our subsidiaries. We may
not be able to improve or sustain positive cash flows from operations. Our
liquidity could be significantly affected if improvements do not occur. Failure
to generate sufficient cash flows from operations, asset sales or financing
transactions to meet all of our long-term debt service requirements would have a
material adverse effect on liquidity.
As further described in the note to the consolidated financial statements
entitled "Changes in Direct Corporate Obligations", we completed a debt exchange
offer in April 2002.
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CONSECO, INC. AND SUBSIDIARIES
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An aggregate of $1,292.6 million in principal amount of notes were tendered
by noteholders and accepted by Conseco in the exchange offer. The results by
issue are as follows:
Originally Tendered for %
Outstanding Exchange Tendered
----------- -------- --------
8.50% senior notes due 2002.................. $302,299,000 $ 991,000 -
6.40% senior notes due 2003.................. 250,000,000 14,936,000 6%
8.75% senior notes due 2004.................. 788,000,000 364,294,000 46%
6.80% senior notes due 2005.................. 250,000,000 150,783,000 60%
9.00% senior notes due 2006.................. 550,000,000 399,200,000 73%
10.75% senior notes due 2008................. 400,000,000 362,433,000 91%
The maturities of the direct debt of the parent company including amounts
related to the Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts at June 30, 2002, (assuming the Company: (i) does not make the
optional debt payments required to extend the maturity date of the $1.5 billion
bank credit facility; and (ii) does make the optional debt payments required to
extend such maturity date and excluding any acceleration of debt payments which
would result from the covenant violation and cross-default provisions described
above) were as follows (dollars in millions):
(i) (ii)
Maturity date Maturity date
not extended extended
------------ --------
2002............................................................................ $ 226.7 $ 420.0
2003............................................................................ 1,791.9 598.6
2004............................................................................ 463.1 463.1
2005............................................................................ 99.2 1,099.2
2006............................................................................ 515.1 515.1
Thereafter...................................................................... 2,880.6 2,880.6
-------- --------
Total par value at June 30, 2002............................................ $5,976.6 $5,976.6
======== ========
The tables above exclude any amounts related to our guarantees of D&O loans
totaling $537.3 million as of June 30, 2002, to approximately 155 current and
former directors, officers and key employees. Such D&O loans are due on December
31, 2003. The funds were used by the participants to purchase approximately 18.0
million shares of our common stock in open market or negotiated transactions
with independent parties. Such shares are held by the banks as collateral for
the loans. In addition, we have provided loans to participants for interest on
the bank loans totaling $159.0 million. We have established a non-cash reserve
for the exposure we have in connection with such guarantees and interest loans.
At June 30, 2002, our reserve for losses on the loan guarantees and the interest
loans totaled $560.0 million based upon the value of the collateral and the
creditworthiness of the participants. At June 30, 2002, the guaranteed bank
loans and interest loans exceeded the value of the collateral held and the
reserve for losses by approximately $95 million. If we are required to pay on
the guarantees when the bank loans become due on December 31, 2003 or earlier
under the default provisions described above, it would have a material adverse
impact on our liquidity position.
The degree of our leverage has had material adverse consequences to us and
the holders of our debt, including the following: (i) our ability to obtain
additional financing in the future for working capital, capital expenditures or
other purposes is impaired; (ii) a substantial portion of our cash flow from
operations is required to be dedicated to the payment of interest expense and
principal repayment obligations; (iii) higher interest rates will cause the
interest expense on our variable rate debt to be higher; (iv) we are more highly
leveraged than other companies with which we compete, and this may place us at a
competitive disadvantage; (v) our degree of leverage has made us more vulnerable
to a downturn in our business or in the general economy; (vi) our degree of
leverage has adversely affect the ratings of our insurance company subsidiaries
which in turn may adversely affect their competitive position and ability to
sell products; and (vii) the ability of our finance operations to finance the
receivables we originate in the secondary markets through loan securitizations
has been impaired.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. No
assurance can be given that we will possess sufficient income and liquidity to
meet all of our long-term debt service requirements and other obligations.
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CONSECO, INC. AND SUBSIDIARIES
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The ratings assigned to Conseco's senior debt and trust preferred
securities are important factors in determining Conseco's ability to access the
public capital markets for additional liquidity. Rating agencies have recently
downgraded the ratings on our debt and trust preferred securities. On August 2,
2002, the credit rating for our unexchanged senior notes was downgraded two
notches to "Caa3" from "Caa1" by Moody's, which said its ratings outlook for us
is negative. Moody's employs a system of nine national ratings, ranging from
"Aaa" to "C" with modifiers 1, 2 and 3 to indicate the relative strength or
weakness within each rating. "Caa" is the seventh best rating out of nine.
Moody's believes that our future beyond October 2002 depends on a "radical
change in the company's capital structure".
On August 9, 2002, Standard & Poor's lowered our senior debt rating from
"CCC+" to "CC" (to "D" for notes which have upcoming interest payments which are
being missed). Standard & Poor's maintains 10 ratings categories, ranging from
"AAA" (Extremely strong) to "D" (Defaulted) with pluses and minuses used to
indicate relative positions within each category. "CC" is the eighth highest
rating out of Standard & Poor's 10 credit ratings and the middle, or second
rating within Standard & Poor's third tier of ratings. "D" is the lowest of
Standard & Poor's 10 ratings categories. Standard & Poor's assigned our "CC" and
"D" ratings after our announcement that we intend to exercise a 30 day grace
period on upcoming interest payments and enter into discussions with debt
holders on the restructuring of our capital.
On August 9, 2002, our senior debt ratings were lowered from "CCC" to "C"
by Fitch IBCA. Fitch employs a system of 12 national ratings, ranging from "AAA"
to "D" with pluses and minuses used to indicate the relative position of a
credit within a ratings category. "C" is the ninth best rating out of 12. Fitch
indicated in its August 9 press release that our "C" rating indicates "imminent
default".
At August 9, 2002, our trust preferred securities are rated "CC" by
Standard & Poor's, "C" by Fitch and "Ca" by Moody's.
Our current ratings make it impossible for Conseco to issue additional
securities in the public markets.
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CONSECO, INC. AND SUBSIDIARIES
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INVESTMENTS
At June 30, 2002, the amortized cost and estimated fair value of actively
managed fixed maturities and equity securities were as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
(Dollars in millions)
Investment grade:
Corporate securities................................................ $11,752.0 $210.5 $596.9 $11,365.6
United States Treasury securities and obligations of
United States government corporations and agencies................ 232.5 12.2 .7 244.0
States and political subdivisions................................... 350.4 8.9 1.4 357.9
Debt securities issued by foreign governments....................... 97.6 3.4 .4 100.6
Mortgage-backed securities ......................................... 6,871.2 174.4 16.7 7,028.9
Below-investment grade (primarily corporate securities)................ 2,066.6 11.7 383.4 1,694.9
--------- ------ ------ ---------
Total actively managed fixed maturities............................. $21,370.3 $421.1 $999.5 $20,791.9
========= ====== ====== =========
Equity securities...................................................... $ 233.5 $ 5.8 $ 26.3 $ 213.0
========= ====== ====== =========
Concentration of Corporate Securities
At June 30, 2002, our corporate securities (including below-investment
grade) were concentrated in the following industries:
Percent of Percent of
amortized estimated
cost fair value
---------- ----------
Media and communications......................................................... 13.1% 13.7%
Electric utility................................................................. 11.0 12.3
Bank/savings and loan............................................................ 10.6 12.7
Financial institutions........................................................... 8.8 10.2
Energy........................................................................... 8.5 10.2
Insurance ....................................................................... 5.1 5.6
With respect to our corporate securities, no other industry accounted for
more than 4.2 percent of amortized cost or 4.9 percent of estimated fair value.
Below-Investment Grade Securities
At June 30, 2002, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $2,066.6 million, or 9.7
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $1,694.9 million, or 82 percent of the
amortized cost. The value of these securities varies based on the credit
worthiness of the issuer of the securities. Recently a number of large highly
leveraged issuers have defaulted or filed for bankruptcy relief, which decreases
the value of our assets. These defaults and filings have a material adverse
effect on us.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of loss upon default by the
borrower is significantly greater with respect to below-investment grade
securities than with other corporate debt securities. Below-investment grade
securities are generally unsecured and are often subordinated to other creditors
of the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and are more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than are investment grade
issuers.
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CONSECO, INC. AND SUBSIDIARIES
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The Company attempts to reduce the overall risk in the below-investment
grade portfolio, as in all investments, through careful credit analysis, strict
investment policy guidelines, and diversification by issuer and/or guarantor and
by industry.
Net Investment Losses
During the first six months of 2002, we recognized net investment losses of
$290.8 million, compared to $153.6 million during the comparable period of 2001.
The net investment losses during the first six months of 2002 included: (i)
$266.4 million of writedowns of fixed maturity investments, equity securities
and other invested assets as a result of conditions which caused us to conclude
a decline in fair value of the investment was other than temporary; and (ii)
$24.4 million of net losses from the sales of investments (primarily fixed
maturities) which generated proceeds of $11.5 billion. During the first six
months of 2001, we decided to sell several securities to enhance the yield and
other characteristics of our portfolio. In accordance with GAAP, we were
required to recognize a writedown when it was determined that a loss would occur
upon the planned sale of a security. Accordingly, we recorded $125.4 million of
investment writedowns during the first six months of 2001 related to the
investment restructuring activities and as a result of changes in conditions
related to other investments which caused us to conclude that a decline in the
fair value of the investments was other than temporary. At June 30, 2002, fixed
maturity securities in default as to the payment of principal or interest had an
aggregate amortized cost of $178.0 million and a carrying value of $158.8
million.
During the first six months of 2002, we sold $8.8 billion of fixed maturity
investments which resulted in gross investment losses (before income taxes) of
$115.5 million. Securities sold at a loss are sold for a number of reasons
including: (i) changes in the investment environment; (ii) expectation that the
market value could deteriorate further; (iii) desire to reduce our exposure to
an issuer or an industry; (iv) changes in credit quality; and (v) our analysis
indicates there is a high probability that the security is permanently impaired.
The following summarizes the investments sold at a loss during the first
six months of 2002 which had been continuously in an unrealized position
exceeding 20 percent of the amortized cost basis prior to the sale for the
period indicated:
At date of sale
------------------
Number of Amortized Fair
Period issuers cost value
------ ------- ---- -----
(Dollars in millions)
Less than 6 months prior to sale............................. 8 $10.2 $4.7
Greater than or equal to 6 and less than 12 months
prior to sale............................................. 2 1.1 .7
Greater than 12 months
prior to sale............................................. 8 40.7 26.6
Investments with Other-Than-Temporary Losses
During the six months ended June 30, 2002, we recorded writedowns of fixed
maturity investments, equity securities and other invested assets totaling
$266.4 million. The following is a brief description of the facts and
circumstances that resulted in the other-than-temporary losses:
During the first six months of 2002, we recorded writedowns totaling $32.2
million related to investments in a large capitalization stock fund, a balanced
fund, and a diversified science and technology fund. The events of September 11,
2001 resulted in a decline in the value of most equity securities, including net
assets in these funds. Based on the belief that the economy was improving at
year-end 2001, combined with the general equity market improvement in late 2001,
we concluded that the unrealized loss at December 31, 2001 was temporary.
However, the equity markets in the first half of 2002 have suffered significant
losses due to a combination of corporate restatements, fears over a double-dip
recession, and decreased corporate capital spending. We changed our intent to
hold these funds once we concluded that the loss was other-than-temporary. All
of our holdings in such funds were sold by August 5, 2002.
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CONSECO, INC. AND SUBSIDIARIES
--------------------
During the first six months of 2002, we recorded writedowns totaling $28.4
million related to an investment in a telecommunications company that was rated
investment grade at the time of purchase and was subsequently downgraded to
below-investment grade. The company faced significant financial difficulties and
accounting irregularities that resulted in a restatement of its financials. The
company subsequently defaulted in July.
During the first six months of 2002, we recorded writedowns totaling $10.8
million on a fixed maturity investment in an Australian nickel mining company.
The construction costs of the processing plant at this start-up nickel project
were higher than anticipated. Initially, the project's equity sponsors supported
this project through additional equity and cash infusions. However, during the
first six months of 2002, the equity sponsors notified bond investors that they
were no longer willing to support the project without a restructuring of the
company's debt. As a result, our investment analysts believe the decline in
market value of this security is other-than-temporary.
During the first six months of 2002, we recorded writedowns of $8.1 million
of fixed maturity investments issued by a copper producer. The financial
condition of this company is significantly affected by the price of copper,
which has dropped from as high as $0.80 per pound earlier this year to a current
low of $0.68. In addition, the company was downgraded by a national rating
agency during the first six months of 2002. Despite the fact that the company is
still making the coupon payments on this issue, our investment analysts believe
that the decline in market value of this security is other-than-temporary. All
of our holdings in this company were sold by August 8, 2002.
During the first six months of 2002, we recorded writedowns totaling $8.8
million related to holdings of investment grade securities in a retail chain
that was subsequently downgraded to below-investment grade and defaulted in
early 2002. A writedown was taken as of December 31, 2001 based upon the
estimated fair value of the investment at that time. Given additional
information released since the bankruptcy filing, and the subsequent decrease in
the estimated fair value of our investment, an additional writedown was taken.
During the first six months of 2002, we recorded writedowns totaling $69.2
million related to adjustments to the carrying value of investments in
collateralized debt obligations (CDOs). Given the rise in default rates in 2002
above industry and our expectations for both investment grade and high yield
bonds and the recent downgrades of CDOs by nationally recognized statistical
rating organizations, a revaluation of the carrying value was required per EITF
99-20.
During the first six months of 2002, we recorded writedowns totaling $7.8
million of an investment in a mezzanine tranche of an aircraft securitization.
Lease rates for the underlying aircraft continue to be under pressure due to the
depressed state of the U.S. and global aviation industries. While the investment
remains current on its interest payments, our investment analysts believe that
the decline in market value of this security is other-than-temporary.
During the first six months of 2002, in addition to the specific securities
discussed above, we recorded $101.1 million of writedowns related to various
other investments. In accordance with GAAP, we are required to recognize an
impairment charge when it is determined that we intend to sell a security with
an unrealized loss. We expect to sell securities in conjunction with the planned
sale of our variable annuity business and various reinsurance transactions.
Accordingly, we recorded $66.7 million of investment writedowns during the first
six months of 2002 related to such transactions which caused us to conclude that
the decline in the fair value of certain investments was other than temporary.
Individually, no other writedowns of a single issuer exceeded $4.4 million.
Recognition of Losses
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value.
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time.
Our periodic assessment of whether unrealized losses are "other than
temporary" requires significant judgment and uncertainty. Factors considered
include: (i) the extent to which market value is less than the cost basis; (ii)
the length of time
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CONSECO, INC. AND SUBSIDIARIES
--------------------
that the market value has been less than cost; (iii) whether the unrealized loss
is credit-driven or a result of changes in market interest rates; (iv) the
near-term prospects for improvement in the issuer and/or its industry; (v)
whether the investment is investment-grade and our security analyst's view of
the investment's rating; (vi) whether the issuer is current on all payments in
accordance with the contractual terms of the investment; and (vii) our ability
and intent to hold the investment for a period of time sufficient to allow for
any anticipated recovery.
If a decline in value is determined to be other than temporary and the cost
basis of the security is written down to fair value, we review the circumstances
which caused us to believe that the decline was other than temporary with
respect to other investments in our portfolio. If such circumstances exist with
respect to other investments, those investments are also written down to fair
value. Future events may occur, or additional or updated information may become
available, which may necessitate future realized losses of securities in our
portfolio. Significant losses in the carrying value of our investments could
have a material adverse effect on our earnings in future periods.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at June 30,
2002, by contractual maturity. Actual maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties. Most of the mortgage-backed
securities shown below provide for periodic payments throughout their lives.
Estimated
Amortized fair
cost value
-------------- -------------
(Dollars in millions)
Due in one year or less................................................................... $ 30.2 $ 19.8
Due after one year through five years..................................................... 270.7 252.1
Due after five years through ten years.................................................... 1,712.9 1,547.4
Due after ten years....................................................................... 4,689.6 4,082.3
-------- --------
Subtotal............................................................................... 6,703.4 5,901.6
Mortgage-backed securities (a)............................................................ 2,168.2 1,970.5
-------- --------
Total actively managed fixed maturities ............................................... $8,871.6 $7,872.1
======== ========
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CONSECO, INC. AND SUBSIDIARIES
--------------------
- --------------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $106.5 million and $55.0
million, respectively.
The following summarizes the investments in our portfolio rated
below-investment grade or equity-type securities which have been continuously in
an unrealized loss position exceeding 20 percent of the cost basis for the
period indicated as of June 30, 2002:
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------- ---------- ----- ---- ----------
(Dollars in millions)
Less than 6 months(1) 24 $203.3 $ 72.7 $ 130.6
Greater than or equal to
6 months and less
than 12 months(2) 11 121.8 68.9 52.9
Greater than 12 months:
Fixed maturities issued
by securitization trusts(3) 1 411.3 246.1 165.2
All other investments(4) 24 229.0 77.9 151.1
-- ------- ------ ------
60 $965.4 $465.6 $499.8
== ====== ====== ======
-----------------------
(1) These investments include fixed maturity investments in a
telecommunications company with a cost basis of $57.3
million and a fair value of $32.3 million. See "Investments
with Unrealized Losses" for additional information.
(2) These investments include an investment in a merchant energy
company that provides energy and risk management products
with a cost basis of $100.6 million and a fair value of
$39.8 million. See "Investments with Unrealized Losses" for
additional information.
(3) These securities are issued by non-consolidated
securitization trusts which hold loans originated and
managed by our finance subsidiary. See "Investments with
Unrealized Losses" for additional information.
(4) These investments include: (i) a fixed maturity investment
issued by a commercial property and casualty insurance
company rated BB+ with a cost basis of $54.6 million and an
estimated fair value of $34.7 million; (ii) a fixed maturity
investment issued by a regional retail chain rated B+ with
an amortized cost basis of $29.9 million and a fair value of
$20.8 million; and (iii) a fixed maturity investment issued
by a wireless service provider rated B with an amortized
cost basis of $26.3 million and an estimated fair value of
$13.2 million. See "Investments with Unrealized Losses" for
additional information.
Our investment strategy is to maximize investment income and total
investment return through active investment management. Accordingly, we may sell
securities at a gain or a loss to enhance the total return of the portfolio as
market opportunities change. While we have both the ability and intent to hold
securities with unrealized losses until they mature or recover in value, we may
sell securities at a loss in the future because of actual or expected changes in
our view of the particular investment, its industry, its type or the general
investment environment.
Based on management's current assessment of these securities and other
investments with unrealized losses at June 30, 2002, the Company believes the
issuers of the securities will continue to meet their obligations (or with
respect to equity-type securities, the investment value will recover to its cost
basis). The Company has no intent to sell these securities and has the ability
to hold them to maturity. The recognition of an other-than-temporary impairment
through a charge to earnings may be
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CONSECO, INC. AND SUBSIDIARIES
--------------------
recognized in future periods if management later concludes that the decline in
market value below the cost basis is other than temporary.
Investments with Unrealized Losses
The following is a brief description of our assessment of the potential
other-than-temporary losses related to investments in our below-investment grade
portfolio (or equity-type securities) with significant unrealized losses at June
30, 2002 (unrealized losses which exceed $8.5 million and 20 percent of the cost
basis of the securities by the same issuer):
At June 30, 2002, we held securities with an amortized cost basis of $759.2
million and an estimated fair value of $542.5 million which were lower-rated
securities issued by the non-consolidated securitization trust that holds loans
originated and managed by our finance subsidiary. As described in the note to
the consolidated financial statements entitled "Guarantees", these securities
are guaranteed by our finance subsidiary and any potential payments related to
the guarantees are considered in the projected cash flows we use to determine
the value of our interest-only securities. Since cash flows for the guarantee
payments are appropriately reflected in the valuation of our interest-only
securities, the Company has concluded that no impairment exists with respect to
these securities. The Company follows the guidance of EITF 99-20 in determining
whether these securities have an other-than-temporary impairment.
At June 30, 2002, we held fixed maturity investments issued by a merchant
energy company rated Ba1/BBB- with an amortized cost basis of $100.6 million and
a fair value of $39.8 million. The company's operating results and liquidity
have deteriorated due to weakness in the sector and higher working capital
demands. Recent and future asset sales will help the company's liquidity
position and the company has developed and is implementing a plan to increase
liquidity, reduce debt and reduce costs. The company has demonstrated a plan
which appears to maintain sufficient liquidity, therefore, we concluded that the
unrealized loss at June 30, 2002 was temporary.
At June 30, 2002, we held fixed maturity investments issued by a
telecommunications company rated Ba2/BB with an amortized cost basis of $57.3
million and a fair value of $32.3 million. The Securities and Exchange
Commission and the Department of Justice are currently investigating the company
for accounting irregularities. While liquidity may become an issue in 2003 if
the company is unable to improve its operating results, sell its non-core
assets, or achieve executions of existing lines of credit, our investment
analysts believe the underlying value of the company's local customer base
provides sufficient value to cover the existing debt.
At June 30, 2002 we held fixed maturity investments issued by a commercial
property and casualty insurance company rated Ba2/BB+ with an amortized cost
basis of $54.6 million and an estimated fair value of $34.7 million. Our
securities analysts believe this issuer currently has sufficient liquidity to
cover its debt service through 2005. They believe the underwriting cycle will
improve before then (consistent with prior cycles), allowing the issuer to
continue to service its debt beyond 2005. In addition, this issuer recently
completed the public issuance of equity securities, which further improves its
liquidity and demonstrates the ability to access the capital market, if needed,
to service its future debt obligations.
At June 30, 2002, we held fixed maturity investments issued by a wireless
service provider rated B3/B with an amortized cost basis of $26.3 million and a
fair value of $13.2 million. The company has posted significant improvements in
their operating results in the first six months of 2002 and further improvement
is expected. The company has substantial liquidity in both cash resources and
undrawn capacity on its revolver. Based on the fact that there is no basis on
which to conclude that the company has insufficient financial resources to meet
its debt obligations when due, we concluded that the unrealized loss at June 30,
2002 was temporary.
At June 30, 2002, we held fixed maturity investments issued by a regional
retail chain rated B2/B+ with an amortized cost basis of $29.9 million, a par
amount of $25.2 million and a fair value of $20.8 million. Our investment
analysts have observed that this company has improving fundamentals including
its liquidity position, leverage and operating performance. This fixed maturity
has a long duration and was purchased at a price in excess of par as an
investment grade credit. The market value of this security has increased
significantly during 2002 (from 70 percent of par at December 31, 2001 to 83
percent of par at July 19, 2002). The Company believes that it will recover its
full value from this investment based on the Company's ability and intent to
hold to maturity.
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CONSECO, INC. AND SUBSIDIARIES
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Mortgage Backed Securities
At June 30, 2002, fixed maturity investments included $7.5 billion of
mortgage-backed securities (or 36 percent of all fixed maturity securities). The
yield characteristics of mortgage-backed securities differ from those of
traditional fixed-income securities. Interest and principal payments for
mortgage-backed securities occur more frequently, often monthly. Mortgage-backed
securities are subject to risks associated with variable prepayments. Prepayment
rates are influenced by a number of factors that cannot be predicted with
certainty, including: the relative sensitivity of the underlying mortgages
backing the assets to changes in interest rates; a variety of economic,
geographic and other factors; and the repayment priority of the securities in
the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities
backed by these loans increase when prevailing interest rates decline
significantly relative to the interest rates on such loans. The yields on
mortgage-backed securities purchased at a discount to par will increase when the
underlying mortgages prepay faster than expected. The yields on mortgage-backed
securities purchased at a premium will decrease when they prepay faster than
expected. When interest rates decline, the proceeds from the prepayment of
mortgage-backed securities are likely to be reinvested at lower rates than we
were earning on the prepaid securities. When interest rates increase,
prepayments on mortgage-backed securities decrease as fewer underlying mortgages
are refinanced. When this occurs, the average maturity and duration of the
mortgage-backed securities increase, which decreases the yield on
mortgage-backed securities purchased at a discount, because the discount is
realized as income at a slower rate, and increases the yield on those purchased
at a premium as a result of a decrease in the annual amortization of the
premium.
The following table sets forth the par value, amortized cost and estimated
fair value of mortgage-backed securities, summarized by interest rates on the
underlying collateral at June 30, 2002:
Par Amortized Estimated
value cost fair value
----- ---- ----------
(Dollars in millions)
Below 7 percent..................................................................... $5,610.2 $5,564.5 $5,665.3
7 percent - 8 percent............................................................... 1,092.2 1,085.7 1,129.3
8 percent - 9 percent............................................................... 165.9 166.8 174.0
9 percent and above................................................................. 746.4 749.1 574.1
-------- -------- --------
Total mortgage-backed securities (a)......................................... $7,614.7 $7,566.1 $7,542.7
======== ======== ========
- ----------------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $694.9 million and $513.8
million, respectively.
The amortized cost and estimated fair value of mortgage-backed securities
at June 30, 2002, summarized by type of security, were as follows:
Estimated fair value
--------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
(Dollars in millions)
Pass-throughs and sequential and targeted amortization classes............ $3,822.8 $3,911.2 19%
Planned amortization classes and accretion-directed bonds................. 2,382.1 2,426.6 11
Commercial mortgage-backed securities..................................... 338.4 349.8 2
Subordinated classes and mezzanine tranches............................... 1,010.2 845.3 4
Other..................................................................... 12.6 9.8 -
-------- -------- --
Total mortgage-backed securities (a)............................... $7,566.1 $7,542.7 36%
======== ======== ==
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CONSECO, INC. AND SUBSIDIARIES
--------------------
- ----------------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $694.9 million and $513.8
million, respectively.
Pass-throughs and sequential and targeted amortization classes have similar
prepayment variability. Pass-throughs historically provide the best liquidity in
the mortgage-backed securities market. Pass-throughs are also used frequently in
the dollar roll market and can be used as the collateral when creating
collateralized mortgage obligations. Sequential classes are a series of tranches
that return principal to the holders in sequence. Targeted amortization classes
offer slightly better structure in return of principal than sequentials when
prepayment speeds are close to the speed at the time of creation.
Planned amortization classes and accretion-directed bonds are some of the
most stable and liquid instruments in the mortgaged-backed securities market.
Planned amortization class bonds adhere to a fixed schedule of principal
payments as long as the underlying mortgage collateral experiences prepayments
within a certain range. Changes in prepayment rates are first absorbed by
support or companion classes. This insulates the planned amortization class from
the consequences of both faster prepayments (average life shortening) and slower
prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are bonds secured by
commercial real estate mortgages. Commercial real estate encompasses income
producing properties that are managed for economic profit. Property types
include multi-family dwellings including apartments, retail centers, hotels,
restaurants, hospitals, nursing homes, warehouses, and office buildings. The
CMBS market currently offers high yields, strong credits, and call protection
compared to similar rated corporate bonds. Most CMBS have strong call protection
features where borrowers are locked out from prepaying their mortgages for a
stated period of time. If the borrower does prepay any or all of the loan, they
will be required to pay prepayment penalties.
Subordinated and mezzanine tranches are classes that provide credit
enhancement to the senior tranches. The rating agencies require that this credit
enhancement not deteriorate due to prepayments for a period of time, usually
five years of complete lockout followed by another period of time where
prepayments are shared pro rata with senior tranches. The credit risk of
subordinated and mezzanine tranches is derived from owning a small percentage of
the mortgage collateral, while bearing a majority of the risk of loss due to
property owner defaults. Subordinated bonds can be anything rated "AA" or lower,
while typically we do not buy anything lower than "BB". We retained certain
lower-rated securities that are senior in payment priority to the interest-only
securities from the securitization transactions completed by our finance segment
prior to September 8, 1999. These securities are classified as subordinated
class and mezzanine tranche type securities and have an amortized cost and
estimated fair value of $687.8 million and $511.6 million, respectively, at June
30, 2002.
Mortgage Loans
At June 30, 2002, the mortgage loan balance was primarily comprised of
commercial loans. Less than one percent of the mortgage loan balance was
noncurrent (loans with two or more scheduled payments past due) at June 30,
2002.
Investment Borrowings
Our investment borrowings averaged approximately $1,441.0 million during
the first six months of 2002, compared with approximately $729.4 million during
the same period of 2001 and were collateralized by investment securities with
fair values approximately equal to the loan value. The weighted average interest
rates on such borrowings were 1.6 percent and 4.6 percent during the first six
months of 2002 and 2001, respectively.
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CONSECO, INC. AND SUBSIDIARIES
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STATUTORY INFORMATION
Statutory accounting practices prescribed or permitted by regulatory
authorities for the Company's insurance subsidiaries differ from GAAP. The
statutory income before net realized capital gains (losses) of our life
insurance subsidiaries was $72.9 million and $83.1 million in the first six
months of 2002 and 2001, respectively. The Company's life insurance subsidiaries
reported the following amounts to regulatory agencies at June 30, 2002, after
appropriate eliminations of intercompany accounts among such subsidiaries
(dollars in millions):
Statutory capital and surplus .................................. $1,412.2
Asset valuation reserve......................................... 85.3
Interest maintenance reserve.................................... 3.7
--------
Total........................................................ $1,501.2
========
The statutory capital and surplus shown above included investments in
up-stream affiliates, all of which were eliminated in the consolidated financial
statements prepared in accordance with GAAP, as follows:
June 30,
2002
----
(Dollars in millions)
Securitization debt issued by special purpose entities and guaranteed by our
finance subsidiary, all of which was purchased by our insurance subsidiaries
prior to the acquisition of Conseco Finance (a).................................... $ 71.4
Preferred and common stock of intermediate holding company............................ 141.4
Common stock of Conseco (39.8 million shares)......................................... 6.8
Other ................................................................................ 2.5
------
Total........................................................................... $222.1
======
- --------------------
(a) Total par value, amortized cost and fair value of securities issued by
special purpose entities which hold loans originated by our finance
subsidiary (including the securities that are not guaranteed by Conseco
Finance, and therefore are not considered affiliated investments) were
$280.0 million, $276.0 million and $249.0 million, respectively.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid from earned surplus of the insurance company for any
12-month period in amounts equal to the greater of (or in a few states, the
lesser of): (i) net gain from operations for the prior year; or (ii) 10 percent
of surplus as of the end of the preceding year. Any dividends in excess of these
levels require the approval of the director or commissioner of the applicable
state insurance department. During the first six months of 2002, our insurance
subsidiaries paid dividends to Conseco totaling $240.0 million.
NEW ACCOUNTING STANDARDS
See "Cumulative Effect of Accounting Change" and "Recently Issued
Accounting Standards" in the notes to consolidated financial statements for a
discussion of recently issued accounting standards.
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CONSECO, INC. AND SUBSIDIARIES
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FORWARD-LOOKING STATEMENTS
All statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the Securities and
Exchange Commission, press releases, presentations by Conseco or its management
or oral statements) relative to markets for Conseco's products and trends in
Conseco's operations or financial results, as well as other statements including
words such as "anticipate," "believe," "plan," "estimate," "expect,"
"projected," "intend," "may," "will," "would," "contemplate," "possible,"
"attempts," "seeks," "should," "could," "goal," "target," "on track,"
"comfortable with," "optimistic" and other similar expressions, constitute
forward-looking statements under the Private Securities Litigation Reform Act of
1995. Forward-looking statements are subject to known and unknown risks,
uncertainties and other factors which may cause actual results, performance or
achievements to be materially different from the future results, performance or
achievements expressed or implied by the forward-looking statements. Assumptions
and other important factors that could cause our actual results to differ
materially from those anticipated in our forward-looking statements include,
among other things: (i) general economic conditions and other factors, including
prevailing interest rate levels, stock and credit market performance and health
care inflation, which may affect (among other things) Conseco's ability to sell
its products, its ability to make loans and access capital resources and the
costs associated therewith, the market value of Conseco's investments, the lapse
rate and profitability of policies, and the level of defaults and prepayments of
loans made by Conseco; (ii) Conseco's ability to achieve anticipated synergies
and levels of operational efficiencies, including from our process excellence
initiatives; (iii) customer response to new products, distribution channels and
marketing initiatives; (iv) mortality, morbidity, usage of health care services
and other factors which may affect the profitability of Conseco's insurance
products; (v) performance of our investments; (vi) changes in the Federal income
tax laws and regulations which may affect the relative tax advantages of some of
Conseco's products; (vii) increasing competition in the sale of insurance and
annuities and in the finance business; (viii) regulatory changes or actions,
including those relating to regulation of financial services affecting (among
other things) bank sales and underwriting of insurance products, regulation of
the sale, underwriting and pricing of products, and health care regulation
affecting health insurance products; (ix) the outcome of Conseco's efforts to
sell assets and reduce, refinance or modify indebtedness and the availability
and cost of capital in connection with this process; (x) actions by rating
agencies and the effects of past or future actions by these agencies on
Conseco's business including the impact of recent downgrades; (xi) the ultimate
outcome of lawsuits filed against Conseco; (xii) the risk factors or
uncertainties listed from time to time in Conseco's filings with the Securities
and Exchange Commission; and (xiii) the outcome and timing of the restructuring
of our indebtedness. Other factors and assumptions not identified above are also
relevant to the forward-looking statements, and if they prove incorrect, could
also cause actual results to differ materially from those projected.
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The substantial majority of the Company's investment portfolio consists of
debt securities and other interest bearing investments. Interest rates in the
United States markets, particularly short-term interest rates, have declined in
recent periods. In addition, default rates on below-investment grade securities
have increased.
See the note to the accompanying consolidated financial statements entitled
"Accounting for Derivatives" for information about interest rate swap
agreements.
As described in "Liquidity" within "Management's Discussion and Analysis of
Financial Condition and Results of Operations", the recent adverse developments
concerning the parent company's liquidity have adversely affected certain
aspects of our finance and insurance segment operations. While these
developments do not change the way we manage market risk, such developments can
affect our ability to effectively manage them.
Our market risks, and the ways we manage them, are summarized in
management's discussion and analysis of financial condition and results of
operations as of December 31, 2001, included in the Company's Form 10-K for the
year ended December 31, 2001. There have been no material changes other than
those summarized above in the first six months of 2002 to such risks or our
management of such risks.
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PART II - OTHER INFORMATION
ITEM 1. LITIGATION AND OTHER LEGAL PROCEDINGS.
We and our subsidiaries are involved on an ongoing basis in lawsuits
(including purported class actions) relating to our operations, including with
respect to sales practices, and we and current and former officers and directors
are defendants in pending class action lawsuits asserting claims under the
securities laws and derivative lawsuits. The ultimate outcome of these lawsuits
cannot be predicted with certainty.
Conseco Finance was served with various related lawsuits filed in the
United States District Court for the District of Minnesota. These lawsuits were
generally filed as purported class actions on behalf of persons or entities who
purchased common stock or options to purchase common stock of Conseco Finance
during alleged class periods that generally run from July 1995 to January 1998.
One action (Florida State Board of Admin. v. Green Tree Financial Corp., et. al,
Case No. 98-1162) was brought not on behalf of a class, but by the Florida State
Board of Administration, which invests and reinvests retirement funds for the
benefit of state employees. In addition to Conseco Finance, certain current and
former officers and directors of Conseco Finance are named as defendants in one
or more of the lawsuits. Conseco Finance and other defendants obtained an order
consolidating the lawsuits seeking class action status into two actions, one of
which pertains to a purported class of common stockholders (In re Green Tree
Financial Corp. Stock Litig., Case No. 97-2666) and the other of which pertains
to a purported class of stock option traders (In re Green Tree Financial Corp.
Options Litig., Case No. 97-2679). Plaintiffs in the lawsuits assert claims
under Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the
Securities Exchange Act of 1934. In each case, plaintiffs allege that Conseco
Finance and the other defendants violated federal securities laws by, among
other things, making false and misleading statements about the current state and
future prospects of Conseco Finance (particularly with respect to prepayment
assumptions and performance of certain loan portfolios of Conseco Finance) which
allegedly rendered Conseco Finance's financial statements false and misleading.
On August 24, 1999, the United States District Court for the District of
Minnesota issued an order dismissing with prejudice all claims alleged in the
lawsuits. The plaintiffs subsequently appealed the decision to the U.S. Court of
Appeals for the 8th Circuit. A three judge panel issued an opinion on October
25, 2001, reversing the United States District Court's dismissal order and
remanding the actions to the United States District Court. Conseco Finance has
moved to dismiss the options lawsuit on the grounds that stock option traders
lack standing under the federal securities laws. The motion was argued on May
24, 2002. The motion was denied by order dated July 29, 2002. Pretrial discovery
in the options lawsuit was stayed pending disposition of the motion to dismiss
but will commence presently. In the other two lawsuits, pretrial discovery
commenced in April 2002. The Company believes that the lawsuits are without
merit and intends to continue to defend them vigorously. The ultimate outcome of
these lawsuits cannot be predicted with certainty.
A total of forty-five suits were filed in 2000 against the Company in the
United States District Court for the Southern District of Indiana. Nineteen of
these cases were putative class actions on behalf of persons or entities that
purchased the Company's common stock during alleged class periods that generally
run from April 1999 through April 2000. Two cases were putative class actions on
behalf of persons or entities that purchased the Company's bonds during the same
alleged class periods. Three cases were putative class actions on behalf of
persons or entities that purchased or sold option contracts, not issued by the
Company, on the Company's common stock during the same alleged class periods.
One case was a putative class action on behalf of persons or entities that
purchased the Company's "FELINE PRIDES" convertible preferred stock instruments
during the same alleged class periods. With four exceptions, in each of these
twenty-five cases two former officers/directors of the Company were named as
defendants. In each case, the plaintiffs asserted claims under Sections 10(b)
(and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Exchange Act
of 1934. In each case, plaintiffs alleged that the Company and the individual
defendants violated the federal securities laws by, among other things, making
false and misleading statements about the current state and future prospects of
Conseco Finance (particularly with respect to performance of certain loan
portfolios of Conseco Finance) which allegedly rendered the Company's financial
statements false and misleading.
Eleven of the cases in the United States District Court for the Southern
District of Indiana were filed as purported class actions on behalf of persons
or entities that purchased preferred securities issued by various Conseco
Financing Trusts, including Conseco Financing Trust V, Conseco Financing Trust
VI, and Conseco Financing Trust VII. Each of these complaints named as
defendants the Company, the relevant trust (with two exceptions), two former
officers/directors of the Company, and underwriters for the particular issuance
(with one exception). One complaint also named an officer and all of the
Company's directors at the time of issuance of the preferred securities by
Conseco Financing Trust VII. In each case, plaintiffs asserted claims under
Section 11 and Section 15 of the Securities Act of 1933, and eight complaints
also asserted claims under
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CONSECO, INC. AND SUBSIDIARIES
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Section 12(a)(2) of that Act. Two complaints also asserted claims under Sections
10(b) and 20(a) of the Securities Exchange Act of 1934, and one complaint also
asserted a claim under Section 10(b) of that Act. In each case, plaintiffs
alleged that the defendants violated the federal securities laws by, among other
things, making false and misleading statements in Prospectuses and/or
Registration Statements related to the issuance of preferred securities by the
Trust involved regarding the current state and future prospects of Conseco
Finance (particularly with respect to performance of certain loan portfolios of
Conseco Finance) which allegedly rendered the disclosure documents false and
misleading.
All of the Conseco, Inc. securities cases were consolidated into one case
in the United States District Court for the Southern District of Indiana,
captioned: "In Re Conseco, Inc. Securities Litigation", Case number
IP00-C585-Y/S (the "securities litigation"). An amended complaint was filed on
January 12, 2001, which asserted claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, and Sections 11, 12(a)(2), and 15 of the
Securities Act of 1933, with respect to common stock and various other
securities issued by the Company and Conseco Financing Trust VII. The Company
filed a motion to dismiss the amended complaint on April 27, 2001. On January
10, 2002, the Company entered into a Memorandum of Understanding (the "MOU") to
settle the litigation for $120 million subject to court approval. Under the MOU,
as amended on February 12, 2002, $106 million was required to be placed in
escrow by March 8, 2002; the remaining $14 million was to be paid in two
installments: $6 million by April 1, 2002, and $8 million by October 1, 2002
(all payments with interest from January 25, 2002). The $106 million due on
March 8, 2002, was not paid, for reasons set forth in the following paragraph,
and the MOU was terminated by the plaintiffs. On April 15, 2002, a new MOU was
executed (the "April 15 MOU"). Pursuant to the April 15 MOU, $95 million was
funded on April 25, 2002, with the remaining $25 million to await the outcome of
the coverage litigation between the Company and certain of its directors' and
officers' liability insurance carriers as described in the next paragraph. Court
approval of the settlement was received on August 7, 2002.
We maintained certain directors' and officers' liability insurance that was
in force at the time the Indiana securities and derivative litigation (the
derivative litigation is described below) was commenced and which, in our view,
applies to the claims asserted in that litigation. The insurers denied coverage
for those claims, so we commenced a lawsuit against them on June 13, 2001, in
Marion County Circuit Court in Indianapolis, Indiana (Conseco, Inc., et al. v.
National Union Fire Insurance Company of Pittsburgh, PA, Royal & SunAlliance,
Westchester Fire Insurance Company, RLI Insurance Company, Greenwich Insurance
Company and Certain Underwriters at Lloyd's of London, Case No.
49C010106CP001467) (the "coverage litigation") seeking, among other things, a
judicial declaration that coverage for those claims exists. The primary
insurance carrier, National Union Fire Insurance Co. of Pittsburgh, PA, has paid
its full $10 million in policy proceeds toward the settlement of the securities
litigation; in return, National Union has been released from the coverage
litigation. The first excess insurance carrier, Royal & SunAlliance ("Royal"),
has paid its full $15 million in policy proceeds toward the settlement, but
reserved rights to continue to litigate coverage. The second excess insurance
carrier, Westchester Fire Insurance Company, has paid its full $15 million in
policy proceeds toward the settlement without a reservation of rights and is
being released from the coverage litigation. The third excess insurance carrier,
RLI Insurance Company ("RLI"), has paid its full $10 million in policy proceeds
toward the settlement, but reserved rights to continue to litigate coverage. The
fourth excess insurance carrier, Greenwich Insurance Company ("Greenwich"), has
paid its full $25 million in policy proceeds toward the settlement without a
reservation of rights and is being released from the coverage litigation. The
final excess carrier, Certain Underwriters at Lloyd's of London ("Lloyd's"),
refused to pay or to escrow its $25 million in policy proceeds toward the
settlement and is continuing to litigate coverage. Under the April 15 MOU, the
settlement of the securities litigation will proceed notwithstanding the
continuing coverage litigation between the Company, Royal, RLI and Lloyd's.
Since the United States District Court for the Southern District of Indiana has
approved the settlement of the securities litigation prior to resolution of the
coverage litigation, $90 million plus accrued interest is available for
distribution to the putative class. The remaining funds, with interest, will be
distributed at the conclusion of the coverage litigation (or, in the case of the
$25 million at issue in the litigation with Lloyd's, on December 31, 2005, if
the litigation with Lloyd's has not been resolved by that date), with such funds
coming either from Lloyd's (if the Company prevails in the coverage litigation)
or from the Company (if the Company does not prevail). We intend to pursue our
coverage rights vigorously. The ultimate outcome cannot be predicted with
certainty. The directors' and officers' liability insurance that was in force at
the time the litigation commenced provides for coverage of $100 million. In
light of that coverage, the Company's best estimate of its exposure in the
litigation is $20 million (i.e., the excess of the $100 million in coverage).
The Company believes such insurance applies to the claims in the securities
litigation. Accordingly, $20 million is our best estimate of a probable loss at
June 30, 2002. Although the securities litigation has been settled, not all of
the insurance carriers have paid their allocable share of the coverage without
any reservation of rights. Of the $100 million in total coverage, $50 million
was paid without reservation of rights; $25 million was paid under reservations
of rights; and $25 million remains unpaid. We have established an estimated
liability of $50 million and claim for recovery of $50 million at June 30, 2002.
Such amounts include: (i) $25 million related to the two insurers who paid their
portion of the settlement into a fund but reserved their rights to continue to
litigate coverage (which litigation is proceeding); and (ii) $25 million related
to the
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CONSECO, INC. AND SUBSIDIARIES
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insurer that has refused to pay. The Company believes that it is probable that
the coverage litigation will result in a determination that the insurers who
paid under a reservation of rights have no valid rights to recoup the payments
they have made, and that the insurer which refused to pay is obligated to do so
under its policy. We believe it is probable that the latter insurer will pay its
portion of the coverage once such determination is made.
Nine shareholder derivative suits were filed in 2000 in the United States
District Court for the Southern District of Indiana. The complaints named as
defendants the current directors, certain former directors, certain non-director
officers of the Company (in one case), and, alleging aiding and abetting
liability, certain banks that allegedly made loans in relation to the Company's
"Stock Purchase Plan" (in three cases). The Company is also named as a nominal
defendant in each complaint. Plaintiffs allege that the defendants breached
their fiduciary duties by, among other things, intentionally disseminating false
and misleading statements concerning the acquisition, performance and proposed
sale of Conseco Finance, and engaged in corporate waste by causing the Company
to guarantee loans that certain officers, directors and key employees of the
Company used to purchase stock under the Stock Purchase Plan. These cases have
now been consolidated into one case in the United States District Court for the
Southern District of Indiana, captioned: "In Re Conseco, Inc. Derivative
Litigation", Case Number IP00655-C-Y/S. An amended complaint was filed on April
12, 2001, making generally the same allegations and allegations of violation of
the Federal Reserve Board's margin rules. Three similar cases have been filed in
the Hamilton County Superior Court in Indiana. Schweitzer v. Hilbert, et al.,
Case No. 29D01-0004CP251; Evans v. Hilbert, et al., Case No. 29D01-0005CP308
(both Schweitzer and Evans name as defendants certain non-director officers);
Gintel v. Hilbert, et al., Case No. 29003-0006CP393 (naming as defendants, and
alleging aiding and abetting liability as to, banks that allegedly made loans in
relation to the Stock Purchase Plan). The cases filed in Hamilton County have
been stayed pending resolution of the derivative suits filed in the United
States District Court. The Company believes that these lawsuits are without
merit and intends to defend them vigorously. The ultimate outcome of these
lawsuits cannot be predicted with certainty.
Conseco Finance is a defendant in two arbitration proceedings in South
Carolina (Lackey v. Green Tree Financial Corporation, n/k/a Conseco Finance
Corp. and Bazzle v. Green Tree Financial Corporation, n/k/a Conseco Finance
Corp.) where the arbitrator, over Conseco Finance's objection, allowed the
plaintiffs to pursue purported class action claims in arbitration. The two
purported arbitration classes consist of South Carolina residents who obtained
real estate secured credit from Conseco Finance's Manufactured Housing Division
(Lackey) and Home Improvement Division (Bazzle) in the early and mid 1990s, and
did not receive a South Carolina specific disclosure form relating to selection
of attorneys and insurance agents in connection with the credit transactions.
The arbitrator, in separate awards issued on July 24, 2000, awarded a total of
$26.8 million in penalties and attorneys' fees. The awards were confirmed as
judgments in both Lackey and Bazzle. These cases have been consolidated into one
case and are currently on appeal before the South Carolina Supreme Court. Oral
argument was heard on March 21, 2002. Conseco Finance has posted appellate
bonds, including $20 million of cash, for these cases. Conseco Finance intends
to vigorously challenge the awards and believes that the arbitrator erred by,
among other things, conducting class action arbitrations without the authority
to do so and misapplying South Carolina law when awarding the penalties. The
ultimate outcome of this proceeding cannot be predicted with certainty.
On January 15, 2002, Carmel Fifth, LLC ("Carmel"), an indirect, wholly
owned subsidiary of the Company, exercised its rights to require 767 Manager,
LLC ("Manager"), an affiliate of Donald J. Trump, to elect within 60 days,
either to acquire Carmel's interests in 767 LLC for $499.4 million, or sell its
interests in 767 LLC to Carmel for $15.6 million (the "Buy/Sell Right"). Such
rights were exercised pursuant to the Limited Liability Company Agreement of 767
LLC. 767 LLC is a Delaware limited liability company that owns the General
Motors Building, a 50-story office building in New York, New York. 767 LLC is
owned by Carmel and Manager. On February 6, 2002, Mr. Trump commenced a civil
action against the Company, Carmel and 767 LLC in New York State Supreme Court,
entitled Donald J. Trump v. Conseco, Inc., et al. Plaintiff claims that the
Company and Carmel breached an agreement, dated July 3, 2001, to sell Carmel's
interests to plaintiff for $295 million on or before September 15, 2001 (the
"July 3rd Agreement"). Specifically, plaintiff claims that the Company and
Carmel improperly refused to accept a reasonable guaranty of plaintiff's payment
obligations, refused to complete the sale of Carmel's interest before the
September 15, 2001 deadline, repudiated an oral promise to extend the September
15 deadline indefinitely and repudiated the July 3rd Agreement by exercising
Carmel's Buy/Sell Right. Plaintiff asserts claims for breach of contract, breach
of the implied covenant of good faith and fair dealing, promissory estoppel,
unjust enrichment and breach of fiduciary duty. Plaintiff is seeking
compensatory and punitive damages of approximately $1 billion and declaratory
and injunctive relief blocking Carmel's Buy/Sell Right. On March 25, 2002,
Carmel filed a Demand for Arbitration and Petition and Statement of Claim with
the American Arbitration Association ("AAA") to have the issues relating to the
Buy/Sell Right resolved by arbitration. Manager and Mr. Trump requested the New
York State Supreme Court to stay that arbitration, but the
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CONSECO, INC. AND SUBSIDIARIES
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Court denied Manager's and Trump's request on May 2, 2002, allowing the
arbitration to proceed. In addition, Conseco and Carmel filed a Motion to
Dismiss Mr. Trump's lawsuit on March 25, 2002. The Company believes that Mr.
Trump's lawsuit is without merit and intends to defend it vigorously.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against the Company, Conseco Services, LLC, and two former officers in
the Boone Circuit Court (Inlow et al. v. Conseco, Inc., et al., Cause No.
06C01-0206-CT-244). The heirs assert that unvested options to purchase 756,248
shares of our common stock should have been vested at Mr. Inlow's death. The
heirs further claim that if such options had been vested, they would have been
exercised, and that the resulting shares of common stock would have been sold
for a gain of approximately $30 million based upon a stock price of $58.125 per
share, the highest stock price during the alleged exercise period of the
options. We believe the heirs' claims are without merit and will defend the
action vigorously.
On March 27, 2002, seven holders of our bank debt filed a lawsuit in the
United States District Court for the Northern District of Illinois (AG Capital
Funding Partners LP, et al. v. Conseco, Inc., Case No. 02C2236). They filed a
voluntary dismissal of that action on April 25, 2002, and an order dismissing
the case was entered on April 26, 2002. On April 15, 2002, the same holders
filed an action in the Circuit Court of Cook County, Illinois (AG Capital
Funding Partners LP, et al. v. Conseco, Inc., Case No. 02CH07453). On March 20,
2002, we amended our credit facilities to provide, in part, that in the event of
certain asset sales, we are not obligated to prepay amounts borrowed under the
credit agreement until we have received in excess of $352 million of net
proceeds from those sales. The plaintiff holders assert that 100 percent of the
holders of the bank debt must vote in favor of an amendment of the provisions
relating to the triggering of mandatory prepayments. We believe that the
amendment of the mandatory prepayment provisions of the credit agreement
complied with the terms of the credit agreement, and we believe this lawsuit is
without merit and intend to defend it vigorously. The ultimate outcome of these
proceedings cannot be predicted with certainty. Except with respect to the
mandatory prepayment provisions of the credit agreement, this lawsuit does not
challenge any other portion of the March 20, 2002 amendment to the credit
agreement.
The Company has been notified that the staff of the U.S. Securities and
Exchange Commission has obtained a formal order of investigation in connection
with an inquiry that relates to events in and before the spring of 2000,
including the Company's accounting for its interest-only securities and
servicing rights. These issues were among those addressed in the Company's
write-down and restatement in the spring of 2000, and were the subject of
shareholder class action litigation, which has been recently settled. The
Company is cooperating with the SEC staff in this matter.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits (including purported class actions) related to their
operations. These actions include one action brought by the Texas Attorney
General regarding long term care policies, two purported nationwide class
actions involving claims related to "vanishing premiums," and two purported
nationwide class actions involving claims related to "modal premiums" (the
alleged imposition and collection of insurance premium surcharges in excess of
stated annual premiums). 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 to individually 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.
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
See "Changes in Direct Corporate Obligations" in the "Notes to Consolidated
Financial Statements" for a description of an April 2002 exchange offer by
Conseco.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
At the Company's annual meeting on June 13, 2002, the shareholders elected
John M. Mutz, Robert S. Nickoloff and Gary C. Wendt to serve as directors for
terms ending in 2005. Directors whose class was not up for election and whose
term of office continued after the meeting are Julio A. Barea, Carol Bellamy,
Lawrence M. Coss, Thomas M. Hagerty, David V. Harkins, M. Phil Hathaway and
Samme Thompson. William J. Shea was added to the Board of Directors on July 26,
2002. The results of the voting were as follows (there were no broker
non-votes):
John M. Robert S. Gary C.
Mutz Nickoloff Wendt
---- --------- -----
For 315,597,296 315,634,261 298,318,117
Withheld 5,566,239 5,529,274 22,845,418
At the annual meeting, the shareholders also defeated a shareholder
proposal regarding subprime lending (there were 12,165,749 shares voted for the
proposal, 151,999,959 shares voted against the proposal, 9,031,982 abstentions
and 147,965,845 broker non-votes).
The shareholders also defeated a shareholder proposal regarding
performance-based stock options (there were 37,120,206 shares votes for the
proposal, 128,377,637 shares voted against the proposal, 7,699,850 abstentions
and 147,965,842 broker non-votes).
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CONSECO, INC. AND SUBSIDIARIES
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The third shareholder proposal presented at the annual meeting concerned
independent directors. There were 35,412,356 shares voted for the proposal,
129,715,151 shares voted against the proposal, 8,070,172 abstentions and
147,965,856 broker non-votes.
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 5. OTHER INFORMATION.
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a) Exhibits.
4.31.15 Five-Year Credit Agreement, dated as of September 25,
1998, among Conseco, Inc., Bank of America National
Trust and Savings Association, as Agent, First Union
National Bank and JPMorgan Chase Bank, as Syndication
Agents, Morgan Guaranty Company of New York, as
Documentation Agent, and the other financial
institutions party thereto incorporated by reference to
Exhibit 4.11 to Amendment No. 1 to Conseco, Inc.'s
Registration Statement on Form S-4 (No. 333-89802),
dated July 25, 2002.
4.32.1 First Senior Supplemental Indenture, dated as of April
24, 2002 to Second Senior Indenture for the 10.75%
Guaranteed Senior Notes dated as of April 24, 2002
between Conseco, Inc., CIHC, Incorporated and State
Street Bank and Trust Company incorporated by reference
to Exhibit 4.1 to Conseco, Inc.'s Registration
Statement on Form S-4 (No. 333-89802), dated June 5,
2002.
4.32.2 Second Senior Indenture, dated as of April 24, 2002 for
10.75% Guaranteed Senior Notes, between Conseco, Inc.,
CIHC, Incorporated and State Street Bank and Trust
Company incorporated by reference to Exhibit 4.2 to
Conseco, Inc.'s Registration Statement on Form S-4 (No.
333-89802), dated June 5, 2002.
4.32.3 First Senior Indenture, dated as of April 24, 2002
among Conseco, Inc., CIHC, Incorporated and State
Street Bank and Trust Company incorporated by reference
to Exhibit 4.3 to Conseco, Inc.'s Registration
Statement on Form S-4 (No. 333-89802), dated June 5,
2002.
4.32.4 Terms Resolution, dated as of April 24, 2002 with
respect to the 6.4% Guaranteed Senior Notes, due
February 10, 2004 incorporated by reference to Exhibit
4.4 to Conseco, Inc.'s Registration Statement on Form
S-4 (No. 333-89802), dated June 5, 2002.
4.32.5 Terms Resolution, dated as of April 24, 2002 with
respect to the 8.5% Guaranteed Senior Notes due October
15, 2003 incorporated by reference to Exhibit 4.5 to
Conseco, Inc.'s Registration Statement on Form S-4 (No.
333-89802), dated June 5, 2002.
4.32.6 Terms Resolution, dated as of April 24, 2002 with
respect to the 6.8% Guaranteed Senior Notes due June
15, 2007 incorporated by reference to Exhibit 4.6 to
Conseco, Inc.'s Registration Statement on Form S-4 (No.
333-89802), dated June 5, 2002.
4.32.7 Terms Resolution, dated as of April 24, 2002 with
respect to the 9% Guaranteed Senior Notes due April 15,
2008 incorporated by reference to Exhibit 4.7 to
Conseco, Inc.'s Registration Statement on Form S-4 (No.
333-89802), dated June 5, 2002.
4.32.8 Terms Resolution, dated as of April 24, 2002 with
respect to the 8.75% Guaranteed Senior Notes due August
9, 2006 incorporated by reference to Exhibit 4.8 to
Conseco, Inc.'s Registration Statement on Form S-4 (No.
333-89802), dated June 5, 2002.
4.32.9 Registration Rights Agreement, dated as of April 24,
2002 among Conseco, Inc., CIHC, Incorporated and Banc
of America Securities LLC, J.P. Morgan Securities Inc.
and Lehman Brothers Inc., as Dealer Managers
incorporated by reference to Exhibit 4.9 to Conseco,
Inc.'s Registration Statement on Form S-4 (No.
333-89802), dated June 5, 2002.
10.1.27 Amendment to Employment and Restricted Stock Agreements
by and between Gary C. Wendt and Conseco, Inc., dated
as of June 26, 2002.
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CONSECO, INC. AND SUBSIDIARIES
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12.1 Computation of Ratio of Earnings to Fixed Charges,
Preferred Dividends and Distributions on
Company-obligated Mandatorily Redeemable Preferred
Securities of Subsidiary Trusts.
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
b) Reports on Form 8-K.
None.
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CONSECO, INC. AND SUBSIDIARIES
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: August 14, 2002 By: /s/ William J. Shea
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William J. Shea, President, Chief Operating
Officer and Acting Chief Financial Officer
(authorized officer and principal
financial officer)
102