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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ -------
Commission File Number 1-9250
Conseco, Inc.
Indiana No. 35-1468632
------------------------ ------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
----------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]
Shares of common stock outstanding as of November 11, 2002: 346,007,133
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
September 30, December 31,
2002 2001
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost: 2002 - $19,481.6;
2001 - $22,422.8).......................................................................... $19,785.4 $21,818.5
Retained interests in securitization trusts at fair value (amortized cost: 2002 - $526.0;
2001 - $876.1)............................................................................. 526.0 710.1
Equity securities at fair value (cost: 2002 - $156.2; 2001 - $257.3)......................... 139.1 227.0
Mortgage loans............................................................................... 1,281.3 1,228.0
Policy loans................................................................................. 538.8 635.8
Venture capital investment in AT&T Wireless Services, Inc. (cost: 2002 - $14.2; 2001- $39.0). 17.7 155.3
Other invested assets ....................................................................... 337.9 292.4
---------- -----------
Total investments........................................................................ 22,626.2 25,067.1
Cash and cash equivalents:
Held by the parent company................................................................... 109.4 152.2
Held by the parent company in segregated accounts............................................ - 54.7
Held by subsidiaries......................................................................... 1,498.8 2,853.9
Accrued investment income....................................................................... 653.7 688.6
Finance receivables............................................................................. 2,572.3 3,810.7
Finance receivables - securitized............................................................... 13,947.7 14,198.5
Cost of policies purchased...................................................................... 1,220.9 1,657.8
Cost of policies produced....................................................................... 2,050.5 2,570.2
Reinsurance receivables......................................................................... 957.3 663.0
Income tax assets............................................................................... 79.8 678.1
Goodwill........................................................................................ 100.0 3,695.4
Assets held in separate accounts and investment trust .......................................... 704.7 2,376.3
Cash held in segregated accounts for investors.................................................. 432.4 550.2
Cash held in segregated accounts related to servicing agreements and securitization
transactions................................................................................. 1,197.2 994.6
Assets of discontinued operations............................................................... 2,542.5 -
Other assets.................................................................................... 1,592.2 1,420.9
----------- -----------
Total assets............................................................................. $52,285.6 $61,432.2
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
2
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
September 30, December 31,
2002 2001
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products.............................................................. $13,944.6 $15,787.7
Traditional products..................................................................... 7,826.0 8,172.8
Claims payable and other policyholder funds.............................................. 933.9 1,005.5
Liabilities related to separate accounts and investment trust............................ 704.7 2,376.3
Liabilities related to certificates of deposit........................................... 2,124.1 1,790.3
Investor payables.......................................................................... 432.4 550.2
Guarantee liability related to interests in securitization trusts held by others........... 198.6 39.9
Other liabilities.......................................................................... 1,977.2 1,699.3
Liabilities of discontinued operations..................................................... 2,458.8 -
Investment borrowings...................................................................... 843.1 2,242.7
Notes payable:
Direct corporate obligations............................................................. 4,016.7 4,087.6
Direct finance obligations:
Master repurchase agreements........................................................... 465.8 1,670.8
Credit facility collateralized by retained interests in securitizations................ 512.3 507.3
Other borrowings....................................................................... 76.4 349.8
Related to securitized finance receivables structured as collateralized borrowings....... 14,662.9 14,484.5
--------- ---------
Total liabilities.................................................................... 51,177.5 54,764.7
--------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts......... 1,919.9 1,914.5
Shareholders' equity (deficit):
Preferred stock............................................................................ 501.7 499.6
Common stock and additional paid-in capital (no par value, 1,000,000,000 shares
authorized, shares issued and outstanding: 2002 - 346,007,133; 2001 - 344,743,196)....... 3,497.3 3,484.3
Accumulated other comprehensive income (loss).............................................. 130.4 (439.0)
Retained earnings (deficit)................................................................ (4,941.2) 1,208.1
---------- ----------
Total shareholders' equity (deficit)................................................. (811.8) 4,753.0
----------- ----------
Total liabilities and shareholders' equity (deficit)................................. $52,285.6 $61,432.2
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
-------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
Revenues:
Insurance policy income.......................................................... $ 902.6 $ 986.7 $2,726.2 $3,005.5
Net investment income:
Insurance and fee-based segment general account assets......................... 371.4 429.9 1,163.2 1,290.3
Finance segment assets......................................................... 533.3 582.1 1,647.2 1,698.9
Equity-indexed and separate account products................................... (32.6) (29.7) (106.3) (87.7)
Venture capital loss related to investment in AT&T Wireless Services, Inc...... (6.6) (87.4) (106.6) (84.0)
Other.......................................................................... 3.7 2.4 9.4 20.0
Gain (loss) on sale of finance receivables....................................... (31.3) 6.0 (13.9) 21.6
Gain on sale of interest in riverboat............................................ - - - 192.4
Net realized investment losses .................................................. (271.7) (156.6) (524.9) (302.7)
Impairment charge related to retained interests in securitization transactions... (701.3) (345.2) (701.3) (386.9)
Fee revenue and other income..................................................... 85.5 105.0 257.3 333.8
-------- --------- -------- --------
Total revenues............................................................... 853.0 1,493.2 4,350.3 5,701.2
-------- --------- -------- --------
Benefits and expenses:
Insurance policy benefits........................................................ 883.4 893.8 2,469.9 2,685.7
Provision for losses............................................................. 286.5 193.8 735.2 420.5
Interest expense................................................................. 372.5 396.8 1,113.1 1,221.0
Amortization..................................................................... 200.2 207.4 635.2 610.8
Other operating costs and expenses............................................... 348.1 338.8 963.2 1,024.4
Goodwill impairment.............................................................. 500.0 - 500.0 -
Special charges.................................................................. 88.2 14.7 213.0 70.5
-------- --------- -------- --------
Total benefits and expenses.................................................. 2,678.9 2,045.3 6,629.6 6,032.9
-------- --------- -------- --------
Loss before income taxes, minority interest, discontinued operations,
extraordinary gain (loss) and cumulative effect of accounting change...... (1,825.9) (552.1) (2,279.3) (331.7)
Income tax expense (benefit):
Tax benefit on period income................................................. (487.8) (182.3) (640.3) (91.5)
Valuation allowance for deferred tax assets.................................. 311.4 - 1,314.4 -
-------- --------- -------- --------
Loss before minority interest, discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change..................... (1,649.5) (369.8) (2,953.4) (240.2)
Minority interest:
Distributions on Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts, net of income taxes..................................... 29.2 29.1 87.6 90.4
-------- --------- -------- --------
Loss before discontinued operations, extraordinary gain (loss) and cumulative
effect of accounting change................................................ (1,678.7) (398.9) (3,041.0) (330.6)
Discontinued operations............................................................. (90.3) (9.3) (162.1) (14.5)
Extraordinary gain (loss) on extinguishment of debt, net of income taxes............ - .7 5.1 (4.0)
Cumulative effect of accounting change for goodwill impairment...................... - - (2,949.2) -
-------- --------- -------- --------
Net loss..................................................................... (1,769.0) (407.5) (6,147.2) (349.1)
Preferred stock dividends........................................................... .2 3.1 2.1 11.6
--------- --------- -------- --------
Net loss applicable to common stock.......................................... $(1,769.2) $(410.6) $(6,149.3) $(360.7)
========= ======= ========= =======
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
------------------- ------------------
2002 2001 2002 2001
---- ---- ---- ----
Loss per common share:
Basic:
Weighted average shares outstanding................................... 346,008,000 340,276,000 345,741,000 336,395,000
=========== =========== =========== ===========
Loss before discontinued operations, extraordinary gain (loss)
and cumulative effect of accounting change......................... $(4.85) $(1.18) $ (8.80) $(1.02)
Discontinued operations............................................... (.26) (.03) (.47) (.04)
Extraordinary gain (loss) on extinguishment of debt................... - - .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ------ ------- ------
Net loss.......................................................... $(5.11) $(1.21) $(17.79) $(1.07)
====== ====== ======= ======
Diluted:
Weighted average shares outstanding................................... 346,008,000 340,276,000 345,741,000 336,395,000
=========== =========== =========== ===========
Loss before discontinued operations, extraordinary gain (loss)
and cumulative effect of accounting change........................ $(4.85) $(1.18) $(8.80) $(1.02)
Discontinued operations............................................... (.26) (.03) (.47) (.04)
Extraordinary gain (loss) on extinguishment of debt................... - - .01 (.01)
Cumulative effect of accounting change................................ - - (8.53) -
------ ------ ------ ------
Net loss.......................................................... $(5.11) $(1.21) $(17.79) $(1.07)
====== ====== ======= ======
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital income (loss) (deficit)
----- ----- --------------- ------------- -------
Balance, January 1, 2002............................. $4,753.0 $499.6 $3,484.3 $(439.0) $ 1,208.1
Comprehensive loss, net of tax:
Net loss........................................ (6,147.2) - - - (6,147.2)
Change in unrealized appreciation
(depreciation) of investments (net of
applicable income tax expense of $324.0)...... 569.4 - - 569.4 -
--------
Total comprehensive loss.................... (5,577.8)
Change in shares for stock options and for
employee benefit plans.......................... 13.0 - 13.0 - -
Payment-in-kind dividends on convertible
preferred stock................................. 2.1 2.1 - - -
Dividends on preferred stock...................... (2.1) - - - (2.1)
-------- ------ -------- ------- ----------
Balance, September 30, 2002.......................... $ (811.8) $501.7 $3,497.3 $ 130.4 $(4,941.2)
======== ====== ======== ======= =========
Balance, January 1, 2001............................. $4,374.4 $486.8 $2,911.8 $(651.0) $ 1,626.8
Comprehensive income, net of tax:
Net loss........................................ (349.1) - - - (349.1)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $200.0)............................ 350.6 - - 350.6 -
--------
Total comprehensive income.................. 1.5
Issuance of shares pursuant to stock purchase
contracts related to FELINE PRIDES.............. 496.6 - 496.6 - -
Issuance of shares pursuant to acquisition of
ExlServices.com, Inc............................ 52.6 - 52.6 - -
Issuance of shares for stock options and for
employee benefit plans.......................... 20.5 - 20.5 - -
Payment-in-kind dividends on convertible
preferred stock................................. 11.6 11.6 - - -
Dividends on preferred stock...................... (11.6) - - - (11.6)
-------- ------ -------- ------- ---------
Balance, September 30, 2001.......................... $4,945.6 $498.4 $3,481.5 $(300.4) $ 1,266.1
======== ====== ======== ======= =========
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Nine months ended
September 30,
--------------------
2002 2001
---- ----
Cash flows from operating activities:
Insurance policy income....................................................................... $ 2,313.1 $ 2,646.1
Net investment income......................................................................... 2,723.6 2,906.9
Fee revenue and other income.................................................................. 236.6 300.9
Insurance policy benefits..................................................................... (1,810.4) (2,060.1)
Interest expense.............................................................................. (1,013.1) (1,184.5)
Policy acquisition costs...................................................................... (391.4) (515.6)
Special charges............................................................................... (46.7) (21.1)
Other operating costs......................................................................... (1,143.9) (1,129.8)
Taxes......................................................................................... (130.4) (97.6)
--------- ---------
Net cash provided by operating activities................................................... 737.4 845.2
--------- ---------
Cash flows from investing activities:
Sales of investments.......................................................................... 15,592.4 15,185.1
Maturities and redemptions of investments..................................................... 1,143.9 941.3
Purchases of investments...................................................................... (15,771.7) (15,998.2)
Cash received from the sale of finance receivables, net of expenses........................... 1,450.6 787.4
Principal payments received on finance receivables............................................ 6,196.6 6,315.2
Finance receivables originated................................................................ (6,401.8) (9,268.0)
Other......................................................................................... (139.2) (128.4)
--------- ---------
Net cash provided (used) by investing activities ........................................... 2,070.8 (2,165.6)
--------- ---------
Cash flows from financing activities:
Amounts received for deposit products......................................................... 3,465.0 3,296.1
Withdrawals from deposit products............................................................. (4,228.6) (3,419.2)
Issuance of notes payable..................................................................... 6,034.3 9,015.0
Payments on notes payable..................................................................... (7,918.0) (8,228.6)
Ceding commission received on reinsurance transaction......................................... 83.0 -
Change in cash held in restricted accounts for settlement of borrowings....................... (210.7) (81.9)
Investment borrowings......................................................................... (1,399.6) 709.0
Issuance of common and convertible preferred shares........................................... - 4.1
Dividends on preferred shares and distributions on Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts............................ (86.2) (95.0)
--------- ---------
Net cash provided (used) by financing activities.......................................... (4,260.8) 1,199.5
--------- ---------
Net decrease in cash and cash equivalents................................................. (1,452.6) (120.9)
Cash and cash equivalents, beginning of period................................................... 3,060.8 1,663.6
---------- ---------
Cash and cash equivalents, end of period......................................................... $ 1,608.2 $ 1,542.7
========== =========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2001 Form 10-K of Conseco,
Inc. ("we", "Conseco" or the "Company").
Conseco is a financial services holding company with subsidiaries operating
throughout the United States. Our insurance subsidiaries develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. Conseco Finance Corp. ("Conseco Finance"), a wholly
owned subsidiary of Conseco, originates, sells and services manufactured
housing, home equity, home improvement, retail credit, consumer finance and
floorplan loans.
During the third quarter of 2002, Conseco entered into an agreement to sell
Conseco Variable Insurance Company ("CVIC"), its wholly-owned subsidiary and the
primary writer of its variable annuity products. The sale was completed in
October 2002. The operating results of CVIC have been reported as discontinued
operations in all periods presented in the accompanying consolidated statement
of operations. For the purpose of our September 30, 2002 consolidated balance
sheet, the assets and liabilities of CVIC are each combined and presented
separately in the consolidated balance sheet. See the note to the consolidated
financial statements entitled "Discontinued Operations."
During 2001, we began the process of non-renewing our major medical lines
of business. These lines of business are referred to herein as the "major
medical business in run-off."
EVENTS OF DEFAULT AND LIQUIDITY ISSUES
As we announced on August 9, 2002, Conseco did not make its August 2002
interest payments on its 6.4% senior notes due 2003, 6.4% guaranteed senior
notes due 2004, 8.75% senior notes due 2004, and 8.75% guaranteed senior notes
due 2005. Since the August 9, 2002 announcement, Conseco has not made any
interest or principal payments on any of its direct corporate obligations, nor
has Conseco made any distributions on its Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts. The failure to make the
interest payments on these notes within the 30-day grace period constituted an
event of default under the notes which gave the holders of the notes the right
to accelerate the maturity of all principal and past due interest. We did not
pay the $224.9 million of principal (plus accrued interest) that was due on
October 15, 2002 under the terms of the 8.5% notes due October 15, 2002.
Conseco's default with respect to the payment of principal on these notes also
resulted in defaults under approximately $4.0 billion principal amount of debt
obligations, approximately $481.3 million principal amount of bank loans to
current and former directors, officers and key employees (the "D&O loans") which
Conseco has guaranteed (as further described in the note to our consolidated
financial statements entitled "Guarantees") and approximately $1.9 billion of
trust preferred securities through cross-default provisions contained in the
respective governing instruments. If the holders of such indebtedness or
preferred securities exercised their rights to accelerate the maturity of all
principal and interest due, we would be unable to satisfy these obligations.
The Company is not in compliance with certain covenants under its bank
credit agreement and the guarantees of the D&O loans. Although Conseco received
a waiver of the covenant violations from the relevant lenders, the waiver, as
extended, expired on October 17, 2002. Conseco has obtained forbearance
agreements from the relevant lenders, pursuant to which the lenders have agreed
to temporarily refrain from exercising default-related remedies with respect to
certain specified events of default under the bank credit agreement and the
guarantees of the D&O loans. These forbearance agreements expire on November 27,
2002, and are subject to various conditions. The Company is currently in
negotiations with the relevant lenders to extend the expiration date of these
forbearance agreements, although we cannot assure you that we will be able to do
so.
The Company is currently in negotiations with its senior lenders, the D&O
lenders, certain holders of its senior notes and certain holders of its trust
originated preferred securities with the goal of fundamentally restructuring the
Company's capital. The noteholders have formed an informal committee that has
retained Fried, Frank, Harris, Shriver & Jacobson and Houlihan Lokey Howard &
Zukin Capital as its advisors. The holders of trust originated preferred
securities have formed an informal committee that has retained Saul Ewing LLP
and Raymond James & Associates as its advisors. The Company and its advisors
have been engaged in discussions with these creditors and their representatives
regarding the terms of a potential restructuring plan, including the conversion
of a significant amount of Conseco's debt into common equity. If an agreement on
such a plan is reached, the Company would present the plan for judicial approval
under Chapter 11 of the U.S. Bankruptcy Code, which provides for companies to
reorganize and continue to operate as going concerns. The Company is not
currently in a position to predict the outcome of these discussions. As a result
of our current defaults, certain debt holders of the Company could at any time
file an involuntary petition against the Company under the U.S. Bankruptcy Code
although we
8
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
are not aware of any current efforts to do so.
Conseco's leveraged condition and liquidity difficulties have severely
impacted the operations of Conseco Finance, principally by eliminating Conseco
Finance's access to the securitization markets, historically its main source of
funding. The loss of access to the securitization markets has severely affected
Conseco Finance's ability to originate, purchase and sell loans. In addition,
Conseco Finance has historically relied on these markets to finance the sale of
repossessed manufactured housing units which often minimized the loss on
defaulted loans. Our inability to access this market for repossessed
manufactured housing units will slow down the liquidation of our repossessed
units as well as force us to place a greater reliance on the manufactured
housing wholesale channel at higher severity rates, resulting in higher losses
on these portfolios. In addition, market valuations of Conseco Finance's
securitization trusts have decreased due to uncertainty regarding Conseco
Finance's liquidity position and its ability to continue to provide servicing
for the securitized portfolios, thereby, reducing the value of our retained
interests pledged as collateral on our residual facility.
Conseco Finance's remaining liquidity sources (excluding its bank
subsidiaries) are a warehouse and a residual facility with Lehman Brothers, Inc.
and certain affiliates thereof (collectively referred to herein as "Lehman") and
a credit facility with U.S. Bank National Association ("U.S. Bank"). Conseco
Finance's diminished access to the securitization markets and the constrained
liquidity under its other funding sources have had a material adverse effect on
Conseco Finance's business and results of operations.
Conseco Finance is currently in violation of several financial covenants
required by its warehouse and residual facilities. Conseco Finance has entered
into a forbearance agreement with Lehman pursuant to which Lehman has agreed to
temporarily refrain from exercising any rights arising from events of default
that occurred under the warehouse and residual facilities as of the date of such
forbearance agreement, including certain events of default triggered by Conseco
Finance not being in compliance with certain financial covenants. This
forbearance agreement expires on November 29, 2002 and is subject to various
conditions. In addition, Conseco Finance was not in compliance with various
financial covenants with respect to its bank credit facility. Conseco Finance is
currently in the process of attempting to obtain a forbearance or similar
agreement. Absent the forbearance or similar agreement, the covenant violation
gives the lender the right to declare all borrowings under the bank credit
facility due and payable ($75.0 million was outstanding pursuant to this
facility at September 30, 2002).
Conseco Finance's residual facility is collateralized by retained interests
in securitizations. Conseco Finance is required to maintain collateral based on
current estimated fair values in accordance with the terms of such facility. Due
to the decrease in the estimated fair value of its retained interests, Conseco
Finance's collateral was $128.9 million deficient at September 30, 2002 (as
calculated in accordance with the relevant transaction documents). Conseco
Finance has executed a forbearance agreement with Lehman in which, among other
things, Lehman has agreed not to cause accelerated repayment of the residual
facility based on the collateral deficiency through November 29, 2002. Under the
terms of the forbearance agreement, Lehman is retaining certain cash flows from
Conseco Finance's retained interests pledged to this facility and applying these
cash flows to the margin deficit. Conseco Finance is currently unable to provide
sufficient additional collateral or repay this credit facility.
On October 22, 2002, Conseco announced that its board of directors approved
a plan to seek new investors or acquirers for Conseco's finance businesses and
that it had engaged the investment banking firms of Lazard Freres & Co. LLC and
Credit Suisse First Boston to pursue various alternatives, including securing
new investors and/or selling Conseco Finance's three lines of business: (i)
manufactured housing; (ii) mortgage services; and (iii) consumer finance.
The book value of Conseco's investment in Conseco Finance was approximately
$1.2 billion at September 30, 2002. It currently seems highly unlikely that the
net proceeds to Conseco from any of the various alternatives will result in such
value.
As described in "Liquidity for insurance and fee-based operations" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", A.M. Best has further downgraded the financial strength ratings of
our primary insurance subsidiaries to "B (fair)". The downgrade has caused sales
of our insurance products to fall and policyholder redemptions and lapses to
increase, which has had a material adverse effect on our financial results.
Since the August 2002 announcement of our restructuring, we have been
working closely with insurance regulators in each of the states in which our
insurance subsidiaries are domiciled (including Arizona, Illinois, Indiana, New
York, Pennsylvania and Texas) in connection with their monitoring of the
operations and financial status of our insurance subsidiaries. The Commissioner
of Insurance for the State of Texas has
9
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
acted as the lead regulator among the foregoing states and has coordinated the
oversight and monitoring efforts associated with our financial restructuring.
On October 30, 2002, Bankers National Life Insurance Company and Conseco
Life Insurance Company of Texas (on behalf of itself and its subsidiaries), our
two insurance subsidiaries domiciled in Texas, each entered into consent orders
with the Commissioner of Insurance for the State of Texas whereby they agreed:
(i) not to request any dividends or other distributions before January 1, 2003
and, thereafter, not to pay any dividends or other distributions to parent
companies outside of the insurance system without the prior approval of the
Texas Insurance Commissioner; (ii) to continue to maintain sufficient
capitalization and reserves as required by the Texas Insurance Code; (iii) to
request approval from the Texas Insurance Commissioner before making any
disbursements not in the ordinary course of business; (iv) to complete any
pending transactions previously reported to the proper insurance regulatory
officials prior to and during Conseco's restructuring, unless not approved by
the Texas Insurance Commissioner; (v) to obtain a commitment from Conseco and
CIHC, Incorporated ("CIHC"), our intermediate holding company, to maintain their
infrastructure, employees, systems and physical facilities prior to and during
Conseco's restructuring; and (vi) to continue to permit the Texas Insurance
Commissioner to examine its books, papers, accounts, records and affairs. The
consent orders do not prohibit the payment of fees in the ordinary course of
business pursuant to existing administrative, investment management and
marketing agreements with our non-insurance subsidiaries.
The accompanying consolidated financial statements have been prepared on a
going concern basis, which assumes continuity of operations and realization of
assets and satisfaction of liabilities in the ordinary course of business. The
financial statements do not include any adjustments that might result from the
outcome of the uncertainties summarized above and if Conseco or any of its
subsidiaries are unable to continue as going concerns.
DELISTING OF COMMON STOCK AND OTHER LISTED SECURITIES
After the issuance of our press release on August 9, 2002, the New York
Stock Exchange ("NYSE") halted trading in Conseco's common stock and all of its
other listed securities. The Securities and Exchange Commission subsequently
granted the NYSE's application for removal from listing and registration with
respect to the following Conseco securities: (i) common stock; (ii) 8.125%
senior notes due 2003; (iii) 10.5% senior notes due 2004; (iv) 9.16% trust
originated preferred securities; (v) 8.70% trust originated preferred
securities; (vi) 9% trust originated preferred securities; and (vii) 9.44% trust
originated preferred securities, effective on the opening of the trading session
on September 25, 2002.
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly Conseco's financial position
and results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2002 presentation. These reclassifications
have no effect on net income or shareholders' equity. Results for interim
periods are not necessarily indicative of the results that may be expected for a
full year.
As described in the note to the consolidated financial statements entitled
"Cumulative Effect of Accounting Change and Goodwill Impairment", the Company
has completed the goodwill impairment test required by Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS
142"), and has recorded the cumulative effect of the accounting change of
$2,949.2 million. Pursuant to the transitional rules of SFAS 142, such effect is
reflected in the consolidated financial statements for the quarter ended March
31, 2002. Accordingly, the consolidated financial statements of the Company as
of March 31, 2002 and for the three months then ended have been restated to
reflect the change.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect various
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions in calculating values for the cost of policies produced, the
cost of policies purchased, retained
10
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
interest in securitization trusts (including interest-only securities and
certain lower-rated securities that are senior in payment priority to the
interest-only securities (the "B-2 securities")), certain investments, servicing
rights, goodwill, liabilities for insurance and asset accumulation products, the
guarantee liability related to interests in securitization trusts, liabilities
related to litigation, guaranty fund assessment accruals, liabilities related to
guarantees of securitized debt issued in conjunction with certain sales of
finance receivables and liabilities related to guarantees of bank loans and the
related interest loans to certain current and former directors, officers and key
employees, gain on sale of finance receivables, allowance for credit losses on
finance receivables and the reliance on generating adequate future taxable
income to support deferred income tax assets. If our future experience differs
from these estimates and assumptions, our financial statements could be
materially affected.
The accompanying financial statements include the accounts of the Company
and all of its wholly-owned subsidiaries. Our consolidated financial statements
exclude the results of material transactions between us and our consolidated
affiliates, or among our consolidated affiliates.
We follow the requirements of Statement of Financial Accounting Standards
No. 140, "Accounting for the Transfer and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 140"), and related authoritative guidance
in determining whether the special purpose entities formed in conjunction with
the securitization of the finance receivables we originate and the
securitization of certain investment portfolios are consolidated. Subsequent to
September 8, 1999, we have structured the securitizations in a manner that
requires the special purpose entities to be consolidated (see "Finance
Receivables and Retained Interests in Securitization Trusts"). For certain other
special purpose entities related to our investment portfolio, we consider the
requirements of EITF Topic D-14 in determining whether to consolidate such
entities. We consolidate such entities if: (i) an independent third party has
not made a substantial capital investment in the entity; (ii) such independent
third party does not control the activities of the entity; and (iii) the
independent third party does not retain substantial risks and rewards of the
special purpose entity's assets.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND GOODWILL IMPAIRMENT
The FASB issued SFAS 142, in June 2001. Under the new rule, intangible
assets with an indefinite life are no longer amortized in periods subsequent to
December 31, 2001, but are subject to annual impairment tests (or more frequent
under certain circumstances), effective January 1, 2002. The Company has
determined that all of its goodwill has an indefinite life and is therefore
subject to the new rules.
Pursuant to SFAS 142, the goodwill impairment test has two steps. The first
step was required to be completed by June 30, 2002 and the second step, if
necessary, was required to be completed by December 31, 2002. Any resulting
impairment is required under SFAS 142 to be recorded in the quarter ended March
31, 2002. For Conseco, the first step consisted of comparing the estimated fair
value of each of the business units comprising our insurance segment to the
unit's book value. Since all of our goodwill relates to the insurance segment
(which is also a reportable segment), the goodwill impairment test is not
relevant to the finance business. If the estimated fair value exceeds the book
value, the test is complete and goodwill is not impaired. If the fair value is
less than the book value, the second step of the impairment test must be
performed, which compares the implied fair value of the applicable business
unit's goodwill with that goodwill to measure the amount of
goodwill impairment, if any.
Pursuant to the transitional rules of SFAS 142, we completed the two-step
impairment test during the second quarter of 2002 and, as a result of that test,
we recorded the cumulative effect of the accounting change for the goodwill
impairment charge of $2,949.2 million for the quarter ended March 31, 2002. The
first quarter of 2002 impairment charge is reflected in the cumulative effect of
an accounting change in the accompanying consolidated statement of operations
for the nine months ended September 30, 2002, and the consolidated financial
statements for the quarter ended March 31, 2002 have been retroactively restated
to reflect this change. Subsequent impairment tests will be performed on an
annual basis in the fourth quarter of each year, or more frequently if
circumstances indicate a possible impairment. Subsequent impairment charges are
classified as an operating expense. As described below, the Company performed an
impairment test in the quarter ended September 30, 2002, as a result of
circumstances which indicated a possible impairment.
The significant factors used to determine the amount of the initial
impairment included analyses of industry market valuations, historical and
projected performance of our insurance segment, discounted cash flow analyses
and the market value of our capital. The valuation utilized the best available
information, including assumptions and projections we considered reasonable and
supportable. The assumptions we used to determine the discounted cash flows
involve significant judgments
11
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
regarding the best estimate of future premiums, expected mortality and
morbidity, interest earned and credited rates, persistency and expenses. The
discount rate used was based on an analysis of the weighted average cost of
capital for several insurance companies and considered the specific risk factors
related to Conseco. Pursuant to the guidance in SFAS 142, quoted market prices
in active markets are the best evidence of fair value and shall be used as the
basis for measurement, if available.
On August 14, 2002, our insurance subsidiaries' financial strength ratings
were downgraded by A.M. Best to "B (fair)" and on September 8, 2002, the Company
defaulted on its public debt. See note to the consolidated financial statements
entitled "Events of Default and Liquidity Issues". These developments caused
sales of our insurance products to fall and policyholder redemptions and lapses
to increase. The adverse impact on our insurance subsidiaries resulting from the
ratings downgrade and parent company default required that an additional
impairment test be performed as of September 30, 2002, in accordance with SFAS
142.
In connection with our negotiations with debt holders, we retained an
outside actuarial consulting firm to assist in valuing our insurance
subsidiaries. That valuation work was used in performing the additional
impairment tests that resulted in an impairment charge to goodwill in third
quarter 2002 of $500.0 million. The charge is reflected in the line item
entitled "Goodwill impairment" in our consolidated statement of operations for
the three and nine months ended September 30, 2002. The most significant changes
made to the January 1, 2002 valuation that resulted in the third quarter 2002
impairment charge were: (i) reduced estimates of projected future sales of
insurance products; (ii) increased estimates of future policyholder redemptions
and lapses; and (iii) a higher discount rate to reflect the current rates used
by the market to value life insurance companies as of September 30, 2002.
Management believes that the assumptions and estimates used are reasonable given
all available facts and circumstances. However, if projected cash flows are not
realized in the future, we may be required to recognize additional impairments.
Prior to the adoption of SFAS 142, we determined whether goodwill was
recoverable from projected undiscounted net cash flows for the earnings of our
subsidiaries over the remaining amortization period. If we determined that
undiscounted projected cash flows were not sufficient to recover the goodwill
balance, we would reduce its carrying value with a corresponding charge to
expense or shorten the amortization period. Cash flows considered in such an
analysis were those of the business acquired, if separately identifiable, or the
product line that acquired the business, if such earnings were not separately
identifiable.
Changes in the carrying amount of goodwill for the nine months ended
September 30, 2002 and 2001, are as follows:
Nine months ended
September 30,
-----------------
2002 2001
---- ----
(Dollars in millions)
Goodwill balance, beginning of period....................................... $ 3,695.4 $3,800.8
Amortization expense........................................................ - (82.3)
Cumulative effect of accounting change...................................... (2,949.2) -
Impairment charge........................................................... (500.0) -
Reduction of tax valuation contingencies established at acquisition date
for acquired companies.................................................. (146.2) -
Goodwill related to the acquisition of ExlServices, Inc..................... - 47.2
Goodwill related to businesses sold......................................... - (35.8)
--------- --------
Goodwill balance, end of period............................................. $ 100.0 $3,729.9
========= ========
12
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
In accordance with SFAS 142, we discontinued the amortization of goodwill
expense effective January 1, 2002. The following information summarizes the
impact of goodwill amortization on income before discontinued operations,
extraordinary gain (loss) and cumulative effect of accounting change; net
income; and the respective earnings per share amounts for the periods presented
in our consolidated statement of operations:
Three months ended Nine months ended
September 30, September 30,
------------------- ------------------
2002 2001 2002(a) 2001
---- ---- ---- -----
(Dollars in millions, except per share data)
Reported loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(1,678.7) $(398.9) $(3,041.0) $(330.6)
Add back: goodwill amortization............................... - 27.4 - 82.3
--------- ------- --------- -------
Adjusted loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(1,678.7) $(371.5) $(3,041.0) $(248.3)
========= ======= ========= =======
Reported net loss applicable to common stock.................... $(1,769.2) $(410.6) $(6,149.3) $(360.7)
Add back: goodwill amortization................................ - 27.4 - 82.3
--------- ------- --------- -------
Adjusted net loss applicable to common stock.................... $(1,769.2) $(383.2) $(6,149.3) $(278.4)
========= ======= ========= =======
Basic earnings per share:
Reported loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.18) $(8.80) $(1.02)
Add back: goodwill amortization................................ - .08 - .24
------ ------ ------ ------
Adjusted loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.10) $(8.80) $ (.78)
====== ====== ====== ======
Reported net loss applicable to common stock.................... $(5.11) $(1.21) $(17.79) $(1.07)
Add back: goodwill amortization................................ - .08 - .24
------ ------ ------- ------
Adjusted net loss applicable to common stock.................... $(5.11) $(1.13) $(17.79) $ (.83)
====== ====== ======= ======
Diluted earnings per share:
Reported loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.18) $(8.80) $(1.02)
Add back: goodwill amortization............................... - .08 - .24
------ ------ ------ ------
Adjusted loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change...... $(4.85) $(1.10) $(8.80) $ (.78)
====== ====== ====== ======
Reported net loss applicable to common stock.................... $(5.11) $(1.21) $(17.79) $(1.07)
Add back: goodwill amortization................................ - .08 - .24
------ ------ ------- ------
Adjusted net loss applicable to common stock.................... $(5.11) $(1.13) $(17.79) $ (.83)
====== ====== ======= ======
- ------------------
(a) Adjusted net loss for the nine months ended September 30, 2002,
includes the cumulative effect of the accounting change for goodwill
impairment of $2,949.2 million (calculated as of January 1, 2002 as
required by SFAS 142) and the goodwill impairment operating charge of
$500.0 million.
13
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following summarizes the impact of the cumulative effect of the
accounting change for goodwill impairment on our results of operations for the
three months ended March 31, 2002 (dollars in millions, except per share data):
Net loss, applicable to common stock as reported................ $ (96.9)
Cumulative effect of accounting change.......................... (2,949.2)
---------
Net loss, as adjusted........................................... $(3,046.1)
=========
Net loss per common share:
Basic:
Net loss, as reported..................................... $ (.28)
Cumulative effect of accounting change.................... (8.54)
------
Net loss, as adjusted..................................... $(8.82)
======
Diluted:
Net loss, as reported..................................... $ (.28)
Cumulative effect of accounting change.................... (8.54)
------
Net loss, as adjusted..................................... $(8.82)
======
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value); (ii) "trading"
(which we carry at estimated fair value); and (iii) "held to maturity" (which we
carry at amortized cost). We had no fixed maturity securities in the "trading"
or "held to maturity" categories at September 30, 2002.
Accumulated other comprehensive income (loss) is primarily comprised of
unrealized gains (losses) on actively managed fixed maturity investments. Such
amounts, included in shareholders' equity as of September 30, 2002, and December
31, 2001, were as follows:
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Unrealized gains (losses) on investments.............................................. $278.2 $(816.0)
Adjustments to cost of policies purchased and cost of policies produced............... (60.1) 133.9
Deferred income tax asset (liability)................................................. (75.8) 249.6
Other................................................................................. (9.5) (6.5)
Accumulated other comprehensive loss related to discontinued operations............... (2.4) -
------ -------
Accumulated other comprehensive income (loss).................................... $130.4 $(439.0)
====== =======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
At December 31, 2001, our venture capital investments consisted of 12.6
million shares of TeleCorp PCS, Inc. ("TeleCorp"), a company in the wireless
communication business. In the first quarter of 2002, AT&T Wireless Services,
Inc. ("AWE") acquired TeleCorp. Pursuant to the merger agreement, our shares of
TeleCorp were converted into 11.4 million shares of AWE. Upon the completion of
the merger, there were no restrictions on our ability to sell our interest in
AWE. In the first nine months of 2002, Conseco sold 10.3 million shares of AWE
generating net proceeds of $75.7 million. Our investment in AWE is carried at
estimated fair value, with changes in fair value recognized as investment income
(loss).
14
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
During the fourth quarter of 2001, the parent company transferred 4.6
million shares of TeleCorp common stock to certain investment trusts. Conseco's
insurance subsidiaries hold substantially all of the economic interests in these
trusts. Pursuant to SFAS 140 and other authoritative guidance, the transfer of
the shares to the trust is not a sale and the accounts of the trusts are
consolidated with the accounts of the Company. The parent company received cash
of $60.3 million (the market value of the shares on the date of transfer) in
exchange for the shares transferred to the trusts. After the transfer of the
common shares, Conseco continues to recognize in its consolidated financial
statements the change in the market value of the common shares, with changes in
fair value recognized as investment income (loss).
At September 30, 2002, our holdings of AWE common stock included 4.1
million shares valued at $17.7 million which are held in the investment trusts
described in the previous paragraph. In addition, during the third quarter of
2002, we entered into an agreement to unwind the forward sale contract (which
was entered into in 2001) pursuant to which we held 1.0 million AWE shares as
collateral for a $12.5 million investment borrowing transaction. The net effect
of unwinding the forward purchase contract resulted in an immaterial gain.
The forward contract was a derivative that was required to be
marked-to-market each period. Since the hedged asset (i.e., a portion of the
shares of AWE that we owned) was required to be carried at market value, the
hedge rules of SFAS 133 (as defined under the caption "Accounting for
Derivatives") were not applicable. However, since the value of the derivative
fluctuated in relation to the change in value of the related AWE common stock,
the forward contract acted as a hedge and reduced earnings volatility associated
with the AWE common stock. The market values of AWE and many other companies in
AWE's business sector have declined significantly in recent periods. We
recognized venture capital investment losses of $6.6 million and $87.4 million
in the third quarters of 2002 and 2001, respectively, related to this
investment. Such venture capital investment losses were $106.6 million and $84.0
million in the first nine months of 2002 and 2001, respectively.
FINANCE RECEIVABLES AND RETAINED INTERESTS IN SECURITIZATION TRUSTS
During the first nine months of 2002, Conseco Finance completed six
securitization transactions, securitizing $2.7 billion of finance receivables.
These securitizations were structured in a manner that requires them to be
accounted for as secured borrowings, whereby the loans and securitization debt
remain on our balance sheet, rather than as sales, pursuant to SFAS 140. Such
accounting method is referred to as the "portfolio method".
We classify the finance receivables transferred to the securitization
trusts and held as collateral for the notes issued to investors as "finance
receivables-securitized." The average interest rate earned on these receivables
at September 30, 2002, was approximately 12.4 percent. We classify the notes
issued to investors in the securitization trusts as "notes payable related to
securitized finance receivables structured as collateralized borrowings."
As discussed in the note to the consolidated financial statements entitled
"Events of Default and Liquidity Issues", Conseco's leveraged condition and
liquidity difficulties have eliminated Conseco Finance's ability to access the
securitization markets. This has required Conseco Finance to pursue whole loan
sales to maintain availability under its warehouse facilities for new
originations. Accordingly, Conseco Finance has classified certain of its
unsecuritized finance receivables as held for sale which requires the assets to
be carried at the lower of cost or market. At September 30, 2002, we have an
allowance of $27.4 million for certain finance receivables with current market
values below cost.
During the 2002 and 2001 periods, Conseco Finance completed various loan
sale transactions. During the first nine months of 2002, Conseco Finance sold
$1.2 billion of finance receivables which generated net losses of $13.9 million.
We also recognized a loss of $94.4 million related to the sale of $.4 billion of
certain finance receivables sold as part of our cash raising initiatives in
order to meet our debt obligations. See "Special Charges" elsewhere in the notes
to the consolidated financial statements. In the first nine months of 2001, we
sold $1.6 billion of receivables including: (i) our $802.3 million vendor
services loan portfolio (which was marked-to-market in the fourth quarter of
2000 and no additional gain or loss was recognized in the first nine months of
2001); (ii) $568.4 million of high-loan-to-value mortgage loans; and (iii)
$191.1 million of other loans. These sales resulted in net gains of $21.6
million in the first nine months of 2001.
15
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following table summarizes our finance receivables - securitized by
business line (there were no such finance receivables related to discontinued
lines):
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................. $ 7,268.2 $ 6,940.4
Mortgage services................................................................ 5,657.6 5,658.2
Retail credit.................................................................... 897.8 878.9
Consumer finance - closed-end.................................................... 444.7 580.8
Floorplan........................................................................ 130.2 436.9
--------- ---------
14,398.5 14,495.2
Less allowance for credit losses................................................. 450.8 296.7
--------- ---------
Total finance receivables - securitized........................................ $13,947.7 $14,198.5
========= =========
16
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following table summarizes our other finance receivables by business
line and categorized as either a part of our continuing lines or a part of our
discontinued lines:
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Continuing lines:
Manufactured housing............................................................... $ 268.9 $ 609.3
Mortgage services.................................................................. 386.8 1,128.9
Retail credit...................................................................... 1,955.4 1,811.1
Consumer finance - closed-end...................................................... 15.5 6.3
-------- --------
2,626.6 3,555.6
Less allowance for credit losses................................................... 112.5 111.6
-------- --------
Net other finance receivables for continuing lines............................... 2,514.1 3,444.0
-------- --------
Discontinued lines.................................................................... 65.0 379.7
Less allowance for credit losses................................................... 6.8 13.0
-------- --------
Net other finance receivables for discontinued lines............................. 58.2 366.7
-------- --------
Total other finance receivables.................................................. $2,572.3 $3,810.7
======== ========
The changes in the allowance for credit losses included in finance
receivables (both securitized and other portfolios) were as follows:
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Allowance for credit losses, beginning of period................ $ 466.4 $ 318.2 $ 421.3 $ 306.8
Additions to the allowance:
Provision for losses......................................... 234.2 134.2 550.9 360.9
Change in allowance due to purchases and sales of certain
finance receivables........................................ 1.4 3.7 5.3 (1.8)
Credit losses................................................... (131.9) (101.3) (407.4) (311.1)
------- ------- ------- -------
Allowance for credit losses, end of period...................... $ 570.1 $ 354.8 $ 570.1 $ 354.8
======= ======= ======= =======
17
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The securitizations structured prior to September 8, 1999, met the
applicable criteria to be accounted for as sales. At the time the loans were
securitized and sold, we recognized a gain and recorded our retained interest
represented by the interest-only security and servicing rights. The
interest-only security represents the right to receive, over the life of the
pool of receivables: (i) the excess of the principal and interest received on
the receivables transferred to the special purpose entity over the principal and
interest paid to the holders of other interests in the securitization; and (ii)
contractual servicing fees. In some of those securitizations, we also retained
B-2 securities (certain lower-rated securities that are senior in payment
priority to the interest-only securities). Our net retained interests in
securitization trusts at September 30, 2002 and December 31, 2001 are summarized
below:
September 30, 2002 December 31, 2001
------------------------- ----------------------
Amortized Estimated Amortized Estimated
cost fair value cost fair value
---- ---------- ---- ----------
(Dollars in millions)
Retained interests in securitization trusts:
Interests securitized in the form of B-2 securities............. $ 554.2 $ 554.2 $704.9 $528.5
Interest-only securities........................................ (28.2) (28.2) 171.2 181.6
------- ------- ------ ------
Total retained interests, excluding guarantee liabilities... 526.0 526.0 876.1 710.1
Guarantee liability related to interests in securitization
trusts held by others........................................... (198.6) (198.6) (39.9) (39.9)
------- ------- ------ ------
Total retained interests, net of guarantee liabilities...... $ 327.4 $ 327.4 $836.2 $670.2
======= ======= ====== ======
The retained interests in securitization trusts on our balance sheet
represent an allocated portion of the cost basis of the finance receivables in
the securitization transactions accounted for as sales. Our retained interests
in those securitization transactions are subordinate to the interests of other
investors. Their values are subject to credit, prepayment, and interest rate
risk on the securitized finance receivables. We determine the discount rate to
value these securities based on our estimates of current market rates of
interest for securities with similar yield, credit quality and maturity
characteristics. We include the difference between estimated fair value and the
amortized cost of the retained interests (after adjustments for impairments
required to be recognized in earnings) in "accumulated other comprehensive loss,
net of taxes."
The determination of the value of our retained interests in securitization
trusts requires significant judgment. The Company has recognized significant
charges when the interest-only securities did not perform as well as anticipated
based on our assumptions and expectations. Our current valuation of retained
interests may prove inaccurate in future periods. In securitizations to which
these retained interests relate, Conseco Finance has retained certain contingent
risks in the form of guarantees of certain lower rated securities issued by the
securitization trusts. As of September 30, 2002, the total nominal amount of
these guarantees was approximately $1.4 billion. We consider any potential
payments related to these guarantees in the projected cash flows. The discounted
present value of the expected future payments related to the guarantees are
classified as the "Guarantee liability related to interests in securitization
trusts held by others" in the accompanying consolidated balance sheet. See the
note to the consolidated financial statements entitled "Guarantees."
Together, the interest-only securities and the B-2 securities, represent
our retained interests in these securitization trusts.
During the quarter ended September 30, 2002, Conseco Finance's ability to
access the securitization markets was eliminated. The securitization markets are
Conseco Finance's main source of funding for loans made to purchasers of
repossessed manufactured homes. Conseco Finance believes that its loss severity
rates were positively impacted when it used retail channels to dispose of
repossessed inventory (where the repossessed units are sold through
company-owned sales lots or our dealer network). Since Conseco Finance is no
longer able to fund the loans made on repossessed homes sold through these
channels, sales through these channels have decreased and we must place greater
reliance on the wholesale channel to dispose of repossessed manufactured housing
units, through which recovery rates are typically significantly lower.
Accordingly, we changed the loss severity assumptions we use to value our
retained interests to reflect the higher loss severity we expect to experience
in the future. In addition, our previous assumptions reflected our belief that
the adverse manufactured housing
18
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
default experience in recent periods would continue through the first half of
2002 and then improve over time. Given recent circumstances, default experience
is not expected to improve as previously planned. Accordingly, we increased the
default assumptions we use to value our retained interests to reflect our future
expectations. Our home equity/home improvement assumptions have also been
adjusted to reflect recent default experience as well as our future
expectations.
Under current accounting rules (pursuant to EITF Issue No. 99-20
"Recognition of Interest Income and Impairments on Purchased and Retained
Beneficial Interests in Securitized Financial Assets" ("EITF 99-20")) which we
adopted effective July 1, 2000, declines in the value of our retained interests
in securitization trusts are recognized when: (i) the fair value of the retained
beneficial interests are less than their carrying value; and (ii) the timing
and/or amount of cash expected to be received from the retained beneficial
interests have changed adversely from the previous valuation which determined
the carrying value of the retained beneficial interests. When both occur, the
retained beneficial interests are written down to fair value as an
other-than-temporary impairment.
As a result of the requirements of EITF 99-20 and the assumption changes
described above, we recognized an impairment charge (net of adjustments to the
valuation allowance associated with our servicing rights) of $585.5 million in
the first nine months of 2002 for the retained beneficial interests. We also
recognized a $115.8 million increase in the valuation allowance related to our
servicing rights as a result of the changes in assumptions in the first nine
months of 2002.
We recognized an impairment charge of $386.9 million in the first nine
months of 2001 for the interest-only securities that were not performing as well
as expected based on our previous valuation estimates.
We used the following assumptions to adjust the amortized cost of retained
interests to estimated fair value at September 30, 2002 and December 31, 2001.
If actual performance differs from these assumptions, we may be required to
recognize additional impairment charges related to the value of our retained
interests. Many of the assumptions and expectations underlying our valuation are
not possible to predict with certainty and may change adversely in the future as
a result of factors beyond our control.
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
September 30, 2002 housing home improvement equipment Total others Conseco
- ------------------ ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Retained interests, net of guarantee
liabilities, at fair value....................... $ 82.4 $ 276.5 $ 11.1 $ 370.0 $(42.6) $327.4
Cumulative principal balance of sold finance
receivables at September 30, 2002................ 15,950.9 3,925.2 870.4 20,746.5
Weighted average stated customer interest rate
on sold finance receivables...................... 9.8% 12.0% 10.5%
Assumptions to determine estimated fair value
of retained interests at September 30, 2002:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a).............................. 7.2% 19.1% 18.1%
Expected nondiscounted credit losses as a
percentage of principal balance of
related finance receivables (a).............. 15.4% 9.3% 8.3%
Weighted average discount rate ................ 16.0% 16.0% 16.0%
19
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Interests Interests
Manufactured Home equity/ Consumer/ held by held by
December 31, 2001 housing home improvement equipment Total others Conseco
- ----------------- ------- ---------------- --------- ----- ------ -------
(Dollars in millions)
Retained interests, net of guarantee
liabilities, at fair value..................... $ 307.1 $ 389.5 $ 28.8 $ 725.4 $(55.2) $670.2
Cumulative principal balance of sold finance
receivables at December 31, 2001............... 17,732.2 4,947.4 1,210.1 23,889.7
Weighted average stated customer interest rate on
sold finance receivables....................... 9.8% 12.0% 10.6%
Assumptions to determine estimated fair value of
retained interests at December 31, 2001:
Expected prepayment speed as a percentage
of principal balance of sold finance
receivables (a)............................ 7.1% 17.4% 18.8%
Expected nondiscounted credit losses as a
percentage of principal balance of related
finance receivables (a).................... 11.7% 7.4% 6.1%
Weighted average discount rate............... 16.0% 16.0% 16.0%
- -------------------
(a) The valuation of retained interests in securitization trusts is
affected not only by the projected level of prepayments of principal
and net credit losses, but also by the projected timing of such
prepayments and net credit losses. Should such timing differ materially
from our projections, it could have a material effect on the valuation
of our retained interests. Additionally, such valuation is determined
by discounting cash flows over the entire expected life of the
receivables sold.
The following table summarizes certain cash flows received from and paid to
the securitization trusts during the three and nine month periods ended
September 30, 2002 and 2001 (dollars in millions):
Three months Nine months
ended September 30, ended September 30,
----------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
Servicing fees received.............................................. $ 11.0 $ 13.7 $ 33.6 $ 56.1
Cash flows from retained interests................................... 1.9 32.8 24.6 78.5
Servicing advances paid.............................................. (66.5) (185.0) (221.9) (584.9)
Repayment of servicing advances...................................... 59.9 183.8 208.7 571.8
During the quarter ended September 30, 2002, we changed the assumptions
used to estimate the value of our retained interests to: (i) project higher
rates of default in the future, based on our current expectations; and (ii)
project higher severity losses related to the defaults, reflecting our inability
to finance the sale of repossessed manufactured homes. As a result of these
assumptions, we project that payments related to guarantees issued in
conjunction with the sales of certain finance receivables will exceed the gross
cash flows from the retained interests by approximately $15 million during the
remainder of 2002, $75 million in 2003, $25 million in 2004 and $1 million in
2005. These projected payments are considered in the projected cash flows we use
to value our retained interests. Without additional liquidity in the near
future, Conseco Finance will be unable to make these projected guarantee
payments when such payments are required to be made. We project the gross cash
flows from the retained interests will exceed the payments related to guarantees
issued in conjunction with the sales of certain finance receivables by
approximately $1,105 million in all years thereafter.
Effective September 30, 2001, we transferred substantially all of our
interest-only securities into a securitization trust. The transaction provided a
means to finance a portion of the value of our interest-only securities by
selling some of the cash flows
20
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
to Lehman. The transfer was accounted for as a sale in accordance with SFAS 140.
However, no gain or loss was recognized because the aggregate fair value of the
interest retained by the Company and the cash received from the sale were equal
to the carrying value of the interest-only securities prior to their transfer to
the trust. The trust is a qualifying special purpose entity and is not
consolidated pursuant to SFAS 140. We received a trust security representing an
interest in the trust equal to 85 percent of the estimated future cash flows of
the interest-only securities held in the trust. Lehman purchased the remaining
15 percent interest. The value of the interest purchased by Lehman was $42.6
million at September 30, 2002. Conseco Finance continues to be the servicer of
the finance receivables underlying the interest-only securities transferred to
the trust. Lehman has the ability to accelerate the principal payments related
to their interest after a stated period. Until such time, Lehman is required to
maintain a 15 percent interest in the estimated future cash flows of the trust.
By aggregating the interest-only securities into one structure, the impairment
tests for these securities are conducted on a single set of cash flows
representing Conseco Finance's 85 percent interest in the trust. Accordingly,
adverse changes in cash flows from one interest-only security are offset by
positive changes in another. The new structure does not avoid an impairment
charge if sufficient positive cash flows in the aggregate are not available
(such as was the case at September 30, 2002).
The following table summarizes quantitative information about
delinquencies, net credit losses, and components of managed finance receivables:
Principal balance
60 days or more Net credit
Principal balance past due losses
--------------------------- ---------------------------- ---------------------
Nine months
September 30, December 31, September 30, December 31, ended September 30,
---------------------
2002 2001 2002 2001 2002 2001
---- ---- ---- ---- ---- ----
(Dollars in millions)
Type of finance receivables
Manufactured housing.................. $23,918.3 $25,575.1 $675.4 $610.5 $438.2 $411.4
Home equity/home improvement.......... 10,043.7 11,851.4 127.7 139.9 184.6 181.7
Consumer.............................. 4,010.4 4,198.8 85.9 112.6 172.0 148.9
Commercial............................ 236.6 1,377.0 4.5 16.2 17.6 35.3
--------- --------- ------ ------ ------ ------
Total managed receivables............. 38,209.0 43,002.3 893.5 879.2 812.4 777.3
Less finance receivables securitized
and repossessed assets........... 20,857.1 24,297.3 425.6 464.9 405.0 466.2
--------- --------- ------ ------ ------ ------
Finance receivables held on balance
sheet before allowance for credit
losses and deferred points and
other, net....................... 17,351.9 18,705.0 $467.9 $414.3 $407.4 $311.1
====== ====== ====== ======
Less allowance for credit losses...... 570.1 421.3
Less deferred points and other, net... 261.8 274.5
--------- ---------
Finance receivables held on
balance sheet...................... $16,520.0 $18,009.2
========= =========
21
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The following schedule reconciles our retained interests, net of guarantee
liabilities, from the beginning to the end of the periods presented:
Nine months ended
September 30,
2002 2001
---- ----
(Dollars in millions)
Balance, beginning of period................................................................... $ 670.2 $ 927.5
Additions during the period................................................................. 9.7 -
Investment income........................................................................... 69.7 102.5
Cash paid (received):
Gross cash received....................................................................... (61.3) (98.7)
Guarantee payments related to clean-up calls (a).......................................... - 34.9
Guarantee payments related to interests held by others.................................... 36.7 20.2
Impairment charge to reduce carrying value.................................................. (585.5) (264.8)
Sale of securities related to a discontinued line and other................................. 9.3 (12.4)
Change in interest purchased by Lehman in conjunction with securitization transaction....... 12.6 (52.2)
Transfer to servicing rights in conjunction with securitization transactions................ - (50.0)
Change in unrealized appreciation (depreciation) recorded in shareholders' deficit.......... 166.0 28.5
------- -------
Balance, end of period......................................................................... $ 327.4 $ 635.5
======= =======
- ---------------------------
(a) During the first nine months of 2001, clean-up calls were exercised for
certain securitizations that were previously recognized as sales. The
interest-only securities related to these securitizations had previously
been separately securitized with other interest-only securities in
transactions recognized as sales. The Company holds the residual interests
issued by the securitization trusts. The terms of the residual interests
require the holder to make payments to the securitization trust when a
clean-up call related to an underlying trust (a trust which issued
interest-only securities held by the securitization trust) occurs. These
payments are used to accelerate principal payments to the holders of the
other securities issued by the securitization trusts. During the first nine
months of 2001, the Company was required to make payments to the
securitization trusts. These payments increased our basis in the retained
interests, as the related liability assumed by the Company (and reflected
in the value of the retained interest) was extinguished.
In the third quarter of 2002, we completed a securitization that was
structured in a manner that met the applicable criteria to be accounted for as a
sale. We recorded a loss of $10.7 million and a retained interest of $9.7
million on the sale of $180 million of loans.
AMORTIZATION OF THE COST OF POLICIES PURCHASED
The cost assigned to the right to receive future cash flows from insurance
contracts existing at the date of an acquisition is referred to as the cost of
policies purchased, which is an intangible asset subject to amortization. We
amortize these costs using the interest rate credited to the underlying
insurance policy: (i) in relation to the estimated gross profits for universal
life-type and investment-type products; or (ii) in relation to future
anticipated premium revenue for other products.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the cost of
policies purchased for the change in amortization that would have been recorded
if actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income (loss)
within shareholders' equity.
The amortization related to the cost of policies purchased was $169.4
million and $197.9 million in the first nine months of 2002 and 2001,
respectively. The Company expects to amortize approximately 15 percent of the
December 31, 2001,
22
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
balance of cost of policies purchased in 2002, 14 percent in 2003, 11 percent in
2004, 10 percent in 2005 and 8 percent in 2006.
EARNINGS PER SHARE
A reconciliation of income (loss) before extraordinary gain (loss) and
cumulative effect of accounting change and shares used to calculate basic and
diluted earnings per share is as follows:
Three months ended Nine months ended
September 30, September 30,
-------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions
and shares in thousands)
Income (loss) before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change............. $(1,678.7) $(398.9) $(3,041.0) $(330.6)
Preferred stock dividends............................................. (.2) (3.1) (2.1) (11.6)
--------- ------- --------- ------
Loss before discontinued operations, extraordinary
gain (loss) and cumulative effect of accounting change
applicable to common ownership for basic earnings per share.... (1,678.9) (402.0) (3,043.1) (342.2)
Effect of dilutive securities......................................... - - - -
--------- ------- --------- -------
Loss before discontinued operations, extraordinary gain (loss) and
cumulative effect of accounting change applicable to common
ownership andassumed conversions
for diluted earnings per share................................. $(1,678.9) $(402.0) $(3,043.1) $(342.2)
========= ======= ========= =======
Shares:
Weighted average shares outstanding for basic and diluted
earnings per share.............................................. 346,008 340,276 345,741 336,395
======= ======= ======= =======
There were no dilutive common stock equivalents during the 2002 and 2001
periods because of the net loss realized by the Company during such periods.
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and nine months ended September 30, 2002 and 2001, because doing so would
have been antidilutive in the periods presented. Such securities could
potentially dilute earnings per share in future periods.
Three months ended Nine months ended
September 30, September 30,
--------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
(Shares in thousands)
Equivalent common shares that were antidilutive during the period:
Stock options....................................................... - 9,769 100 12,098
Employee benefit plans.............................................. 4,089 3,063 3,810 2,768
Assumed conversion of convertible preferred stock................... 28,698 27,578 28,415 27,306
------ ------ ------ ------
Antidilutive equivalent common shares............................. 32,787 40,410 32,325 42,172
====== ====== ====== ======
23
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
BUSINESS SEGMENTS
We manage our business operations through two segments, based on the
products offered, in addition to the corporate segment.
Insurance and fee-based segment. Our insurance and fee-based segment
provides supplemental health, annuity and life insurance products to a broad
spectrum of customers through multiple distribution channels, each focused on a
specific market segment. These products are primarily marketed through career
agents, professional independent producers and direct marketing. Fee-based
activities include services performed for other companies, including investment
management and insurance product marketing.
Finance segment. Our finance segment provides a variety of finance products
including: (i) loans for the purchase of manufactured housing, home improvements
and various consumer products; (ii) home equity loans; (iii) private label
credit card programs; and (iv) floorplan financing. These products are primarily
marketed through intermediary channels such as dealers, vendors, contractors and
retailers.
Corporate and other segment. Our corporate segment includes certain
investment activities, such as our venture capital investment in AWE, and, prior
to its sale, our ownership interest in the riverboat casino in Lawrenceburg,
Indiana. In addition, the corporate segment includes interest expense related to
the Company's corporate debt, special corporate charges, income (loss) from the
major medical business in run-off and other income and expenses. Corporate
expenses are net of charges to our subsidiaries for services provided by the
corporate operations.
24
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Segment operating information was as follows:
Three months ended Nine months ended
September 30, September 30,
------------------ ------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Revenues:
Insurance and fee-based segment:
Insurance policy income:
Annuities................................................. $ 48.2 $ 19.3 $ 111.3 $ 63.8
Supplemental health....................................... 568.6 554.1 1,705.9 1,665.7
Life...................................................... 155.0 198.8 469.8 595.4
Other..................................................... 28.8 30.9 88.1 96.9
Net investment income (a)................................... 335.1 396.5 1,045.5 1,183.6
Fee revenue and other income (a)............................ 21.5 25.2 74.9 77.5
Net realized investment losses (a).......................... (271.7) (156.6) (524.9) (302.7)
-------- -------- -------- --------
Total insurance and fee-based segment revenues.......... 885.5 1,068.2 2,970.6 3,380.2
-------- -------- -------- --------
Finance segment:
Net investment income:
Retained interest (a)..................................... 23.5 33.7 69.7 102.5
Manufactured housing...................................... 216.1 214.0 659.3 604.0
Mortgage services......................................... 174.9 200.6 548.7 576.4
Consumer/credit card...................................... 114.4 111.7 334.2 325.9
Commercial................................................ 7.4 26.7 44.3 99.0
Other (a)................................................. - - - 7.3
Gain (loss) on sale of finance receivables.................. (31.3) 6.0 (13.9) 21.6
Fee revenue and other income................................ 70.1 82.1 201.3 257.4
Impairment charge related to retained interests in
securitization transactions............................... (701.3) (345.2) (701.3) (386.9)
-------- -------- -------- --------
Total finance segment revenues.......................... (126.2) 329.6 1,142.3 1,607.2
-------- -------- -------- --------
Corporate and other:
Net investment income....................................... 3.7 2.4 9.4 20.0
Venture capital loss related to investment in AWE........... (6.6) (87.4) (106.6) (84.0)
Gain on sale of interest in riverboat....................... - - - 192.4
Revenue from the major medical business in run-off.......... 107.0 188.1 366.8 605.0
Other income................................................ - - - .9
-------- -------- -------- --------
Total corporate segment revenues........................ 104.1 103.1 269.6 734.3
-------- -------- -------- --------
Eliminations.................................................. (10.4) (7.7) (32.2) (20.5)
--------- -------- -------- --------
Total revenues.......................................... 853.0 1,493.2 4,350.3 5,701.2
-------- -------- -------- --------
Expenses:
Insurance and fee-based segment:
Insurance policy benefits................................... 841.1 736.1 2,256.9 2,190.7
Amortization................................................ 160.0 170.8 555.0 503.4
Interest expense on investment borrowings................... 1.1 7.8 11.4 22.7
Other operating costs and expenses.......................... 139.6 135.1 397.5 418.5
Goodwill impairment......................................... 500.0 - 500.0 -
Special charges............................................. 2.2 4.7 42.0 17.4
-------- -------- -------- -------
Total insurance and fee-based segment expenses............ 1,644.0 1,054.5 3,762.8 3,152.7
-------- -------- -------- --------
(continued)
25
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Finance segment:
Provision for losses........................................ $ 234.2 $ 134.2 $ 550.9 $ 360.9
Interest expense............................................ 284.8 308.6 860.3 936.8
Special charges............................................. 53.4 .5 109.9 16.7
Other operating costs and expenses.......................... 176.1 159.5 478.7 480.2
--------- -------- --------- --------
Total finance segment expenses............................ 748.5 602.8 1,999.8 1,794.6
--------- -------- --------- --------
Corporate and other:
Interest expense on corporate debt.......................... 83.2 85.3 238.6 278.8
Provision for losses and expenses related to stock
purchase plan............................................. 60.0 59.6 200.0 59.6
Expenses from the major medical in run-off business......... 107.0 249.8 366.8 735.4
Other corporate expenses, less charges to subsidiaries for
services provided......................................... 14.0 9.3 32.7 15.4
Special charges and other................................... 32.6 (8.3) 61.1 16.9
--------- -------- --------- --------
Total corporate segment expenses.......................... 296.8 395.7 899.2 1,106.1
--------- -------- --------- --------
Eliminations.................................................. (10.4) (7.7) (32.2) (20.5)
--------- -------- --------- --------
Total expenses............................................ 2,678.9 2,045.3 6,629.6 6,032.9
--------- -------- --------- --------
Loss before income taxes, minority interest, extraordinary
gain (loss) and cumulative effect of accounting change:
Insurance and fee-based operations.......................... (758.5) 13.7 (792.2) 227.5
Finance operations.......................................... (874.7) (273.2) (857.5) (187.4)
Corporate interest expense and other items.................. (192.7) (292.6) (629.6) (371.8)
--------- -------- --------- --------
Loss before income taxes, minority interest,
extraordinary gain (loss) and cumulative effect of
accounting change..................................... $(1,825.9) $ (552.1) $(2,279.3) $ (331.7)
========= ======== ========= ========
- --------------------
(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 $72.8 million and $89.7 million
in the first nine 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-indexed
products before this expense was $(24.8) million and $5.4 million in the first
nine months of 2002 and 2001,
26
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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 $15.2 million and $49.8 million at September 30, 2002 and December
31, 2001, respectively. We classify such instruments as other invested assets.
The Company accounts for the options attributed to the policyholder for the
estimated life of the annuity contract as embedded derivatives as defined by
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", as amended by Statement of Financial
Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement
No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities" (collectively
referred to as "SFAS 138"). 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 $297.0 million and $491.2
million at September 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 was carried at market
value, with the change in such value being recognized as venture capital income
(loss). The value of the derivative fluctuated in value in relation to the AWE
common stock it related to. In the third quarter of 2002, we agreed with the
counterparty to unwind the forward sale contract. 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 September 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, Conseco Finance
provided guarantees aggregating approximately $1.4 billion at September 30,
2002. We consider any potential payments related to these guarantees in the
projected net cash flows used to determine the value of our retained interests.
The discounted present value of expected future payments under the guarantees
are classified as the "Guarantee liability related to interests in
securitization trusts held by others" in the accompanying consolidated balance
sheet. See note to the consolidated financial statements entitled "Finance
Receivables and Retained Interests in Securitization Trusts" for additional
discussion of these guarantees. 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 nine months of 2002 and 2001,
interest and principal payments related to such guarantees totaled $36.7 million
and $20.2 million, respectively. Without additional liquidity in the near
future, Conseco Finance will be unable to make these guarantee payments when
such payments are required to be made.
We have guaranteed D&O loans totaling $481.3 million. As described in the
note to the consolidated financial statements entitled "Events of Default and
Liquidity Issues", Conseco has defaulted on certain notes, which has resulted in
the immediate maturity of the D&O loans through cross-acceleration and
cross-default provisions contained in the governing instruments. Conseco has
obtained forbearance agreements from the relevant D&O lenders, pursuant to which
the lenders have agreed to temporarily refrain from exercising default-related
remedies with respect to certain specified events of default. The
27
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
forbearance agreements expire on November 27, 2002, and are subject to various
conditions. The proceeds of the bank loans 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 have
been held by the D&O lenders as collateral for the loans. In addition, Conseco
has provided loans to participants for interest on the D&O loans totaling $166.6
million. During the third quarter of 2000, the Company negotiated new guarantees
with the D&O lenders which expire on December 31, 2003, and guaranteed the D&O
loans of the participants who qualified and chose to participate in a
refinancing of their D&O loans.
The Company is exploring a number of alternatives to reduce the balance of
certain participants' D&O loans. The plan currently being considered would
reduce the D&O loan balance of certain participants who collectively owe less
than 10 percent of the entire amount due under the stock purchase program. In
the third quarter of 2002, $55.5 million of the D&O bank loans were repaid by
Conseco utilizing cash held in a segregated cash account that served as
collateral for our guarantee of the bank loans. Such loans are now held by
Conseco. 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
nine months of 2002, we established a noncash provision in connection with these
guarantees and loans of $200.0 million. Such provision is included as a
component of the provision for losses. At September 30, 2002, the reserve for
losses on the loan guarantees and the liability related to the pay for
performance benefits totaled $620.0 million. At September 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 $90 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 ceded 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 were approximately $400 million. The reinsurance agreement and
the related dividends of $110.5 million were approved by the appropriate state
insurance departments and the dividends were paid to 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.
During the second quarter of 2002, one of our subsidiaries, Colonial Penn
Life Insurance Company (formerly known as Conseco Direct Life Insurance
Company), ceded a block of graded benefit life insurance policies to an
unaffiliated company pursuant to a modified coinsurance agreement. Our
subsidiary received a ceding commission of $83.0 million. The cost of policies
purchased and the cost of policies produced were reduced by $123.0 million and
we recognized a loss of $39.0 million related to the transaction.
We expect that all reinsurance transactions completed in 2002 will reduce
the income before income taxes of our insurance segment by approximately $20
million for the year ended December 31, 2002.
The cost of reinsurance ceded totaled $263.3 million and $150.2 million in
the first nine 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
$232.0 million and $115.1 million in the first nine months of 2002 and 2001,
respectively. Reinsurance premiums assumed totaled $64.9 million and $106.5
million in the first nine months of 2002 and 2001, respectively.
28
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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.
A valuation allowance of $1,314.4 million has been provided for the entire
balance of net deferred income tax assets at September 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. We
increased the valuation allowance for deferred taxes by $311.4 million during
the quarter ended September 30, 2002.
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 tax asset) and reduced
goodwill by $146.2 million.
29
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
The components of the Company's income tax assets and liabilities were as
follows:
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Deferred tax assets:
Net operating loss carryforwards................................................ $ 448.0 $ 411.7
Deductible temporary differences:
Actively managed fixed maturities............................................ 234.2 124.9
Interest-only securities..................................................... 249.9 -
Insurance liabilities........................................................ 765.5 827.5
Allowance for loan losses.................................................... 180.7 148.2
Reserve for loss on loan guarantees.......................................... 193.2 147.0
Unrealized depreciation...................................................... - 247.1
Debt obligations............................................................. 113.2 -
--------- ---------
Total deferred tax assets................................................. 2,184.7 1,906.4
Valuation allowance.......................................................... (1,314.4) -
--------- ---------
Net deferred tax assets................................................... 870.3 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..................... (744.6) (1,075.6)
Unrealized appreciation...................................................... (75.8) -
Other........................................................................ (49.9) (56.2)
--------- ---------
Total deferred tax liabilities............................................ (870.3) (1,243.7)
--------- ---------
Current income taxes prepaid................................................. 79.8 15.4
---------- ---------
Net income tax assets (liabilities)....................................... $ 79.8 $ 678.1
========== =========
At September 30, 2002, Conseco had federal income tax loss carryforwards of
$1,279.9 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; $77.0 million in 2016; $45.4 million in 2017; $322.8 million in
2018; $159.1 million in 2019; $490.2 million in 2020; and $69.2 million in 2022.
30
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Income tax expense (benefit) was as follows:
For the nine months
ended September 30,
----------------------
2002 2001
---- ----
(Dollars in millions)
Current tax provision................................................................. $ 127.7 $ 71.9
Deferred tax provision (benefit)...................................................... (768.0) (163.4)
-------- -------
Income tax expense (benefit) on period income....................................... (640.3) (91.5)
Valuation allowance................................................................... 1,314.4 -
-------- -------
Total income tax expense (benefit)............................................ $ 674.1 $ (91.5)
======== =======
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:
Nine months ended
September 30,
2002 2001
---- ----
U.S. statutory corporate rate.................................................................. (35.0)% (35.0)%
Valuation allowance............................................................................ 57.7 -
Nondeductible goodwill amortization............................................................ 7.6 8.4
Other nondeductible expenses................................................................... - (.3)
State taxes.................................................................................... (1.2) 3.7
Provision for tax issues and other............................................................. .5 (4.4)
----- -----
Effective tax rate...................................................................... 29.6% (27.6)%
===== =====
31
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 September 30, 2002):
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
$1.5 billion bank credit facility (8.5%)..................................... $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 -
8.125% senior notes due 2003................................................. 63.5 63.5
6.4% senior notes due 2003................................................... 234.1 250.0
6.4% guaranteed senior notes due 2004 (a).................................... 14.9 -
10.5% senior notes due 2004.................................................. 24.5 24.5
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........................................................................ 2.2 2.6
-------- --------
Total principal amount.................................................. 4,046.4 4,124.2
Unamortized net discount related to issuance of notes payable ............... (38.7) (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")...................... 9.0 -
-------- --------
Direct corporate obligations............................................ $4,016.7 $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
"Events of Default and Liquidity Issues," the Company has not made any interest
or principal payments on any of its direct corporate obligations since its
August 9, 2002 announcement that it intends to effectuate a fundamental
restructuring of the Company's capital structure. As a result of its failure to
make such payments, Conseco has defaulted on its obligations under certain
notes, which gave the holders of the notes the right to accelerate the maturity
of all principal and past due interest. Conseco's default with respect to the
payment of principal on the notes due October 15, 2002 also resulted in defaults
under approximately $4.0 billion principal amount of debt obligations, $481.3
million of principal amount of the guaranteed D&O loans and approximately $1.9
billion of trust preferred securities through cross-default provisions contained
in the governing instruments. The Company is also not in compliance with certain
covenants under its bank credit agreement and the guarantees of the D&O loans.
Although Conseco received a waiver of the covenant violations from the relevant
lenders, the waiver, as extended, expired on October 17, 2002. Conseco has
obtained forbearance agreements from the relevant lenders, pursuant to which the
lenders have agreed to temporarily refrain from exercising default-related
remedies with respect to certain specified events of default under the bank
credit agreement and the guarantees of the D&O loans. These forbearance
agreements expire on November 27, 2002 and are subject to various conditions.
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
32
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
non-U.S. persons in transactions outside the United States. The bonds which were
exchanged have identical principal and interest components, 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, 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. We entered into a
registration rights agreement for the benefit of each exchange participant in
which we agreed to file, and did file, an exchange offer registration statement
with the SEC with respect to the new notes. However, as a result of 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:
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 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 certain covenants of the amended credit facility. As
stated above, we have obtained forbearance agreements from the relevant lenders,
pursuant to which the lenders have agreed to temporarily refrain from exercising
default-related remedies with respect to certain specified events of default
under the amended credit facility. These forbearance agreements expire on
November 27, 2002 and are subject to various conditions.
As a result of the defaults described above, all amounts outstanding under
the amended credit facility have been accelerated and are immediately due and
payable, subject to the terms of the forbearance agreement. Absent these
defaults, the amended credit facility would have been due on December 31, 2003,
and could have been extended to March 31, 2005, subject to the satisfaction of
a number of conditions.
Pursuant to our amended credit facility, we agreed to the manner in which
any proceeds received from asset sales (including our AWE investment) occurring
after September 30, 2002 (with certain exceptions), would be applied. The first
$219 million of such proceeds could be retained by the Company to be used to
meet our other debt obligations. The next $313 million were to be applied pro
rata to the principal payments on the amended credit facility and to a
segregated cash account to be held as collateral for our guarantee of the D&O
loans. The next $250 million were to be divided equally between the Company and
to pay pro rata the principal payments on the amended 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 were to 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 amended credit facility and the D&O loans. Proceeds
received after March 31, 2004, were to be divided equally between the Company
and to pay pro rata the principal payments on the amended bank credit facility
and the D&O loans. Given its current intentions to effectuate a restructuring,
the Company does not anticipate completing any material asset sales or financing
transactions in the near-term which would be subject to the provisions described
above.
33
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Our amended credit facility requires the Company to maintain various
financial ratios and balances, as defined in the agreement. At September 30,
2002, we were not in compliance with several covenants in our amended credit
facility but have received forbearance agreements from the relevant lenders,
pursuant to which the lenders have agreed to temporarily refrain from exercising
default-related remedies with respect to certain specified events of default
under the amended credit facility. The forbearance agreements expire on November
27, 2002 and are subject to various conditions. Absent the agreements, the
covenant violations give the lenders the right to declare all borrowings under
the amended credit facility due and payable. We were in violation of the
following financial covenants we agreed to maintain at September 30, 2002: (i) a
debt to capitalization ratio of less than .375:1.0 at September 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 .458:1.0 at September 30, 2002); (ii) an
interest coverage ratio greater than 1.10:1.0 for the four quarters ending
September 30, 2002 and changing over time, as defined in the agreement, to
2.50:1.0 for the four quarters ending September 30, 2004 and thereafter (such
ratio was 1.09:1.0 for the four quarters ended September 30, 2002); (iii)
adjusted earnings, as defined in the agreement, of at least $1,200.0 million for
the four quarters ending September 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 September 30, were
$1,103.8 million); and (iv) Conseco Finance tangible net worth, as defined in
the agreement, of at least $1.2 billion at September 30, 2002; and $1.6 billion
at March 31, 2005 (such tangible net worth was less than $1.2 billion at
September 30, 2002). We also agreed to maintain the ratio of aggregate total
adjusted capital to aggregate authorized control level risk-based capital (as
defined by the National Association of Insurance Commissioners) with respect to
our insurance subsidiaries of at least 250 percent (such ratio was greater than
250 percent at September 30, 2002). Our amended 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 amended credit facility. All of our significant insurance
subsidiaries are rated "B" by A.M. Best.
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 facility 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.
Effective September 9, 2002, we were subject to the default interest rate
on the amended credit facility. Such rate is based on the prime rate plus a
margin of 3.75 percent. Prior to September 9, 2002, the interest rate on the
amended credit facility was based on an IBOR rate plus a margin of 3.25 percent.
Borrowings under our amended credit facility averaged $1,493.3 million during
the first nine months of 2002, at a weighted average interest rate of 5.21
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 nine 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); and $25.0 million par value
of the 8.5% senior notes due 2002 (resulting in an extraordinary gain of $.6
million, net of income taxes of $.3 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.
34
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 Conseco Finance were as
follows (interest rates as of September 30, 2002):
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Master repurchase agreements (warehouse facilities) due on various dates in
2002 and 2003 (2.88%)..................................................... $ 465.8 $1,679.0
Residual facility collateralized by retained interests in securitizations
due 2004 (3.82%).......................................................... 512.3 507.3
Medium term notes due September 2002......................................... - 189.7
10.25% senior subordinated notes due June 2002............................... - 138.2
Bank credit facility due December 2002 (9.31%)............................... 75.0 21.0
Other........................................................................ 1.4 1.5
-------- --------
Total principal amount.................................................. 1,054.5 2,536.7
Unamortized net discount and deferred fees................................... - (8.8)
-------- --------
Direct finance obligations.............................................. $1,054.5 $2,527.9
======== ========
Conseco Finance is not in compliance with its adjusted tangible net worth
requirement, fixed charge coverage ratio, GAAP net worth to total managed
receivables ratio or non-warehouse debt to GAAP net worth ratio as of September
30, 2002 as required by its warehouse facility and residual facility. Conseco
Finance entered a forbearance agreement with Lehman pursuant to which Lehman has
agreed to temporarily refrain from exercising any rights arising from events of
default that occurred under such facilities as of the date of such forbearance
agreement, including certain events of default triggered by Conseco Finance not
being in compliance with certain financial covenants. This forbearance agreement
expires on November 29, 2002 and is subject to various conditions. In addition,
Conseco Finance was not in compliance with various financial covenants with
respect to its bank credit facility. Conseco Finance is currently in the process
of attempting to obtain a forbearance or similar agreement. Absent the
forbearance or similar agreement, the covenant violation gives the lender the
right to declare all borrowings under the bank credit facility due and payable
($75.0 million was outstanding pursuant to this facility at September 30, 2002).
Conseco Finance has obtained a waiver from U.S. Bank in connection with
cross-defaults that have occurred under this credit facility resulting from
Conseco defaulting on its debt obligations. This waiver also provides for
amendments to the credit facility that further restrict Conseco Finance's access
to liquidity by successive step-downs in the size of the facility and for the
termination of the facility and its repayment in full by December 31, 2002.
Pursuant to Conseco Finance's residual facility collateralized by retained
interests in securitizations, Conseco Finance is required to maintain collateral
based on estimated fair values. Due to the decrease in estimated fair value of
its retained interests, Conseco Finance's collateral was $128.9 million
deficient at September 30, 2002 (as calculated in accordance with the relevant
transaction documents). Conseco Finance has executed a forbearance agreement
with Lehman, in which among other things, Lehman has agreed not to cause
accelerated repayment of the residual facility based on the collateral
deficiency through November 29, 2002. Under the terms of the forebearance
agreement, Lehman is retaining certain cash flows from Conseco Finance's
retained interests pledged to this facility and applying these cash flows to the
margin deficit. We are currently not able to provide sufficient additional
collateral or repay this credit facility.
At November 15, 2002, Conseco Finance had $1.4 billion of committed master
repurchase agreements and other facilities for the purpose of financing its
consumer and commercial finance loan production. 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 lender to continue to provide financing. At September 30,
2002, Conseco Finance had borrowed $1.1 billion under these agreements. Conseco
Finance is unable to predict whether it will be able to obtain replacement
financing when current facilities expire or terminate. There can be no assurance
that financing will
35
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
be obtainable on favorable terms, if at all. To the extent that Conseco Finance
is unable to arrange any third party or other financing, its loan origination
activities would be adversely affected, which would have further material
adverse effects on its operations, financial results and cash position.
In the first quarter of 2002, Conseco Finance 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. Conseco Finance agreed to an amortization schedule by
which the outstanding balance under the Miscellaneous Borrowings is required to
be repaid by June 2003. Conseco Finance 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.
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
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 warrant had a nominal value at September 30, 2002. 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 derivative had a
nominal value at September 30, 2002. See the note to the consolidated financial
statements entitled "Special Charges - Reduction in Value of Warrant" for the
amount reported in earnings for the quarter ended September 30, 2002.
The residual facility collateralized by retained interests in
securitizations and the warehouse facility require Conseco Finance to maintain
various financial ratios, as defined in such agreements. At September 30, 2002,
Conseco Finance was not in compliance with the adjusted tangible net worth
requirement, fixed charge coverage ratio, GAAP net worth to total managed
receivables ratio or non-warehouse debt to GAAP net worth ratio. Conseco Finance
has entered into a forbearance agreement related to these facilities through
November 29, 2002. At the end of the forbearance period, the covenant violation
gives the lender the ability to declare all borrowings under these facilities
due and payable. These ratios include: (i) an adjusted tangible net worth of at
least $1.5 billion (such amount was $.8 billion at September 30, 2002); (ii) a
fixed charge coverage ratio of not less than 1.0:1.0 for the four quarters
ending September 30, 2002, and defined periods thereafter (such ratio was
..58:1.0 for the period ended September 30, 2002); (iii) a ratio of net worth to
total managed receivables of not less than 4:100 (such ratio was 2.39:100 at
September 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 2.00:2.0 at September 30, 2002). These
credit facilities also require Conseco Finance to maintain liquidity of greater
than $50 million. As of September 30, 2002, Conseco Finance's liquidity was
$63.9 million. Subsequent to September 30, 2002, Conseco
36
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Finance's liquidity was less than $50 million.
The credit facility with U.S. Bank requires Conseco Finance to maintain
various financial ratios, as defined in the agreements. As of September 30,
2002, Conseco Finance was not in compliance with any of the following financial
ratios. Conseco Finance is currently in the process of attempting to obtain a
forbearance or similar agreement from U.S. Bank. Absent the forbearance or
similar agreement, the covenant violation gives the lender the right to declare
all borrowings under the bank credit facility due and payable. These ratios
include: (i) an adjusted tangible net worth of at least $1.5 billion (such
amount was $.8 billion at September 30, 2002); (ii) a fixed charge coverage
ratio of not less than 1.0:1.0 for the four quarters ending September 30, 2002,
and defined periods thereafter (such ratio was .58:1.0 for the four quarters
ended September 30, 2002); (iii) a ratio of net worth to total managed
receivables of not less than 4:100 (such ratio was 2.39:100 at September 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 2.00:2.0 at September 30, 2002).
During the first nine 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 of the notes
plus accrued interest. The remaining principal amount outstanding of the medium
term notes after giving effect to both tender offers and other debt repurchases
completed prior to the tender offers of $2.7 million was retired at maturity on
September 26, 2002.
NOTES PAYABLE RELATED TO SECURITIZED FINANCE RECEIVABLES STRUCTURED AS
COLLATERALIZED BORROWINGS
Notes payable related to securitized finance receivables structured as
collateralized borrowings were $14,662.9 million at September 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 September 30, 2002, was 6.3 percent. The notes payable balance
also includes amounts related to financing transactions securitized by: (i)
capitalized expenses related to the refurbishment of repossessed assets; and
(ii) principal and interest advances. The outstanding liability on these
facilities at September 30, 2002 was $85 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.
37
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CHANGES IN COMMON STOCK
Changes in the number of shares of common stock outstanding were as
follows:
Nine months ended
September 30,
-------------------
2002 2001
---- ----
(Shares in thousands)
Balance, beginning of period............................................................. 344,743 325,318
Stock options exercised............................................................... 6 407
Shares issued in conjunction with the acquisition of Exl.............................. - 3,411
Shares issued pursuant to stock purchase contracts related to the FELINE PRIDES....... - 11,351
Shares issued under employee benefit compensation plans............................... 1,258 913
------- -------
Balance, end of period................................................................... 346,007 341,400
======= =======
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. We have also followed this standard in
determining that our variable annuity business line should be presented as a
discontinued operation in our consolidated financial statements (see the note to
the consolidated financial statements entitled "Discontinued Operations").
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 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 and Goodwill
Impairment" for additional discussion).
The FASB issued Statement of Financial Accounting Standards No. 146,
"Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146
addresses financial accounting and reporting for costs that are associated with
exit and disposal activities and supercedes Emerging Issues Task Force Issue No.
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)"
("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal
activities that are initiated after December 31, 2002. The provisions of EITF
94-3 shall continue to apply for an exit activity initiated prior to the
adoption of SFAS 146. SFAS 146 requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of commitment to an exit or disposal plan. The Company plans to adopt the
provisions of SFAS 146 on January 1, 2003. We do not expect the initial adoption
of SFAS 146 to have an impact on the Company's consolidated financial
statements.
38
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
DISCONTINUED OPERATIONS
In October 2002, Conseco Life Insurance Company of Texas completed the sale
of CVIC to Inviva, Inc. ("Inviva"), a holding company that owns The American
Life Insurance Company of New York. CVIC marketed tax qualified annuities and
certain employee benefit-related insurance products through professional
independent agents. Pursuant to SFAS 144, CVIC is accounted for as a
discontinued operation and our consolidated statements of operation for all
periods have been restated to reflect this presentation. For the purpose of our
September 30, 2002, consolidated balance sheet, the combined assets and
liabilities of CVIC are presented separately. The consideration received from
Inviva at closing (subject to adjustment based upon the adjusted statutory
balance sheet of CVIC at September 30, 2002) totaled $83.7 million, of which
$35.0 million was in the form of Series D Preferred Shares (the "Preferred
Shares") issued by Inviva and the remainder was in cash. In addition, Conseco
Life Insurance Company of Texas received a dividend of approximately $75 million
from CVIC immediately prior to the closing. We recognized a loss on the sale of
$71.0 million (net of an income tax benefit of $38.2 million).
The issuance of the Preferred Shares was intended to provide Inviva with
short-term bridge financing. The Preferred Shares accrue dividends (in-kind) at
an annual rate of 19 percent. On or after December 31, 2002, our insurance
subsidiary that holds these shares may elect to exchange the Preferred Shares
for non-voting common stock of JNF Holding Company, Inc., a wholly owned
subsidiary of Inviva, ("JNF") that now owns all of the stock of CVIC. If not
previously exchanged, on October 15, 2003, the Preferred Shares will be
mandatorily exchanged into the common stock of JNF and our insurance subsidiary
that holds the Preferred Shares will be entitled to receive a $1.67 million cash
fee upon the occurrence of such exchange. After the exchange has occurred, such
JNF common stock may be repurchased by JNF at any time at 115 percent of the
stated value of the Preferred Shares plus accrued and unpaid dividends thereon
immediately prior to the exchange.
In connection with the sale of CVIC, we agreed to provide, for a fee,
various administrative and technical services in order to allow CVIC to continue
to operate and to facilitate the transition of CVIC to Inviva. Such services are
being provided pursuant to an Administrative and Transition Services Agreement
(the "Transition Agreement"). The term of the Transition Agreement is nine
months subject to extension or early termination. As part of the CVIC sale,
Conseco agreed that it would not engage in the variable annuity or variable
insurance business for a period of three years after the closing.
The following summarizes selected financial information of CVIC:
September 30, December 31,
2002 2001
------------- ------------
(Dollars in millions)
Total investments........................................................... $ 750.3 $1,400.1
Cost of policies purchased.................................................. 20.7 100.7
Cost of policies produced................................................... 44.1 228.0
Assets held in separate accounts............................................ 1,191.4 1,649.1
Total assets................................................................ 2,542.5 3,631.1
Insurance liabilities....................................................... 1,252.5 1,382.9
Liabilities related to separate accounts.................................... 1,191.4 1,649.1
Investment borrowings....................................................... - 151.8
Total liabilities........................................................... 2,458.8 3,242.6
Net assets of discontinued operations....................................... 83.7 388.5
39
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Nine months
ended
September 30,
--------------------
2002 2001
---- ----
(Dollars in millions)
Insurance policy income..................................................... $ 30.5 $ 52.5
Net investment income....................................................... (217.3) (63.3)
Net realized investment losses.............................................. (57.8) (31.0)
Total revenues.............................................................. (244.4) (41.7)
Insurance policy benefits................................................... (234.7) (74.6)
Amortization................................................................ 224.6 30.7
Total expenses.............................................................. 4.3 (21.5)
Pre-tax income (loss)....................................................... (248.7) (20.2)
LITIGATION AND OTHER LEGAL PROCEEDINGS
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. Pretrial discovery
has commenced. 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
40
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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 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 has
been 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 initially reserved rights to continue to litigate
coverage. RLI has subsequently settled (for $50,000 paid by certain of the
individual insureds as partial payment of RLI's attorneys' fees incurred in the
coverage litigation), and RLI is no
41
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
longer continuing to dispute 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 has
been 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 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.
Because the directors' and officers' liability insurance that was in force at
the time the litigation commenced provides for coverage of $100 million, 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 that the
insurance applies to the claims in the securities litigation and that the two
insurers who are continuing to litigate the coverage issue were obligated to pay
their policy limits to fund the settlement, as the other four carriers have
done. Accordingly, $20 million is our best estimate of a probable loss at
September 30, 2002. We have established an estimated liability of $40 million
and claim for recovery of $40 million at September 30, 2002. Such amounts
include: (i) $15 million related to the insurer that paid its portion of the
settlement into a fund but reserved its 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 insurer that paid
under a reservation of rights has no right to recoup the payment that it made,
and that the insurer that 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. The ultimate outcome cannot be
predicted with certainty.
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.
Commencing in August 2002 a total of eight purported securities fraud class
action lawsuits have been filed in the United States District Court for the
Southern District of Indiana. The complaints name as defendants the Company,
along with certain current and former officers of the Company, and were filed on
behalf of persons or entities who purchased the Company's common stock on
various dates between October 24, 2001 and August 9, 2002. In each case
Plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934, and allege material omissions and dissemination of
materially misleading statements regarding, among other things, the liquidity of
the Company and alleged problems in the Company's manufactured housing division,
allegedly resulting in the artificial inflation of the Company's stock price in
the marketplace. These cases are expected to be consolidated into one action.
The Company believes 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.)
42
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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 were consolidated into one case, and
Conseco Finance appealed them to the South Carolina Supreme Court. Oral argument
was heard on March 21, 2002. On August 26, 2002 the South Carolina Supreme Court
affirmed the arbitration judgments, and Conseco Finance filed a petition for
writ of certiorari with the U.S. Supreme Court on October 23, 2002. Conseco
Finance has posted appellate bonds, including $21 million of cash, for these
cases. Conseco Finance intends to challenge the awards vigorously 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 to 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. (the "State Court
Action"). 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 (the
"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. By
Stipulation and Order, dated June 14, 2002, the State Court Action was stayed,
pending resolution of the Arbitration. On June 10, 2002, Manager and Trump filed
their Statement of Position which included affirmative defenses and
counterclaims against Carmel and the Company, arising out of the same alleged
breaches of the July 3rd Agreement that had formed the basis of the State Court
Action. The Arbitration was heard by a Panel of three arbitrators in five
hearing days between September 25, 2002 and October 29, 2002, and the parties
filed Post-Hearing Briefs on November 5, 2002. The parties are awaiting a
decision from the Panel. The Company believes that Mr. Trump's lawsuit is
without merit and intends to defend it vigorously. The ultimate outcome cannot
be predicted with certainty.
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. The ultimate outcome cannot be predicted with certainty.
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
43
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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. In June 2002, the plaintiff holders filed a motion for summary
judgment. The parties began discovery in connection with that motion, and the
Circuit Court scheduled a hearing on the motion for October 4, 2002. However, we
and the plaintiffs subsequently agreed to adjourn that hearing and to postpone
indefinitely all further proceedings in the litigation. Accordingly, there is no
schedule currently in place for the resolution of the plaintiffs' motion or the
litigation generally, although the litigation remains pending. 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 recently been settled as
described above. The Company is cooperating with the SEC staff in this matter.
The Company has been notified that the Alabama Securities Commission is
examining the Company's 1998 Directors/Officers & Key Employees Stock Purchase
Program and the 2000 Employee Stock Purchase Program Work-Down Plan. The Company
is cooperating with the Commissioner's staff in this matter.
In October, 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSavePlan filed an action
in the United States District Court for the Southern District of Indiana against
the Company, Conseco Services LLC and certain current and former officers of the
Company (Roderick Russell, et al v Conseco, Inc., et al, Case No. 1:02-CV-1639
LJM). The purported class action consists of all individuals whose 401(k)
accounts held common stock of the Company at any time from April 28, 1999
through the present. The complaint alleges, among other things, breaches of
fiduciary duties under ERISA by continuing to permit employees to invest in the
common stock of the Company without full disclosure of the Company's true
financial condition. The Company believes the lawsuit is without merit and
intends to defend it vigorously. The ultimate outcome of the lawsuit cannot be
predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits and arbitrations (including purported class actions)
related to their operations. 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," 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) and an arbitration involving a dispute with a
reinsurer of a block of long term care business. The ultimate outcome of all of
these other legal matters pending against the Company or its subsidiaries cannot
be predicted, and, although such lawsuits are not expected individually to have
a material adverse effect on the Company, such lawsuits could have, in the
aggregate, a material adverse effect on the Company's consolidated financial
condition, cash flows or results of operations.
44
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows:
Nine months ended
September 30,
---------------------
2002 2001
---- ----
(Dollars in millions)
Cash flows from operating activities:
Net loss.................................................................................. $(6,147.2) $(349.1)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Interest-only securities investment income............................................ (15.8) (47.0)
Cash received from interest-only securities, net...................................... (54.2) 18.8
Servicing income...................................................................... (54.5) (89.0)
Cash received from servicing activities............................................... 33.7 56.1
Provision for losses.................................................................. 735.2 420.5
Loss (gain) on sale of finance receivables............................................ 13.9 (21.6)
Amortization and depreciation......................................................... 800.3 688.2
Income taxes.......................................................................... 410.7 (245.5)
Insurance liabilities................................................................. 279.9 279.4
Accrual and amortization of investment income......................................... 162.8 86.6
Deferral of cost of policies produced and purchased................................... (391.4) (515.6)
Gain on sale of interest in riverboat................................................. - (192.4)
Impairment charges.................................................................... 701.3 386.9
Goodwill impairment................................................................... 500.0 -
Special charges....................................................................... 166.3 49.4
Cumulative effect of change in accounting............................................. 2,949.2 -
Minority interest..................................................................... 134.8 139.1
Net investment losses................................................................. 582.7 333.7
Loss on CVIC sale..................................................................... 109.3 -
Extraordinary (gain) loss on extinguishment of debt................................... (8.1) 5.7
Other................................................................................. (171.5) (159.0)
-------- ------
Net cash provided by operating activities........................................... $ 737.4 $845.2
======== ======
Nine months ended
September 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....................... $13.0 $16.5
Issuance of convertible preferred shares..................................................... 2.1 11.6
Value of FELINE PRIDES retired and transferred from minority interest to common
stock and additional paid-in capital....................................................... - 496.6
Issuance of common stock in connection with the acquisition of Exl........................... - 52.6
Increase in other invested assets and notes payable-direct corporate obligations reflecting the
estimated fair value of interest rate swap agreements...................................... - 29.1
45
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 nine months ended September 30, 2002, which are further
described in the paragraphs which follow (dollars in millions):
Three months Nine months
ended ended
September 30, September 30,
2002 2002
------------- -------------
Loss related to reinsurance transactions and businesses sold to raise cash..... $ 71.1 $146.6
Costs related to debt modification and refinancing transactions................ 23.5 47.8
Restructuring costs............................................................ 12.1 12.1
Reduction in value of Lehman warrant........................................... (38.1) (38.1)
Other items.................................................................... 19.6 44.6
------- ------
Special charges before income tax benefit.................................. $ 88.2 $213.0
====== ======
Loss related to reinsurance transactions and businesses sold to raise cash
We have sold portions of our insurance and financing businesses to raise
cash. We completed various asset sales (including the sale of Manhattan National
Life Insurance Company) and reinsurance transactions which resulted in net
losses of $71.1 million and $146.6 million in the three and nine months ended
September 30, 2002. Such amounts included: (i) a loss of $94.4 million ($48.7
million of which was recognized in the third quarter of 2002) related to the
sales of $383 million of certain finance receivables; (ii) a loss of $39.0
million recognized in the second quarter of 2002 related to the reinsurance of a
portion of our life insurance business; and (iii) an impairment charge of $20.0
million (recognized in the third quarter of 2002) associated with the value of a
subsidiary which we have entered into an agreement to sell. Such losses were
partially offset by asset sales resulting in a net gain of $6.8 million during
the first nine months of 2002.
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) and the recognition of deferred expenses for terminated financing
arrangements, we incurred costs of $47.8 million in the first nine months of
2002 (of which $23.5 million was recognized in the third quarter of 2002) which
are not permitted to be deferred pursuant to GAAP.
Restructuring costs
We incurred expenses totaling $12.1 million in the three and nine months
ended September 30, 2002, related to professional and advisory fees incurred
related to the restructuring of our capital.
Reduction in value of warrant
As partial consideration for a financing transaction, Conseco Finance
issued a warrant which permits the holder to purchase 5 percent of Conseco
Finance at a nominal price. The holder of the warrant or Conseco Finance may
cause the warrant and any stock issued upon its exercise to be purchased for
cash at an appraised value in May 2003. Additionally, until May 2003, the holder
has the right (subject to certain terms and conditions) to convert the warrant
into convertible preferred stock of Conseco. 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 September
30, 2002 was nil based on current valuations of Conseco Finance. Accordingly, we
recorded a $38.1 million reduction in the value of the warrant during the third
quarter of 2002.
46
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Other items
In the third quarter of 2002, we incurred a $16.3 million charge for the
abandonment of certain computer processing systems at Conseco Finance. We are
abandoning such systems given the recent changes to our business and our
decision to no longer originate certain types of loans.
In addition, other items include expenses incurred: (i) as a result of the
termination of our chief financial officer in the first quarter of 2002; (ii) in
conjunction with the transfer of certain customer service and backroom
operations to our India subsidiary; (iii) for severance benefits; and (iv) for
other items which are not individually significant. The Company has recently
sold its India subsidiary and expects to reduce the customer service and
backroom operations conducted there. See the note to the consolidated financial
statements entitled "Subsequent Events."
SPECIAL CHARGES
2001
The following table summarizes the special charges incurred by the Company
during the third quarter of 2001 and for the first nine months of 2001, which
are further described in the paragraphs which follow (dollars in millions):
Three months Nine months
ended ended
September 30, September 30,
2001 2001
--------------- --------------
Organizational restructuring:
Severance benefits............................................................. $ - $15.3
Office closings and sale of artwork............................................ - 7.1
Loss related to sale of certain finance receivables............................ - 11.2
Amounts related to discontinued operations........................................ - 8.5
Other items....................................................................... 14.7 28.4
----- -----
Special charges before income tax benefit...................................... $14.7 $70.5
===== =====
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 nine months of 2001.
The Company has recently sold its India subsidiary and expects to reduce
the customer service and backroom operations conducted there. See the note to
the consolidated financial statements entitled "Subsequent Events."
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 nine months of 2001.
47
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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.
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.
Other items
Other items included expenses incurred: (i) in conjunction with the
transfer of certain customer service and backroom operations to our India
subsidiary; (ii) for legal and consulting fees with respect to services provided
related to various debt and organizational restructuring transactions; (iii)
pursuant to the terms of the employment agreement for our chief executive
officer; and (iv) for other items which are not individually significant.
The Company has recently sold its India subsidiary and expects to reduce
the customer service and backroom operations conducted there. See the note to
the consolidated financial statements entitled "Subsequent Events."
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.
CONDENSED FINANCIAL INFORMATION AND GUARANTEES OF CIHC, INCORPORATED
CIHC has guaranteed the following debt: (i) Conseco's amended credit
facilities which had a principal balance of $1,493.3 million at September 30,
2002; (ii) up to $250.0 million of certain obligations of Conseco Finance; (iii)
up to $481.3 million of D&O loans; 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 amended credit
facilities, CIHC's guarantee of certain obligations of Conseco Finance, CIHC's
guarantee of the D&O loans and certain other debt (including $353.5 million owed
to Conseco Finance).
In addition to these guarantees, CIHC has pledged its stock in Conseco
Finance and its interest in certain intercompany notes to secure $141.6 million
of the D&O loans. This CIHC collateral, as well as certain Conseco collateral,
is shared pro rata with holders of the 8.125% senior notes due 2003 ($63.5
million of which was outstanding as of September 30, 2002) and the 10.5% senior
notes due 2004 ($24.5 million of which was outstanding as of September 30,
2002).
48
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
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
September 30,
2002
----
(Dollars in millions)
Cash and cash equivalents............................................. $ .5
Other invested assets................................................. 5.7
Investment in wholly owned subsidiaries
(eliminated in consolidation)..................................... 5,034.3
Notes receivable from Conseco Finance
(eliminated in consolidation)..................................... 316.5
Receivable from subsidiaries (eliminated in consolidation)............ 1,547.3
Other assets.......................................................... .2
--------
Total assets................................................ $6,904.5
========
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities:
Notes payable to subsidiaries (eliminated in consolidation)....... $1,054.9
Payable to subsidiaries (eliminated in consolidation)............. 330.3
Income taxes...................................................... 173.8
Other liabilities................................................. .8
--------
Total liabilities........................................... 1,559.8
--------
Shareholder's equity:
Preferred stock................................................... 263.9
Common stock and additional paid-in capital....................... 8,718.8
Accumulated other comprehensive loss.............................. 135.3
Accumulated deficit............................................... (3,773.3)
--------
Total shareholder's equity.................................. 5,344.7
--------
Total liabilities and shareholder's equity.................. $6,904.5
========
49
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Three months ended Nine months ended
September 30, 2002 September 30, 2002
------------------ ------------------
(Dollars in millions)
Revenues:
Net investment income......................................... $ .1 $ .3
Dividends from subsidiaries (eliminated in consolidation)..... - 276.0
Fee and interest income from subsidiaries
(eliminated in consolidation).............................. (2.6) 59.2
--------- ---------
Total revenues.......................................... (2.5) 335.5
---------- ---------
Expenses:
Intercompany expenses (eliminated in consolidation)........... 4.1 35.6
Special charges............................................... (.2) .1
Operating costs and expenses.................................. .8 2.4
--------- ---------
Total expenses.......................................... 4.7 38.1
--------- ---------
Income before income taxes, equity in undistributed earnings of
subsidiaries, discontinued operations, extraordinary gain and
cumulative effect of
accounting change.................................... (7.2) 297.4
Income tax expense (benefit)...................................... (2.4) 8.2
--------- ---------
Income (loss) before equity in undistributed earnings
of subsidiaries, discontinued operations, extraordinary
gain and cumulative effect of accounting change...... (4.8) 289.2
Equity in undistributed earnings of subsidiaries (net of dividends from
subsidiaries) before extraordinary gain and cumulative
effect of accounting change (eliminated in consolidation)..... (1,986.1) (2,591.0)
--------- ---------
Loss before discontinued operations, extraordinary
gain and cumulative effect of accounting change...... (1,990.9) (2,301.8)
Discontinued operations, net of tax, of subsidiary................ (162.1) (162.1)
Extraordinary gain on extinguishment of debt, net of tax,
of subsidiary................................................. - 3.9
Cumulative effect of accounting change, net of tax, of
subsidiaries.................................................. - (2,949.2)
--------- ----------
Net loss................................................... (2,153.0) (5,409.2)
Preferred stock dividends......................................... 6.6 19.9
--------- ---------
Loss applicable to common stock............................ $(2,159.6) $(5,429.1)
========= =========
50
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
SUBSEQUENT EVENTS
Recent Changes in Executive Management
On October 3, 2002, Gary C. Wendt, Conseco's Chairman and Chief Executive
Officer, resigned his position of Chief Executive Officer. Mr. Wendt remains
Chairman of the Board of Conseco.
On November 7, 2002, Conseco's Board of Directors elected William J. Shea
to serve as Chief Executive Officer of Conseco. Mr. Shea will also continue to
serve as President and Chief Operating Officer.
On November 7, 2002, Conseco's Board of Directors also elected Eugene M.
Bullis to serve as Executive Vice President and Chief Financial Officer of
Conseco. Mr. Bullis replaced Mr. Shea, who had been the Acting Chief Financial
Officer.
Recent Events Regarding Our Finance Subsidiary
On October 22, 2002, Conseco announced that its board of directors approved
a plan to seek new investors or acquirers for Conseco's finance businesses and
that it had engaged the investment banking firms of Lazard Freres & Co. LLC and
Credit Suisse First Boston to pursue various alternatives, including securing
new investors and/or selling Conseco Finance's three lines of business: (i)
manufactured housing; (ii) mortgage services; and (iii) consumer finance.
In furtherance of this effort, Conseco Finance has initiated a process to
sell its wholly-owned subsidiary, Mill Creek Bank Inc. ("Mill Creek Bank"
formerly known as Conseco Bank, Inc.), and its home equity and private label
credit card businesses. On behalf of Conseco Finance, Credit Suisse First Boston
has received several non-binding indications of interest to acquire Mill Creek
Bank. Non-binding indications of interests have been received in connection with
the potential acquisition of the home equity and private label businesses.
Although Conseco Finance intends to maximize the value obtainable from any
transaction involving Conseco Finance's businesses, there can be no assurance
that any transaction will be completed or if completed, will be on acceptable
terms to satisfy Conseco Finance's current liquidity requirements.
Conseco Finance is also undertaking efforts to restructure its manufactured
housing business. Originations have been significantly curtailed and Conseco
Finance is analyzing potential approaches to reducing the negative cash flow
that currently results from the servicing of this portfolio and the payment of
guarantees on the B-2 securities issued in connection with securitizations of
manufactured housing receivables. These approaches may require amendments of
documentation with respect to the manufactured housing securitizations and such
amendments may require the approval of a majority or supermajority of the
investors in some or all of the classes of securities issued under those
securitizations on a transaction by transaction basis. There can be no assurance
that Conseco Finance will be successful in receiving such consents, effecting
such amendments, or otherwise restructuring its manufactured housing business.
The book value of Conseco's investment in Conseco Finance was approximately
$1.2 billion at September 30, 2002. It currently seems highly unlikely that the
net proceeds to Conseco from the potential transactions summarized above will
result in such value.
Sale of Investment in India Subsidiary
In November 2002, the Company completed the sale of its India subsidiary,
where the Company had planned to move a significant number of jobs. The Company
had previously written off a significant portion of the value of this investment
in conjunction with the impairment charge related to goodwill. Accordingly, no
significant additional loss is expected to be recognized on the sale.
The Company expects to reduce the customer service and backroom operations
conducted in India in the next several months.
51
CONSECO, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------
Sale of CVIC
In October 2002, the Company completed the sale of CVIC. See the note to
the consolidated financial statements entitled "Discontinued Operations."
52
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 nine months ended September 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 $1,769.2 million in the third
quarter of 2002, or $5.11 per diluted share, included: (i) net investment losses
(net of related costs, amortization and taxes) of $162.0 million, or 47 cents
per share; (ii) a loss of $4.3 million, or 1 cent per share, related to our
venture capital investment in AWE; (iii) a provision for loss of $39.0 million,
or 11 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 $57.3 million, or 16 cents per share, as
summarized in the note to the consolidated financial statements entitled
"Special Charges"; (v) a deferred income tax valuation allowance of $311.4
million, or 90 cents per share; (vi) charges related to discontinued operations
of $90.3 million, or 26 cents per share; (vii) a goodwill impairment charge of
$500.0 million, or $1.45 per share; and (viii) an impairment charge of $440.1
million, or $1.27 per share, related to the Company's retained interests in
securitization trusts and servicing rights. The net loss applicable to common
stock of $410.6 million in the third quarter of 2001, or $1.21 cents per diluted
share, included: (i) net investment losses (net of related costs, amortization
and taxes) of $98.9 million, or 29 cents per share; (ii) a loss of $45.2
million, or 13 cents per share, related to our venture capital investment in
AWE; (iii) an impairment charge of $224.4 million, or 66 cents per share,
related to the Company's retained interests in securitization trusts and
servicing rights; (iv) a provision for loss of $38.7 million, or 11 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; (v) special
charges and amounts related to the major medical business in run-off of $49.7
million, or 15 cents per share, as summarized in the note to the consolidated
financial statements entitled "Special Charges"; (vi) amounts related to
discontinued operations of $9.3 million, or 3 cents per share; and (vii) an
extraordinary gain of $.7 million, or nil cents per share, related to the early
retirement of debt.
The net loss applicable to common stock of $6,149.3 million in the first
nine months of 2002, or $17.79 per diluted share, included: (i) net investment
losses (net of related costs, amortization and taxes) of $325.2 million, or 94
cents per share; (ii) a loss of $69.3 million, or 20 cents per share, related to
our venture capital investment in AWE; (iii) a provision for loss of $130.0
million, or 38 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 $138.5 million, or 40 cents per share, as
summarized in the notes to the consolidated financial statements entitled
"Special Charges"; (v) a deferred income tax valuation allowance of $1,314.4
million, or $3.80 per share; (vi) an extraordinary gain of $5.1 million, or 1
cent per share, related to the early retirement of debt; (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; (viii) charges related to
discontinued operations of $162.1 million, or 47 cents per share; (ix) a
goodwill impairment charge of $500.0 million, or $1.45 per share; and (x) an
impairment charge of $440.1 million, or $1.27 per share, related to the
Company's retained interests in securitization trusts and servicing rights. The
net loss applicable to common stock of $360.7 million in the first nine months
of 2001, or $1.07 per diluted share, included: (i) net investment losses
(including related costs, amortization and taxes) of $176.2 million, or 52 cents
per share; (ii) a loss of $41.9 million, or 12 cents 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 $250.4 million, or 74 cents per share, related to the Company's retained
interests in securitization trusts and servicing rights; (v) a provision for
loss of $38.7 million, or 11 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; (vi) special charges, additional amortization and amounts
related to the major medical business in run-off of $128.4 million, or 39 cents
per share, as summarized in the notes to the consolidated financial statements
entitled "Special Charges"; (vii) amounts related to discontinued operations of
$14.5 million, or 4 cents per share; and (viii) an extraordinary charge of $4.0
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 retained interests in securitization trusts and
servicing rights, special charges, changes in deferred income tax valuation
allowance, goodwill impairment and the provision for losses related to loan
53
CONSECO, INC. AND SUBSIDIARIES
--------------------
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 major
medical business in run-off; 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 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.
54
CONSECO, INC. AND SUBSIDIARIES
--------------------
Results of operations by segment for the three and nine months ended September
30, 2002 and 2001
The following tables and narratives summarize our operating results by
business segment.
Three months ended Nine months ended
September 30, September 30,
------------------- -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Operating earnings (losses) from continuing operations
before taxes and goodwill amortization:
Insurance and fee-based segment operating earnings
(losses)............................................... $ (7.1) $ 197.5 $ 250.1 $ 595.8
Finance segment operating earnings (losses).............. (120.0) 72.5 (46.3) 216.2
--------- ------- --------- -------
Subtotal................................................. (127.1) 270.0 203.8 812.0
--------- ------- --------- -------
Holding company activities:
Corporate expenses, less charges to subsidiaries for
services provided........................................ (14.0) (9.3) (32.7) (10.1)
Interest and dividends, net of corporate investment income. (124.6) (130.8) (366.0) (421.2)
Allocation of interest to finance segment.................. - - - 7.3
--------- ------- --------- -------
Operating earnings (losses) from continuing operations
before taxes and goodwill amortization................. (265.7) 129.9 (194.9) 388.0
Taxes ....................................................... 100.9 (48.0) 69.3 (151.0)
--------- ------- --------- -------
Operating earnings (losses) from continuing operations
before goodwill amortization........................... (164.8) 81.9 (125.6) 237.0
Goodwill amortization......................................... - (27.0) - (79.9)
--------- ------- --------- -------
Operating earnings (losses) from continuing operations
applicable to common stock............................. (164.8) 54.9 (125.6) 157.1
--------- ------- --------- -------
Non-operating items, net of tax:
Deferred income tax valuation allowance.................... (311.4) - (1,314.4) -
Loss related to reinsurance transactions and businesses
sold to raise cash....................................... (46.2) - (95.3) (7.5)
Net realized losses........................................ (162.0) (98.9) (325.2) (176.2)
Provision for losses related to loan guarantees............ (39.0) (38.7) (130.0) (38.7)
Venture capital loss related to our investment
in AT&T Wireless Services, Inc........................... (4.3) (45.2) (69.3) (41.9)
Costs related to debt modification and refinancing
transactions............................................. (15.2) - (31.1) -
Major medical business in run-off and other
non-recurring items...................................... 4.1 (49.7) (12.1) (107.2)
Discontinued operations.................................... (90.3) (9.3) (162.1) (14.5)
Gain on sale of interest in riverboat...................... - - - 122.6
Impairment charge related to interest-only securities...... (440.1) (224.4) (440.1) (250.4)
Extraordinary gain (loss) on extinguishment of debt ....... - .7 5.1 (4.0)
Cumulative effect of accounting change..................... - - (2,949.2) -
Goodwill impairment ....................................... (500.0) - (500.0) -
--------- ------- --------- -------
Total non-operating items, net of tax.................... (1,604.4) (465.5) (6,023.7) (517.8)
--------- ------- --------- -------
Net loss applicable to common stock........................... $(1,769.2) $(410.6) $(6,149.3) $(360.7)
========= ======= ========= =======
55
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, our retained interests in
securitization trusts and guarantee liability related to interests in
securitization trusts, goodwill and income taxes.
Investments
At September 30, 2002, the carrying value of our investment portfolio was
$22.6 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 we believe 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 nine months of 2002, the Company
recorded $489.8 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) an 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 September 30, 2002, our net accumulated other
comprehensive income included gross unrealized losses on investments of $732.5
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 September 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."
56
CONSECO, INC. AND SUBSIDIARIES
--------------------
Retained Interests in Securitization Trusts and Guarantee Liability Related
to Interests in Securitization Trusts Held by Others
Our retained interests in securitization trusts represent the right to
receive certain future cash flows from securitization transactions structured
prior to September 8, 1999, and the value of these interests totaled $526.0
million at September 30, 2002. Such cash flows generally are equal to the value
of the principal and interest to be collected on the underlying financial
contracts of each securitization in excess of the sum of the principal and
interest to be paid on the securities sold and contractual servicing fees. We
carry our retained interests at estimated fair value. We estimate fair value by
discounting the projected cash flows over the expected life of the receivables
sold using current estimates of future prepayment, default, loss and interest
rates. We record any unrealized gain or loss determined to be temporary, net of
tax, as a component of shareholders' equity. Declines in value are considered to
be other than temporary when: (i) the fair value of the security is less than
its carrying value; and (ii) the timing and/or amount of cash expected to be
received from the security has changed adversely from the previous valuation
which determined the carrying value of the security. When declines in value
considered to be other than temporary 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
and consultation with external advisors having significant experience in valuing
these securities.
The estimation of the value of our retained interests in securitization
transactions requires significant judgment. The Company has recognized
significant impairment charges when the retained interests did not perform as
well as anticipated based on our assumptions and expectations.
Our current valuation of retained interests in securitization transactions
may prove inaccurate in future periods. In the securitizations to which these
retained interests relate, our finance subsidiary has retained certain
contingent risks in the form of guarantees of certain lower rated securities
issued by the securitization trusts. As of September 30, 2002, the total nominal
amount of these guarantees was $1.4 billion. The net present value of expected
future guarantee payments is classified as the "Guarantee liability related to
interests in securitization trusts held by others" in the accompanying
consolidated balance sheet and totaled $198.6 million at September 30, 2002. We
valued the guarantee liability using the same assumptions used in valuing our
retained interests in securitization trusts. If we have to make more payments on
these guarantees than anticipated, or we experience higher than anticipated
rates of loan prepayments, including those due to foreclosures or charge-offs,
or any adverse changes in our other assumptions used for such valuation (such as
interest rates and our loss mitigation policies), we could be required to
recognize additional impairment charges (including potential payments related to
$1.4 billion of guarantees) which could have a material adverse effect on our
financial condition or results of operations. We consider any estimated payments
related to these guarantees in the projected cash flows used to determine the
value of our retained interests in securitization trusts.
During the quarter ended September 30, 2002, Conseco Finance recognized an
impairment charge related to the value of its retained interests in
securitization trusts of $585.5 million. We also recognized a $115.8 million
increase in the valuation allowance related to our servicing rights as a result
of the changes in assumptions in the third quarter of 2002. See "Finance
Operations - Impairment Charge" included in this "Management's Discussion and
Analysis of Financial Condition" for additional discussion.
Goodwill
As more fully described in the note to our consolidated financial
statements entitled "Cumulative Effect of Accounting Change and Goodwill
Impairment", the Company recorded the cumulative effect of the accounting change
for goodwill impairment of $2,949.2 million in the first quarter 2002. In
addition, we recognized an impairment charge of $500 million in the quarter
ended September 30, 2002, due to changes in the value of our insurance
businesses resulting from recent events.
The significant factors used to determine the amount of the impairments
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 valuations 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 rates used were based on analyses of the
weighted average cost of capital for 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.
57
CONSECO, INC. AND SUBSIDIARIES
--------------------
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 $1,314.4 million has been provided for the entire
net deferred income tax asset balance at September 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 is 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.
58
CONSECO, INC. AND SUBSIDIARIES
--------------------
Insurance and fee-based operations
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Premiums and asset accumulation product collections:
Annuities............................................................ $ 270.4 $ 291.7 $ 804.1 $ 877.0
Supplemental health.................................................. 588.1 561.0 1,794.4 1,744.7
Life................................................................. 112.6 204.6 483.9 632.1
Group major medical.................................................. 83.8 76.3 248.2 280.0
--------- -------- -------- --------
Collections on insurance products from continuing operations..... 1,054.9 1,133.6 3,330.6 3,533.8
Individual major medical in run-off.................................. 16.6 91.8 89.2 293.0
Discontinued operations.............................................. 72.2 85.8 260.8 335.2
--------- -------- -------- --------
Total collections on insurance products.......................... 1,143.7 1,311.2 3,680.6 4,162.0
Deposit type contracts............................................... 78.3 39.1 237.5 134.6
Deposit type contracts - discontinued operations..................... 1.3 2.3 5.8 6.9
Mutual funds......................................................... 18.1 124.3 144.6 356.1
--------- -------- -------- --------
Total premiums and asset accumulation product collections........ $ 1,241.4 $1,476.9 $4,068.5 $4,659.6
========= ======== ======== ========
Average liabilities for insurance and asset accumulation products
(excluding discontinued operations and our major medical
business in run-off):
Annuities:
Mortality based.................................................. $ 251.2 $ 360.2 $ 250.5 $ 365.4
Equity-linked.................................................... 2,086.6 2,634.1 2,258.1 2,632.2
Deposit based.................................................... 7,841.5 7,906.4 7,998.1 7,956.5
Separate accounts and investment trust liabilities............... 2,002.0 2,368.4 2,216.3 2,431.6
Health............................................................. 5,518.1 5,143.3 5,376.3 5,063.8
Life:
Interest sensitive............................................... 4,122.9 4,033.7 4,052.7 4,033.2
Non-interest sensitive........................................... 1,889.7 2,497.1 2,089.7 2,471.1
--------- --------- --------- ---------
Total average liabilities for insurance and asset
accumulation products, net of reinsurance ceded.............. $23,712.0 $24,943.2 $24,241.7 $24,953.8
========= ========= ========= =========
Revenues:
Insurance policy income.............................................. $ 800.6 $ 803.1 $ 2,375.1 $ 2,421.8
Net investment income:
General account invested assets.................................... 367.7 426.2 1,151.8 1,271.3
Equity-indexed products based on the change in
value of the S&P 500 Call Options................................ (27.3) (28.2) (97.8) (84.3)
Separate account assets............................................ (5.3) (1.5) (8.5) (3.4)
Fee revenue and other income......................................... 21.5 25.2 74.9 77.5
--------- --------- --------- ---------
Total revenues (a)............................................... 1,157.2 1,224.8 3,495.5 3,682.9
--------- --------- --------- ---------
Expenses:
Insurance policy benefits............................................ 729.3 606.0 1,907.0 1,797.1
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.................................... 120.8 131.5 377.3 394.8
Equity-indexed products based on S&P 500 Index..................... (3.7) .1 (18.9) 2.2
Separate account liabilities....................................... (5.3) (1.5) (8.5) (3.4)
Amortization related to operations................................... 182.5 148.3 579.6 455.2
Interest expense on investment borrowings............................ 1.1 7.8 11.4 22.7
Other operating costs and expenses................................... 139.6 135.1 397.5 418.5
--------- --------- --------- ---------
Total benefits and expenses (a).................................. 1,164.3 1,027.3 3,245.4 3,087.1
--------- --------- --------- ---------
Operating income before goodwill amortization, goodwill
impairment, income taxes and minority interest................. (7.1) 197.5 250.1 595.8
Goodwill amortization................................................... - (27.0) - (79.9)
Goodwill impairment..................................................... (500.0) - (500.0) -
Net investment losses, including related costs and amortization......... (249.2) (152.1) (500.3) (271.0)
Special charges and additional amortization............................. (2.2) (4.7) (42.0) (17.4)
--------- --------- --------- ---------
Income (loss) before income taxes, minority interest,
extraordinary gain (loss) and cumulative effect of
accounting change.............................................. $ (758.5) $ 13.7 $ (792.2) $ 227.5
========= ========= ========= =========
(continued)
59
CONSECO, INC. AND SUBSIDIARIES
--------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 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)............... 4.00% 4.45% 4.33% 4.42%
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....................................... 2.36% 2.17% 2.19% 2.23%
Health loss ratios:
All health lines:
Insurance policy benefits................................... $575.0 $438.7 $1,492.1 $1,324.1
Loss ratio.................................................. 96.25% 75.00% 83.17% 75.12%
Medicare Supplement:
Insurance policy benefits................................... $161.8 $159.3 $491.6 $488.9
Loss ratio.................................................. 64.07% 65.87% 65.33% 67.00%
Long-Term Care:
Insurance policy benefits................................... $323.8 $195.5 $741.0 $571.9
Loss ratio.................................................. 144.82% 88.73% 110.08% 86.97%
Interest-adjusted loss ratio................................ 122.44% 69.53% 88.52% 68.24%
Specified Disease:
Insurance policy benefits................................... $66.1 $59.1 $192.6 $186.3
Loss ratio.................................................. 71.50% 64.29% 68.72% 66.90%
Other:
Insurance policy benefits................................... $23.3 $24.8 $66.9 $77.0
Loss ratio.................................................. 80.78% 80.39% 75.87% 79.47%
- --------------------
(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 financial strength
ratings were downgraded by A.M. Best on August 14, 2002 to "B (fair)" and the
ratings remain "under review with developing implications". The downgrade has
caused sales of our insurance products to fall and policyholder redemptions and
lapses to increase. This has had a material adverse impact on our financial
results. 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 operations and the major medical business in run-off.
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.
60
CONSECO, INC. AND SUBSIDIARIES
--------------------
Collections on insurance products from continuing operations were $1.1
billion in the third quarter of 2002, down 6.9 percent from 2001. Collections on
insurance products from continuing operations were $3.3 billion in the first
nine months of 2002, down 5.8 percent from 2001. Sales of our insurance products
were adversely affected by the A.M. Best downgrade described above. See "Premium
and Asset Accumulation Product Collections" for further analysis.
Average liabilities for insurance and asset accumulation products, net of
reinsurance receivables, were $23.7 billion in the third quarter of 2002, down
4.9 percent from 2001. Average liabilities for insurance and asset accumulation
products, net of reinsurance receivables, were $24.2 billion in the first nine
months of 2002, down 2.9 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. In addition, policyholder redemptions and lapses have increased following
the downgrade of our A.M. Best financial strength rating to "B (fair)". See the
notes to the consolidated financial statements under the caption "Reinsurance"
for additional discussion of the reinsurance transactions. See "Liquidity for
insurance and fee-based operations" within "Management's Discussion and Analysis
of Financial Condition and Results of Operations" for additional discussion of
the A.M. Best ratings downgrade.
Insurance policy income is comprised of: (i) premiums earned on policies
which provide mortality or morbidity coverage; and (ii) fees and other charges
made against other policies. See "Premium and Asset Accumulation Product
Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on 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 $367.7 million in the third quarter of 2002, down
14 percent from the same period in 2001 and was $1,151.8 million in the first
nine months of 2002, down 9.4 percent from 2001. The average balance of general
account invested assets in the third quarter of 2002 decreased 6.4 percent to
$22.6 billion compared to the same period in 2001. The yield on these assets was
6.5 percent in 2002 and 7.1 percent in 2001. The average balance of general
account invested assets decreased by .7 percent in the first nine months of 2002
to $23.6 billion compared to the same period in 2001. The yield on these assets
decreased by .6 percentage points to 6.5 percent during the first nine 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 reinsurance transactions. 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 $20.7 million and $28.2 million in the third quarters of 2002 and
2001, respectively; and $72.9 million and $89.7 million in the first nine 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 $(6.6) million and nil in the third quarters of 2002 and 2001,
respectively; and $(24.8) million and $5.4 million in the first nine months of
2002 and 2001, respectively. Such amounts were partially offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products of $(3.7) million and $.1 million in the third
quarters of 2002 and 2001, respectively; and $(18.9) million and $2.2 million in
the first nine 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 policyholder account balances subject to this benefit and
to the performance of the S&P 500 Index to which the returns on such products
are linked.
Net investment income (loss) from separate account assets is offset by a
corresponding charge (credit) to amounts added to policyholder account balances
for separate account liabilities. Such income (loss) and related charge (credit)
fluctuated in relationship to total separate account assets and the return
earned on such assets.
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 nine months ended September 30,
2002, this amount includes $6.2 million and $19.4 million, respectively, of
affiliated fee revenue earned by our subsidiary in India compared to $3.0
million in the comparable periods of 2001. Such revenue is eliminated in
61
CONSECO, INC. AND SUBSIDIARIES
--------------------
consolidation. Excluding such affiliated income, fee revenue and other income
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. The
Company has recently sold its India subsidiary and expects to reduce the
customer service and backroom operations conducted there. See the note to the
consolidated financial statements entitled "Subsequent Events."
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.
During the third quarter of 2002, the Company conducted an extensive
examination of the assumptions used to estimate its claim reserves for long-term
care products sold through its independent agent distribution channel. The
examination was prompted by the continuing claim reserve deficiencies that had
been experienced in recent periods based on the assumptions and estimates made
by our actuaries. The Company engaged an independent actuarial firm to assist in
the examination.
The Company's prior reserve estimates were based on claim continuance
tables using experience for the period from January 1, 1990 through September
30, 1999. These tables are used to estimate the length of time an insured will
receive covered long-term care for an incurred event.
In the third quarter of 2002, we completed studies which indicated that the
length of time an insured will receive covered care has increased in recent
periods. In addition, the Company has experienced significant fluctuations in
claim inventories for these products. Accordingly, our actuaries and an
independent actuarial firm concluded that estimates of future claim payments for
incurred claims using the more recent data reflecting the longer covered care
time periods were more appropriate than estimates based on prior data. The
changes in estimation in calculating the reserves resulted in an increase to
insurance policy benefits of $110.0 million in the third quarter of 2002.
Excluding this adjustment related to the change in estimate, insurance policy
benefits on long-term care policies would have been $213.8 million, the loss
ratio for the three month period ended September 30, 2002 would have been 95.62
percent, and the interest-adjusted loss ratio for the three month period ended
September 30, 2002 would have been 73.24 percent.
The loss ratios for long-term care products also increased in 2002 due to
the higher level of benefits paid out on these products as the policies age. The
net cash flows from our long-term care products generally result in the
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the loss ratio will
typically increase, but the increase in the change in reserve will be partially
offset by investment income earned on the assets which have accumulated. The
interest-adjusted loss ratio for long-term care products is calculated by taking
the insurance product's (i) policy benefits less interest income on the
accumulated assets which back the insurance liabilities; divided by (ii) policy
income.
We experienced higher than expected claims on our specified disease
business in the third quarter of 2002. As a result, our loss ratio increased.
Notwithstanding the increased loss ratio, this block of business is performing
within our expectations.
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 8.1 percent in the third quarter of 2002 to $120.8 million and by
4.4 percent in the first nine months of 2002 to $377.3 million, as compared to
the same periods in the prior year. This decrease is primarily due to the
decrease in the weighted average crediting rates. The weighted average crediting
rates for these annuity liabilities was 4.3 percent and 4.5 percent for the
first nine months of 2002 and 2001, respectively. In addition, policyholder
redemptions have increased following the downgrade of our A.M. Best financial
strength rating to "B (fair)". See "Liquidity for insurance and fee-based
operations" within "Management's Discussion and Analysis of Financial Condition
and Results of Operations" for additional discussion of the A.M. Best ratings
downgrade.
Amounts added to equity-indexed products and separate account liabilities
correspond to the related investment income accounts described above.
62
CONSECO, INC. AND SUBSIDIARIES
--------------------
Amortization related to operations includes amortization of the cost of
policies produced and the cost of policies purchased. Amortization generally
fluctuates in relationship to the total account balances subject to
amortization.
Policyholder redemptions of annuity and, to a lesser extent, life products
have increased in recent periods. We have experienced additional redemptions
following the downgrade of our A.M. Best financial strength rating to "B
(fair)". When redemptions are greater than our previous assumptions, we are
required to accelerate the amortization of our cost of policies produced and
cost of policies purchased to write off the balance associated with the redeemed
policies. Accordingly, amortization expense has increased. We have changed the
lapse assumptions used to determine the amortization of the cost of policies
produced and the cost of policies purchased related to certain universal life
products and our annuities to reflect our current estimates of future lapses.
These changes resulted in additional amortization of $48 million in the quarter
ended September 30, 2002 and $122 million in the nine months ended September 30,
2002. 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. Policyholder withdrawals in recent periods have exceeded our
estimates. Such withdrawals were $2,528.3 million in 2001 and $749.9 million,
$837.9 million and $1,149.3 million in the first, second and third quarters of
2002, respectively. 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 previously expected for the next several quarters.
Interest expense on investment borrowings decreased while our investment
borrowing activities increased. Average investment borrowings were $1,226.4
million during the first nine months of 2002 compared to $608.7 million during
the same period of 2001. The weighted average interest rates on such borrowings
were 1.3 percent and 5.5 percent during the first nine months of 2002 and 2001,
respectively.
Other operating costs and expenses increased by 3.3 percent in the third
quarter of 2002 to $139.6 million. Such expenses decreased 5.0 percent in the
first nine months of 2002, to $397.5 million, as compared to the first nine
months of 2001 consistent with our cost cutting programs and the current
business plans for the segment. The 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
were 2.36 percent and 2.19 percent for the three and nine months ended September
30, 2002, respectively, compared to 2.17 percent and 2.23 percent for the three
and nine months ended September 30, 2001, respectively. The increase in the
ratio in the third quarter of 2002, as compared to the same period in the prior
year, is primarily due to the decrease in average liabilities for insurance and
asset accumulation products resulting from the ceding of approximately $870
million of insurance liabilities in the first quarter of 2002.
Net investment gains (losses), including related costs and amortization
fluctuate from period to period. During the first nine months of 2002, we
recognized net investment losses of $524.9 million, compared to $302.7 million
during the comparable period of 2001. During the first nine months of 2002, we
recorded $489.8 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.
The net investment losses during the first nine months of 2001 included: (i)
$251.4 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)
$51.3 million of net losses from the sales of investments (primarily fixed
maturities). 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 a reduction in the
amortization of the cost of policies purchased and the cost of policies produced
of $22.5 million and $4.5 million in the third quarters of 2002 and 2001,
respectively, and $24.6 million and $31.7 million in the first nine months of
2002 and 2001, respectively.
Special charges in 2002 include: (i) losses of $34.5 million on reinsurance
and asset sale transactions entered into as part of our cash raising initiatives
(all recognized in the second quarter of 2002); and (ii) other items totaling
$7.5 million ($2.2 million of which was recognized in the third 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 three and nine months ended September 30, 2001, were $4.7
million and $17.4 million, respectively. Such charges primarily relate to
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CONSECO, INC. AND SUBSIDIARIES
--------------------
severance benefits, costs incurred in conjunction with the transfer of certain
customer service and backroom operations to our India subsidiary. These charges
are described in greater detail in the note to the accompanying consolidated
financial statements entitled "Special Charges".
Finance operations
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Contract originations:
Manufactured housing..................................... $ 277.9 $ 707.1 $ 936.7 $ 1,869.4
Mortgage services........................................ 686.0 932.4 2,060.1 2,208.7
Retail credit............................................ 875.0 937.6 2,520.5 2,745.7
Consumer finance - closed-end............................ 7.7 - 12.4 -
Floorplan................................................ 1.5 540.9 452.2 1,565.0
Discontinued............................................. 5.7 10.1 20.5 76.8
--------- --------- --------- ---------
Total.................................................. $ 1,853.8 $ 3,128.1 $ 6,002.4 $ 8,465.6
========= ========= ========= =========
Sales of finance receivables:
Manufactured housing..................................... $ 202.5 $ 3.1 $ 207.3 $ 3.1
Mortgage services........................................ 665.3 91.6 1,031.8 756.4
Floorplan................................................ - - 126.8 -
Discontinued lines....................................... 60.0 - 233.8 802.3
--------- --------- --------- ---------
Total.................................................. $ 927.8 $ 94.7 $ 1,599.7 $ 1,561.8
========= ========= ========= =========
Managed receivables (average):
Manufactured housing..................................... $24,308.9 $25,890.3 $24,822.4 $26,053.5
Mortgage services........................................ 10,521.2 12,298.4 11,064.8 12,702.4
Retail credit............................................ 2,821.6 2,508.2 2,723.0 2,125.3
Consumer finance - closed-end............................ 1,151.4 1,643.4 1,267.2 1,802.4
Floorplan................................................ 229.6 1,059.2 550.0 1,244.2
Discontinued lines....................................... 182.3 558.8 320.5 722.2
--------- --------- --------- ---------
Total.................................................. $39,215.0 $43,958.3 $40,747.9 $44,650.0
========= ========= ========= =========
Revenues:
Net investment income:
Finance receivables and other.......................... $ 512.8 $ 553.0 $ 1,586.5 $ 1,612.6
Retained interest...................................... 23.5 33.7 69.7 102.5
Gain (loss) on sales of finance receivables.............. (31.3) 6.0 (13.9) 21.6
Fee revenue and other income............................. 70.1 82.1 201.3 257.4
--------- --------- --------- ---------
Total revenues......................................... 575.1 674.8 1,843.6 1,994.1
--------- --------- --------- ---------
Expenses:
Provision for losses..................................... 234.2 134.2 550.9 360.9
Finance interest expense................................. 284.8 308.6 860.3 936.8
Other operating costs and expenses....................... 176.1 159.5 478.7 480.2
--------- --------- --------- ---------
Total expenses......................................... 695.1 602.3 1,889.9 1,777.9
--------- --------- --------- ---------
Operating income (loss) before special charges,
impairment charges and income taxes.................. (120.0) 72.5 (46.3) 216.2
Special charges............................................. (53.4) (.5) (109.9) (16.7)
Impairment charges.......................................... (701.3) (345.2) (701.3) (386.9)
--------- --------- --------- ---------
Loss before income taxes............................... $ (874.7) $ (273.2) $ (857.5) $ (187.4)
========= ========= ========= =========
64
CONSECO, INC. AND SUBSIDIARIES
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General: Conseco's leveraged condition and liquidity difficulties have
severely impacted the operations of Conseco Finance, principally by eliminating
Conseco Finance's access to the securitization markets. The securitization
markets have been Conseco Finance's main source of funding. The loss of access
to the securitization markets has severely affected Conseco Finance's ability to
originate, purchase and sell loans. It has also affected the value of the
retained interests Conseco Finance holds in securitization trusts, since Conseco
Finance relied on the securitization markets to finance the sale of repossessed
manufactured housing units which often helped to minimize the loss on defaulted
loans (compared to selling directly to the manufactured housing wholesale
channel).
Conseco Finance's remaining liquidity sources are a warehouse and a
residual facility with Lehman and a credit facility with U.S. Bank. Conseco
Finance's diminished access to the securitization markets and the constrained
liquidity under its other funding sources have had a material adverse effect on
Conseco Finance's business and results of operations.
Conseco Finance is currently in violation of several financial covenants
required by its warehouse and residual facilities and other credit facility.
Conseco Finance has entered into a forbearance agreement with Lehman pursuant to
which Lehman has agreed to temporarily refrain from exercising any rights
arising from events of default that occurred under the warehouse and residual
facilities as of the date of such forbearance agreement, including certain
events of default triggered by Conseco Finance not being in compliance with
certain financial covenants. This forbearance agreement expires on November 29,
2002 and is subject to various conditions. In addition, Conseco Finance was not
in compliance with various financial covenants with respect to its bank credit
facility. Conseco Finance is currently in the process of attempting to obtain a
forbearance or similar agreement with U.S. Bank. Absent the forbearance or
similar agreement, the covenant violation gives the lender the right to declare
all borrowings under the bank credit facility due and payable ($75.0 million was
outstanding pursuant to this facility at September 30, 2002).
Conseco Finance has obtained a waiver from U.S. Bank in connection with
cross-defaults that have occurred under this credit facility resulting from
Conseco defaulting on its debt obligations. This waiver also provides for
amendments to the credit facility that further restrict Conseco Finance's access
to liquidity by successive step-downs in the size of the facility and for the
termination of the facility and its repayment in full by December 31, 2002. This
waiver expires on November 30, 2002 and is subject to various conditions.
Conseco Finance's residual facility is collateralized by retained interests
in securitizations. Conseco Finance is required to maintain collateral based on
current estimated fair values in accordance with the terms of such facility. Due
to the decrease in the estimated fair value of its retained interests, Conseco
Finance's collateral was $128.9 million deficient at September 30, 2002 (as
calculated in accordance with the relevant transaction documents). Conseco
Finance has executed a forbearance agreement with Lehman in which, among other
things, Lehman has agreed not to require additional collateral with respect to
the residual facility through November 29, 2002. Under the terms of the
forebearance agreement, Lehman is retaining certain cash flows from Conseco
Finance's retained interests pledged to this facility and applying these cash
flows to the margin deficit. Conseco Finance is currently unable to provide
sufficient additional collateral or repay this residual facility.
On October 22, 2002, Conseco announced that its board of directors approved
a plan to seek new investors or acquirers for Conseco's finance businesses and
that it had engaged the investment banking firms of Lazard Freres & Co., LLC and
Credit Suisse First Boston to pursue various alternatives, including securing
new investors and/or selling Conseco Finance's three lines of business: (i)
manufactured housing; (ii) mortgage services; and (iii) consumer finance.
In furtherance of this effort, Conseco Finance has initiated a process to
sell Mill Creek Bank and its home equity and private label credit card
businesses. On behalf of Conseco Finance, Credit Suisse First Boston has
received several non-binding indications of interest to acquire Mill Creek Bank.
Non-binding indications of interest have also been received in connection with
the potential acquisition of the home equity and private label businesses.
Although Conseco Finance intends to maximize the value obtainable from any
such restructuring transaction, there can be no assurance that any transaction
in connection with Mill Creek Bank or the home equity and private label credit
card businesses will be completed or if completed, whether it will satisfy
Conseco Finance's expected liquidity requirements.
Conseco Finance is also undertaking efforts to restructure its manufactured
housing business. Originations have been significantly curtailed and Conseco
Finance is analyzing potential approaches to reducing the negative cash flow
that currently results from the servicing of this portfolio and the payment of
guarantees on the B-2 securities issued in connection with securitizations of
manufactured housing receivables. These approaches may require amendments of
documentation with respect to the manufactured housing securitizations and such
65
CONSECO, INC. AND SUBSIDIARIES
--------------------
amendments may require the approval of a majority or supermajority of the
investors in some or all of the classes of securities issued under those
securitizations on a transaction by transaction basis. There can be no assurance
that Conseco Finance will be successful in receiving such consents, effecting
such amendments, or otherwise restructuring its manufactured housing business.
Conseco Finance provides financing for manufactured housing, home equity,
home improvements, consumer products and equipment, and provides consumer and
commercial revolving credit. Finance products include both fixed-term and
revolving loans and leases. Conseco Finance 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 have generally been structured to include
provisions that entitle Conseco Finance 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 Conseco Finance. In addition, our securitization
transactions are structured so that Conseco Finance, 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 impair their ability to meet their payment obligations.
Higher industry inventory levels of repossessed manufactured homes have affected
recovery rates and may 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 have a material adverse effect on
our financial condition and results of operations.
Loan originations in the third quarter of 2002 were $1.9 billion, down 41
percent from 2001. Loan originations in the first nine months of 2002 were $6.0
billion, down 29 percent from 2001. Given our limited liquidity and inability to
access the securitization market, we no longer originate certain types of loans.
We are limiting future originations primarily to loans we believe can be sold at
a profit in whole-loan sale transactions. In our manufactured housing unit, we
recently announced our decision to shift our focus to the land home business due
to industry wide limitations on access to financing of chattel products
(financing that is secured only by the housing unit itself). These decisions and
continued constraints on liquidity have resulted in origination volume which is
significantly lower than prior periods.
Sales of finance receivables in the first nine months of 2002 and 2001
include the sale of $1.2 billion and $1.6 billion, respectively, of finance
receivables, on which we recognized a loss of $13.9 million and a gain of $21.6
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 nine months of 2002 as part of our cash raising
arrangements.
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 $39.2
billion in the third quarter of 2002, down 11 percent from the same period in
66
CONSECO, INC. AND SUBSIDIARIES
--------------------
2001, and to $40.7 billion in the first nine months of 2002, down 8.7 percent
from the same period in 2001. The decrease reflects the recent decreases in loan
originations described above.
Net investment income on finance receivables and other consists of: (i)
interest earned on finance receivables; and (ii) interest income on short-term
and other investments. Such income decreased by 7.3 percent, to $512.8 million,
in the third quarter of 2002, and by 1.6 percent, to $1,586.5 million in the
first nine months of 2002, as compared to the same periods in 2001. At September
30, 2002, on-balance sheet finance receivables decreased 6.1 percent to $16.5
billion as compared to September 30, 2001. The weighted average yields earned on
finance receivables and other investments were 10.6 percent and 11.9 percent
during the third quarters of 2002 and 2001, respectively, and such weighted
average yields were 10.8 percent and 12.2 percent during the first nine months
of 2002 and 2001, respectively. The average yield decreased due to the declining
interest rate environment, change in product mix of the portfolio, and rising
delinquencies primarily in our manufactured housing business.
Net investment income on retained interests is the income recognized on the
interest-only securities we retain after we sell finance receivables and our
actively managed fixed maturity securities. Such income decreased by 30 percent,
to $23.5 million, in the third quarter of 2002, and by 32 percent, to $69.7
million in the first nine months of 2002, as compared to the same periods in
2001. The decrease is consistent with the change in the average balance of
retained interests. The weighted average yields earned on retained interests
were 13.3 percent and 14.4 percent during the first nine 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 retained interests from
such transactions. Accordingly, future investment income accreted on the
retained interests will decrease, as cash remittances from the prior
gain-on-sale securitizations reduce the retained interests balances. In
addition, the balance of the retained interests was reduced by $585.5 and $264.8
million during 2002 and 2001, respectively, due to impairment charges.
Impairment charges are further explained below.
Gain (loss) on sales of finance receivables in the first nine months of
2002 resulted from the sale of $1.2 billion of finance receivables which
generated net losses of $13.9 million. In the three months ended September 30,
2002, we sold $.9 billion of finance receivables which generated losses of $31.3
million. In the third quarter of 2002, we recognized a lower of cost or market
adjustment of $16.7 million to record an allowance for unsecuritized finance
receivables with market values below carrying value. In the first nine months of
2001, we sold $1.6 billion of receivables including: (i) our $802.3 million
vendor services loan portfolio (which was marked-to-market in the fourth quarter
of 2000 and no additional gain or loss was recognized in the first nine months
of 2001); (ii) $568.4 million of high-loan-to-value mortgage loans; and (iii)
$191.1 million of other loans. These sales resulted in net gains of $6.0 million
and $21.6 million in the three and nine months ended September 30, 2001,
respectively.
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 15 percent, to $70.1
million, in the third quarter of 2002, and by 22 percent, to $201.3 million in
the first nine months of 2002, as compared to the same periods in 2001. Such
decreases are 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 $18.3 million and $32.6 million in the third quarters of
2002 and 2001, respectively, and $54.5 million and $89.0 million in the first
nine months of 2002 and 2001, respectively. We expect servicing income to
continue to decline in future periods as the managed receivables in these
securitizations are paid down.
Provision for losses related to finance operations increased by 75 percent,
to $234.2 million, in the third quarter of 2002, and by 53 percent, to $550.9
million in the first nine months of 2002, as compared to the same periods in
2001. These amounts relate to our on-balance sheet finance receivables. Our
credit losses as a percentage of related loan balances for our on-balance sheet
portfolio have been increasing over the last several quarters (2.26 percent,
2.36 percent, 2.53 percent, 2.61 percent and 2.76 percent for the quarters ended
September 30, 2001, December 31, 2001, March 31, 2002, June 30, 2002 and
September 30, 2002, respectively). The increases to the provision and our credit
losses are due to many factors including: (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
67
CONSECO, INC. AND SUBSIDIARIES
--------------------
are sold given current industry levels of repossessed assets. At September 30,
2002 and 2001, the 60-days-and-over delinquencies as a percentage of on-balance
sheet finance receivables were 2.73 percent and 1.82 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 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.
Delinquencies on loans held in our loan portfolio and our ability to
recover collateral and mitigate loan losses are adversely impacted by a variety
of factors, many of which are outside of 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.
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. Conseco Finance 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 Conseco Finance may fall further, which could have a further material
adverse effect on the financial position and results of our operations.
At September 30, 2002, Conseco Finance had a total of 18,739 unsold
manufactured housing properties (11,754 of which relate to our off-balance sheet
securitizations) in repossession, compared to 14,333 properties (10,438 of which
relate to our off-balance sheet securitizations) at September 30, 2001. We
reduce the value of repossessed property to our estimate of net realizable value
upon repossession. We liquidated 18,410 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 60 percent in the first nine months of 2002
compared to 19,387 units at an average loss severity rate of 56 percent in the
first nine months of 2001. The loss severity rate related to our on-balance
sheet manufactured housing portfolio was 53 percent in the first nine months of
2002, compared to 48 percent in the first nine 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 September 30, 2002, have adversely affected
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 has made 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. During the quarter ended September 30, 2002, Conseco
Finance's ability to access the securitization markets was eliminated. The
securitization markets have been Conseco Finance's main source of funding for
loans made to purchasers of repossessed manufactured homes. Conseco Finance
believes that its severity rates were positively impacted when it used retail
channels to dispose of repossessed inventory (where the repossessed units are
sold through company-owned sales lots or our dealer network). Since Conseco
Finance is no longer able to fund the loans made on repossessed homes sold
through these channels, sales through these channels have decreased and we must
rely on the wholesale channel to dispose of repossessed manufactured housing
units, through which recovery rates are typically significantly lower.
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.
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CONSECO, INC. AND SUBSIDIARIES
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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 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. Loss
mitigation policies were applied to 2.8 percent of average managed accounts in
the third quarter of 2002, compared to 2.9 percent, 3.1 percent, 3.0 percent and
2.7 percent of average managed accounts during the third and fourth quarters of
2001 and the first and second quarters of 2002, respectively.
Finance interest expense decreased by 7.7 percent, to $284.8 million, in
the third quarter of 2002, and by 8.2 percent, to $860.3 million in the first
nine months of 2002, as compared to the same periods in 2001. Such decrease was
primarily the result of: (i) lower average borrowing rates; and (ii) decreased
borrowings to fund the decreased finance receivables. Our average borrowing rate
decreased to 6.1 percent in the third quarter of 2002 from 6.9 percent in the
third quarter of 2001. Our average borrowing rate during the first nine months
of 2002 was 6.1 percent compared to 7.2 percent during the first nine months of
2001. The decrease in average borrowing rates in 2002 as compared to the same
period in 2001 is due to the decrease in the general interest rate environment
between periods and the repurchase and retirement of some of our public debt.
Other operating costs and expenses include the costs associated with
servicing our managed receivables, non-deferrable costs related to originating
new loans and other operating costs. Such expenses increased by 10 percent, to
$176.1 million, in the third quarter of 2002, and decreased by .3 percent, to
$478.7 million in the first nine months of 2002, as compared to the same periods
in 2001. In the third quarter of 2002, we accrued $26.8 million pursuant to
judgments issued in two arbitration proceedings. Such litigation is described in
greater detail in the note to the accompanying consolidated financial statements
entitled "Litigation and Other Legal Proceedings". Excluding the litigation
accrual, such costs have decreased due to the realization of the benefits from
our cost saving initiatives and a decrease in origination volumes.
Special charges in the finance segment for the 2002 periods include: (i)
the loss of $94.4 million related to the sales of certain finance receivables of
$383 million and $1.6 million of additional loss related to receivables required
to be repurchased from the purchaser of the vendor services receivables pursuant
to the repurchase clauses in the agreements; (ii) a $30.1 million charge for
costs associated with various modifications to financing arrangements and
recognition of deferred expenses for terminated warehouse facilities; (iii) a
$16.3 million charge for the abandonment of computer processing systems; (iv) a
$38.1 million benefit due to the reduction in the value of the warrant held by
Lehman to purchase five percent of Conseco Finance, which was caused by a
decrease in the value of Conseco Finance; and (v) restructuring and other
charges of $5.6 million. Special charges recorded for the 2001 periods include:
(i) the loss related to the sale of certain finance receivables of $11.2 million
(none of which was recognized in the third quarter of 2001); and (ii) severance
benefits of $5.5 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 servicing rights) recognized as a
loss in the statement of operations. We carry retained interests 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 retained
interests. 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
retained interests 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 retained interests 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 inaccurate,
in which case there may be an adverse effect on our financial results.
The determination of the value of our retained interests in securitization
trusts requires significant judgment. The Company has recognized significant
charges when the interest-only securities did not perform as well as anticipated
based on our assumptions and expectations. Our current valuation of retained
interests may prove inaccurate in future periods. In securitizations to which
69
CONSECO, INC. AND SUBSIDIARIES
--------------------
these retained interests relate, Conseco Finance has retained certain contingent
risks in the form of guarantees of certain lower rated securities issued by the
securitization trusts. As of September 30, 2002, the total amount of these
guarantees was approximately $1.4 billion. We consider any potential payments
related to these guarantees in the projected cash flows used to determine the
value of our retained interests. See the note to the consolidated financial
statements entitled "Guarantees."
During the quarter ended September 30, 2002, Conseco Finance's ability to
access the securitization markets was eliminated. The securitization markets
have been Conseco Finance's main source of funding for loans made to purchasers
of repossessed manufactured homes. Conseco Finance believes that its loss
severity rates were positively impacted when it used retail channels to dispose
of repossessed inventory (where the repossessed units are sold through
company-owned sales lots or our dealer network). Since Conseco Finance is no
longer able to fund the loans made on repossessed homes sold through these
channels, sales through these channels have decreased and we must place greater
reliance on the wholesale channel to dispose of repossessed manufactured housing
units, through which recovery rates are typically significantly lower.
Accordingly, we changed the loss severity assumptions we use to value our
retained interests to reflect the higher loss severity we expect to experience
in the future. In addition, our previous assumptions reflected our belief that
the adverse manufactured housing default experience in recent periods would
continue through the first half of 2002 and then improve over time. Default
experience did not improve as expected. Accordingly, we increased the default
assumptions we use to value our retained interests to reflect our future
expectations based on current default rates. Our home equity/home improvement
assumptions have also been adjusted to reflect recent default experience as well
as our future expectations.
As a result of the requirements of EITF 99-20 and the assumption changes
described above, we recognized an impairment charge (net of adjustments to the
valuation allowance associated with our servicing rights) of $585.5 million in
the first nine months of 2002 for the retained beneficial interests. We also
recognized a $115.8 million increase in the valuation allowance related to our
servicing rights as a result of the changes in assumptions in the first nine
months of 2002.
We recognized an impairment charge of $386.9 million in the first nine
months of 2001 for the interest-only securities that were not performing as well
as expected based on our previous valuation estimates.
70
CONSECO, INC. AND SUBSIDIARIES
--------------------
The credit quality of managed finance receivables was as follows:
September 30, December 31,
2002 2001
---- ----
60-days-and-over delinquencies as a percentage of managed finance
receivables at period end:
Manufactured housing.................................................... 2.92% 2.45%
Mortgage services (a)................................................... 1.34 1.23
Retail credit........................................................... 2.55 3.39
Consumer finance - closed-end........................................... .84 1.08
Floorplan............................................................... 1.76 .58
Discontinued lines...................................................... 4.69 3.50
Total................................................................. 2.42% 2.10%
Net credit losses incurred during the last twelve months as a percentage
of average managed finance receivables during the period:
Manufactured housing.................................................... 2.33% 2.14%
Mortgage services....................................................... 2.19 1.95
Retail credit........................................................... 6.16 6.65
Consumer finance - closed-end........................................... 3.28 2.50
Floorplan............................................................... 1.36 1.00
Discontinued lines...................................................... 8.24 5.73
Total................................................................. 2.61% 2.35%
Repossessed collateral inventory as a percentage of managed finance
receivables at period end (b):
Manufactured housing.................................................... 3.16% 2.45%
Mortgage services (c)................................................... 5.16 4.07
Retail credit........................................................... .18 .13
Consumer finance - closed-end........................................... 1.16 1.03
Floorplan............................................................... 2.49 .69
Discontinued lines...................................................... 1.89 4.20
Total................................................................. 3.40% 2.68%
- -------------
(a) 60-days-and-over delinquencies exclude loans in the process of foreclosure.
(b) Ratio of: (i) outstanding loan principal balance related to the repossessed
inventory (before writedown) to: (ii) total receivables. 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.
71
CONSECO, INC. AND SUBSIDIARIES
--------------------
The credit quality of on-balance sheet finance receivables was as follows:
September 30, December 31,
2002 2001
---- ----
60-days-and-over delinquencies as a percentage of on-balance sheet
finance receivables at period end:
Manufactured housing.................................................... 4.06% 3.08%
Mortgage services (a)................................................... 1.19 .94
Retail credit........................................................... 2.55 3.39
Consumer finance - closed-end........................................... .95 1.33
Floorplan............................................................... 1.76 .58
Discontinued lines...................................................... 5.41 2.72
Total................................................................. 2.73% 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.................................................... 2.27% 1.87%
Mortgage services....................................................... 1.93 1.53
Retail credit........................................................... 6.16 6.65
Consumer finance - closed-end........................................... 2.96 2.02
Floorplan............................................................... 1.36 1.00
Discontinued lines...................................................... 6.50 4.66
Total................................................................. 2.76% 2.36%
Repossessed collateral inventory as a percentage of on-balance sheet finance
receivables at period end (b) (c):
Manufactured housing.................................................... 3.73% 2.41%
Mortgage services (d)................................................... 5.00 3.50
Retail credit........................................................... .18 .13
Consumer finance - closed-end........................................... 1.50 1.15
Floorplan............................................................... 2.49 .69
Discontinued lines...................................................... .40 2.92
Total................................................................. 3.52% 2.37%
- --------------
(a) 60-days-and-over delinquencies exclude loans in the process of foreclosure.
(b) Ratio of: (i) outstanding loan principal balance related to the repossessed
inventory (before writedown) to: (ii) total receivables.
(c) Although the ratio is calculated using the outstanding loan principal
balance related to the repossessed inventory, the repossessed inventory 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.
72
CONSECO, INC. AND SUBSIDIARIES
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Corporate operations
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars in millions)
Corporate operations:
Interest expense on corporate debt, net of investment
income on cash and cash equivalents..................... $ (79.5) $ (82.9) $(229.2) $(270.5)
Allocation of interest expense to the finance segment..... - - - 7.3
Investment income......................................... - - - 4.4
Other items............................................... (14.0) (9.2) (32.7) (14.5)
------- ------- ------- -------
Operating loss before non-operating items, income
taxes and minority interest......................... (93.5) (92.1) (261.9) (273.3)
Provision for losses and expense related to stock purchase
plan.................................................... (60.0) (59.6) (200.0) (59.6)
Venture capital loss related to investment in
AWE, net of related expenses............................ (6.6) (69.6) (106.6) (64.5)
Major medical business in run-off......................... - (24.4) - (53.0)
Gain on sale of interest in riverboat..................... - - - 192.4
Special charges and additional amortization............... (32.6) (46.9) (61.1) (113.8)
------- ------- ------- -------
Loss before income taxes and minority interest........ $(192.7) $(292.6) $(629.6) $(371.8)
======= ======= ======= =======
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 $4.6 billion in the first nine months of 2002 and 2001,
respectively. The average interest rate on such debt was 7.8 percent and 8.3
percent in the first nine 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 nine months ended September 30, 2002, we
increased our reserve by $200.0 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 September 30, 2002, the reserve
for losses on the loan guarantees and the liability related to the pay for
performance benefits totaled $620.0 million. The outstanding balance on the bank
loans was $481.3 million. In addition, Conseco has provided loans to
participants for interest on the bank loans totaling $166.6 million. During the
third quarter of 2002, Conseco purchased $55.5 million of loans from the banks
utilizing cash held in a segregated cash account as collateral for our guarantee
of the bank loans. The guarantees of the bank loans are discussed in greater
detail in the note to the accompanying consolidated financial statements
entitled "Guarantees".
Venture capital 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 consolidated financial statements
entitled "Venture Capital Investment in AT&T Wireless Services, Inc." Our
73
CONSECO, INC. AND SUBSIDIARIES
--------------------
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.
The major medical business in run-off includes individual major medical
health insurance products. These lines of business had losses of $24.4 million
and $53.0 million in the three and nine months ended September 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 $20.0 million (recognized in the third quarter of 2002) associated
with the value of a subsidiary which we have entered into an agreement to sell;
(ii) $17.7 million related to debt modification and refinancing transactions (of
which $.3 million was recognized in the third quarter of 2002); (iii)
restructuring expenses of $12.1 million (all of which was recognized in the
third quarter of 2002); (iv) other items totaling $18.8 million (of which $.2
million was recognized in the third quarter of 2002); partially offset by (v)
net gains of $7.5 million related to the sale of certain non-core assets.
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 $21.1 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 in the three and nine months ended September 30, 2001, was $37.4
million and $77.4 million, respectively.
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. In July 2002, A.M. Best lowered the
financial strength ratings of our primary insurance subsidiaries from "A-
(excellent)" to "B++ (very good)" and placed the ratings "under review with
negative implications." In August 2002, A.M. Best further downgraded Conseco's
financial strength rating to "B (fair)". These ratings downgrades have caused
sales of our insurance products to fall and policyholder redemptions and lapses
to increase, which had a material adverse impact on Conseco's financial results.
In some cases, the ratings downgrades have also caused defections among our
sales force of agents and/or increases in the commissions we must pay them. The
effect of the recent ratings downgrades 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
74
CONSECO, INC. AND SUBSIDIARIES
--------------------
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.
75
CONSECO, INC. AND SUBSIDIARIES
--------------------
Total premiums and accumulation product collections were as follows:
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001(a) 2002 2001(a)
---- ------- ---- -------
(Dollars in millions)
Premiums collected by our insurance subsidiaries:
Annuities:
Equity-indexed (first-year)................................ $ 43.6 $ 87.5 $ 167.0 $ 263.7
Equity-indexed (renewal)................................... 4.6 5.9 22.2 27.1
-------- -------- -------- --------
Subtotal - equity-indexed annuities...................... 48.2 93.4 189.2 290.8
-------- -------- -------- --------
Other fixed (first-year)................................... 216.2 191.0 591.6 561.2
Other fixed (renewal)...................................... 6.0 7.3 23.3 25.0
-------- -------- -------- --------
Subtotal - other fixed annuities......................... 222.2 198.3 614.9 586.2
-------- -------- -------- --------
Total annuities.......................................... 270.4 291.7 804.1 877.0
-------- -------- -------- --------
Supplemental health:
Medicare supplement (first-year)........................... 38.6 30.5 122.6 83.9
Medicare supplement (renewal).............................. 211.7 202.1 636.4 640.6
-------- -------- -------- --------
Subtotal - Medicare supplement........................... 250.3 232.6 759.0 724.5
-------- -------- -------- --------
Long-term care (first-year)................................ 23.4 25.9 74.1 79.6
Long-term care (renewal)................................... 204.1 192.0 606.3 582.0
-------- -------- -------- --------
Subtotal - long-term care................................ 227.5 217.9 680.4 661.6
-------- -------- -------- --------
Specified disease (first-year)............................. 8.6 10.2 28.0 31.2
Specified disease (renewal)................................ 81.8 79.4 248.4 246.3
-------- -------- -------- --------
Subtotal - specified disease............................. 90.4 89.6 276.4 277.5
-------- -------- -------- --------
Other health (first-year).................................. 2.2 2.6 9.3 8.5
Other health (renewal)..................................... 17.7 18.3 69.3 72.6
-------- -------- -------- --------
Subtotal - other health.................................. 19.9 20.9 78.6 81.1
-------- -------- -------- --------
Total supplemental health................................ 588.1 561.0 1,794.4 1,744.7
-------- -------- -------- --------
Life insurance:
First-year................................................. 22.5 29.6 75.9 89.9
Renewal.................................................... 90.1 175.0 408.0 542.2
-------- -------- -------- --------
Total life insurance..................................... 112.6 204.6 483.9 632.1
-------- -------- -------- --------
Group major medical:
Group (first-year)......................................... - 1.1 .4 16.0
Group (renewal)............................................ 83.8 75.2 247.8 264.0
-------- -------- -------- --------
Total group major medical................................ 83.8 76.3 248.2 280.0
-------- -------- -------- --------
Collections on insurance products from continuing operations:
Total first-year premium collections on insurance products 355.1 378.4 1,068.9 1,134.0
Total renewal premium collections on insurance products.... 699.8 755.2 2,261.7 2,399.8
-------- -------- -------- --------
Total collections on insurance products.................. $1,054.9 $1,133.6 $3,330.6 $3,533.8
======== ======== ======== ========
Mutual funds (excludes variable annuities)...................... $ 18.1 $ 124.3 $ 144.6 $ 356.1
======== ======== ======== ========
Deposit type contracts.......................................... $ 78.3 $ 39.1 $ 237.5 $ 134.6
======== ======== ======== ========
(continued)
76
CONSECO, INC. AND SUBSIDIARIES
--------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2002 2001(a) 2002 2001(a)
---- ------- ---- -------
(Dollars in millions)
Premiums collected from major medical business in run-off and discontinued operations:
Major medical in run-off:
Individual (first-year).................................... $ 1.5 $ 25.0 $ 15.4 $ 96.3
Individual (renewal)....................................... 15.1 66.8 73.8 196.7
------ ------ ------ ------
Total major medical in run-off........................... 16.6 91.8 89.2 293.0
------ ------ ------ ------
Annuities:
Fixed (first year)......................................... 1.6 2.7 7.4 11.3
Fixed (renewal)............................................ 1.3 1.7 4.4 5.1
------ ------ ------ ------
Subtotal other fixed annuities........................... 2.9 4.4 11.8 16.4
------ ------ ------ ------
Variable (first year)...................................... 57.6 58.4 199.6 239.9
Variable (renewal)......................................... 11.6 14.9 49.0 54.1
------ ------ ------ ------
Subtotal variable annuities.............................. 69.2 73.3 248.6 294.0
------ ------ ------ ------
Total annuities.......................................... 72.1 77.7 260.4 310.4
------ ------ ------ ------
Life insurance:
First-year................................................. .1 .1 .4 .4
Renewal.................................................... - 8.0 - 24.4
------ ------ ------ ------
Total life insurance..................................... .1 8.1 .4 24.8
------ ------ ------ ------
Collections on insurance products from major medical business
in run-off and discontinued operations....................... $ 88.8 $177.6 $350.0 $628.2
====== ====== ====== ======
Deposit type contracts.......................................... $ 1.3 $ 2.3 $ 5.8 $ 6.9
====== ====== ====== ======
- --------------
(a) Certain amounts related to deposit type contracts have been reclassified to
a separate category, to conform to the 2002 presentation.
Continuing operations
Annuities include equity-indexed annuities and other fixed 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 $48.2 million in the third quarter of 2002 compared with
$93.4 million in the third quarter of 2001 and were $189.2 million in the first
nine months of 2002 compared with $290.8 million in the first nine months of
2001. The decrease can be attributed to: (i) the general stock market
performance which has made other investment products more attractive; and (ii)
the effect of the A.M. Best ratings downgrade to "B (fair)."
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CONSECO, INC. AND SUBSIDIARIES
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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 minimum rate. The interest rate credited on SPIAs is based on
market conditions existing when a policy is issued and remains unchanged over
the life of the SPIA. Annuity premiums on these fixed rate annuity products
increased by 12 percent, to $222.2 million, in the third quarter of 2002; and by
4.9 percent, to $614.9 million in the first nine months of 2002, as compared to
the same periods in 2001.
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 7.6
percent, to $250.3 million, in the third quarter of 2002, and by 4.8 percent, to
$759.0 million in the first nine months of 2002, as compared to the same periods
in 2001. Sales of Medicare supplement policies have been affected by increased
premium rates and new sales.
Premiums collected on long-term care policies increased by 4.4 percent, to
$227.5 million, in the third quarter of 2002, and by 2.8 percent, to $680.4
million in the first nine months of 2002, as compared to the same periods in
2001. Such sales have been affected by increased premium rates and new sales.
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.
Life products are sold through career agents, professional independent
producers and direct response distribution channels. Life premiums collected
decreased by 45 percent, to $112.6 million in the third quarter of 2002, and by
23 percent, to $483.9 million in the first nine 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. In addition, the A.M. Best
ratings downgrade to "B (fair)" has negatively affected our sales of life
products.
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.
Group major medical premiums increased by 9.8 percent, to $83.8 million, in
the third quarter of 2002, and decreased by 11 percent, to $248.2 million in the
first nine months of 2002, as compared to the same periods in the prior year.
The increase in the third quarter of 2002 is attributable to rate increases.
Mutual fund sales decreased 85 percent to $18.1 million in the third
quarter of 2002, and by 59 percent, to $144.6 million in the first nine 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
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 100 percent, to $78.3 million, in the
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CONSECO, INC. AND SUBSIDIARIES
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third quarter of 2002, and by 76 percent, to $237.5 million in the first nine
months of 2002, as compared to the same periods in the prior year. Such amounts
often fluctuate from period-to-period.
Major medical business in run-off and discontinued operations
Major medical in run-off includes major medical health insurance products
sold to individuals. 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. Individual health premiums collected in the third quarter
of 2002 decreased by 82 percent, to $16.6 million, and by 70 percent, to $89.2
million in the first nine 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.
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 5.6 percent, to $69.2 million in the third quarter of 2002, and by 15
percent, to $248.6 million in the first nine months of 2002. The decreases in
2002 can be attributed to the general stock market performance, which has made
other investment products more attractive; to our announcement that we planned
to sell this business; and to our ratings downgrades. We closed the sale of our
variable annuity business in the fourth quarter of 2002 and we do not expect to
report any variable annuity premiums in the fourth quarter of 2002.
Life product premiums from discontinued operations represent the life
business of CVIC, which was sold in the fourth quarter of 2002.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between September 30, 2002 and
December 31, 2001, reflect: (i) our net loss for the nine months ended September
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 asset; (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
September 30, 2002, we increased the carrying value of such investments by
$278.2 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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Total capital shown below excludes debt of the finance segment used to fund
finance receivables.
September 30, December 31,
2002 2001
---- ----
(Dollars in millions)
Total capital, excluding accumulated other comprehensive loss:
Corporate notes payable................................................ $4,016.7 $ 4,087.6
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts..................................... 1,919.9 1,914.5
Shareholders' equity:
Preferred stock..................................................... 501.7 499.6
Common stock and additional paid-in capital......................... 3,497.3 3,484.3
Retained earnings (accumulated deficit)............................. (4,941.2) 1,208.1
-------- ---------
Total shareholders' equity (deficit), excluding accumulated
other comprehensive loss...................................... (942.2) 5,192.0
-------- ---------
Total capital, excluding accumulated other comprehensive
loss.......................................................... 4,994.4 11,194.1
Accumulated other comprehensive income (loss).............................. 130.4 (439.0)
-------- ---------
Total capital.................................................... $5,124.8 $10,755.1
======== =========
Corporate notes payable decreased during the first nine 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 (deficit), excluding accumulated other comprehensive
loss, decreased by $6.1 billion in the first nine months of 2002, to $(.9)
billion. The significant component of the decrease was our net loss of $6,147.2
million. The accumulated other comprehensive income (loss) increased by $569.4
million, principally related to the increase in the unrealized gains of our
insurance companies' investment portfolio.
Book value per common share outstanding decreased to $(3.80) at September
30, 2002, from $12.34 at December 31, 2001. Such change was primarily
attributable to our net loss for the nine months ended September 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 $(4.17) at September 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 $100.0 million at September 30, 2002 and $3,695.4 million
at December 31, 2001. Goodwill as a percentage of shareholders' equity was 78
percent at December 31, 2001. Goodwill as a percentage of total capital,
excluding accumulated other comprehensive income (loss), was 2.0 percent at
September 30, 2002 and 33 percent at December 31, 2001. Amortization of goodwill
totaled $82.3 million during the first nine 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 comparing the estimated fair
value of each of the business units comprising our insurance segment to the
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CONSECO, INC. AND SUBSIDIARIES
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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 completed the two-step
impairment test during the second quarter of 2002 and, as a result of that test,
we recorded the cumulative effect of the accounting change for the goodwill
impairment charge of $2,949.2 million for the quarter ended March 31, 2002. The
first quarter of 2002 impairment charge is reflected in the cumulative effect of
an accounting change in the accompanying consolidated statement of operations
for the nine months ended September 30, 2002, and the consolidated financial
statements for the quarter ended March 31, 2002 have been retroactively restated
to reflect this change. Subsequent impairment tests will be performed on an
annual basis in the fourth quarter of each year, or more frequently if
circumstances indicate a possible impairment. Subsequent impairment charges are
classified as an operating expense.
The significant factors used to determine the amount of the initial
impairment included analyses of industry market valuations, historical and
projected performance of our insurance segment, discounted cash flow analyses
and the market value of our capital. The valuation utilized the best available
information, including assumptions and projections we considered reasonable and
supportable. The assumptions we used to determine the discounted cash flows
involve significant judgments regarding the best estimate of future premiums,
expected mortality and morbidity, interest earned and credited rates,
persistency and expenses. The discount rate used was based on an analysis of the
weighted average cost of capital for several insurance companies and considered
the specific risk factors related to Conseco. Pursuant to the guidance in SFAS
142, quoted market prices in active markets are the best evidence of fair value
and shall be used as the basis for measurement, if available.
On August 14, 2002, our insurance subsidiaries' financial strength ratings
were downgraded by A.M. Best to "B (fair)" and on September 8, 2002, the Company
defaulted on its public debt. (See the note to the consolidated financial
statements entitled "Events of Default and Liquidity Issues".) These
developments caused sales of our insurance products to fall and policyholder
redemptions and lapses to increase. The adverse impact on our insurance
subsidiaries resulting from the ratings downgrade and parent company default
required that additional impairment tests be performed as of September 30, 2002
in accordance with SFAS 142.
In connection with our negotiations with debt holders, we retained an
outside actuarial consulting firm to assist in valuing our insurance
subsidiaries. That valuation work was used in performing the additional
impairment tests that resulted in an impairment charge to goodwill in the third
quarter of 2002 of $500.0 million. The charge is reflected in the line item
entitled "Goodwill impairment" in our consolidated statement of operations for
the three and nine month periods ended September 30, 2002. The most significant
changes made to the January 1, 2002 valuation that resulted in the third quarter
2002 impairment charge were: (i) reduced estimates of projected future sales of
insurance products; (ii) increased estimates of future policyholder redemptions
and lapses; and (iii) a higher discount rate to reflect the current rates used
by the market to value life insurance companies as of September 30, 2002.
Management believes that the assumptions and estimates used are reasonable given
all available facts and circumstances. However, if projected cash flows are not
realized in the future, we may be required to recognize additional impairments.
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The following table summarizes certain financial ratios as of and for the
nine months ended September 30, 2002, and as of and for the year ended December
31, 2001:
September 30, December 31,
2002 2001
---- ----
Book value per common share:
As reported.................................................................................. $(3.80) $12.34
Excluding accumulated other comprehensive income (loss) (a).................................. (4.17) 13.61
Excluding goodwill and accumulated other comprehensive income (loss) (a)..................... (4.46) 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.................................................................................. (i) 1.22X
Excluding interest expense on direct third party debt of Conseco Finance (b)................. (i) 1.93X
Ratio of earnings to fixed charges, preferred dividends and distributions
on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts:
As reported................................................................................ (j) (g)
Excluding interest added to policyholder account balances.................................. (j) (g)
Excluding interest added to policyholder account balances
and interest expense on direct third party debt of Conseco Finance (b)................... (j) (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................................................................................ (k) 1.09X
Excluding interest expense on direct third party debt of Conseco Finance (b)............... (k) 1.27X
Rating agency ratios (a) (d) (e):
Corporate debt to total capital.............................................................. 80% 37%
Corporate debt and Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts to total capital...................................................... 119% 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 major medical
business in run-off. Operating earnings are determined by adjusting GAAP
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CONSECO, INC. AND SUBSIDIARIES
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net income for the above mentioned items. 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 $413.7 million less than fixed
charges. Adjusted earnings for the year ended December 31, 2001, included:
(i) special charges of $101.9 million; (ii) impairment charges related to
our retained interests in securitization trusts of $386.9 million; and
(iii) 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 $617.4 million less than fixed
charges. Adjusted earnings for the year ended December 31, 2001, included:
(i) special charges of $101.9 million; (ii) impairment charges related to
our retained interests in securitization trusts of $386.9 million; and
(iii) 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 $2,279.3 million less than fixed
charges. Adjusted earnings for the nine months ended September 30, 2002,
included: (i) special charges of $213.0 million; (ii) impairment charges
related to our retained interests in securitization trusts of $701.3
million; (iii) goodwill impairment charges of $500.0 million; and (iv)
provision for losses related to loan guarantees of $200.0 million, as
described in greater detail in the notes to the accompanying consolidated
financial statements.
(i) For such ratio, adjusted earnings were $192.8 million less than fixed
charges.
(j) For such ratios, adjusted earnings were $2,417.3 million less than fixed
charges. Adjusted earnings for the nine months ended September 30, 2002,
included: (i) special charges of $213.0 million; (ii) impairment charges
related to our retained interests in securitization trusts of $701.3
million; (iii) goodwill impairment charges of $500.0 million; and (iv)
provision for losses related to loan guarantees of $200.0 million, as
described in greater detail in the notes to the accompanying consolidated
financial statements.
(k) For such ratios, adjusted earnings were $330.8 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.
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On August 14, 2002, A.M. Best lowered the financial strength ratings of our
primary insurance subsidiaries from "B++ (very good)" to "B (fair)". A.M. Best
ratings for the industry currently range from "A++ (Superior)" to "F (In
Liquidation)" and some companies are not rated. An "A++" 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, fair balance sheet strength, operating
performance and business profile, when compared to the standards established by
A.M. Best, and have an ability in A.M. Best's opinion to meet their current
obligations to policyholders, but their financial strength is vulnerable to
adverse changes in underwriting and economic conditions. The rating reflects
A.M. Best's view of the uncertainty surrounding our restructuring initiatives
and the potential adverse financial impact on the subsidiaries if negotiations
are protracted and execution of the restructuring plan is delayed. Standard &
Poor's has given our insurance subsidiaries a financial strength rating of "B+".
Rating categories from "BB" to "CCC" are classified as "vulnerable", 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.
The A.M. Best downgrades have caused sales of our insurance products to
decline and policyholder redemptions and lapses to increase. In some cases, the
downgrades have also caused defections among our independent agent sales force
and increases in the commissions we must pay. These events have had a material
adverse effect on our financial results. Further downgrades by A.M. Best or
Standard & Poor's could have further material and adverse effects on our
financial results and liquidity.
During the first nine months of 2002, our insurance subsidiaries paid
dividends to Conseco totaling $240 million. As more fully described in the note
to our consolidated financial statements entitled "Events of Default and
Liquidity Issues", our two insurance subsidiaries domiciled in Texas entered
into consent orders with the Texas Department of Insurance. The consent orders
apply to all of our insurance subsidiaries and, among other things, restrict the
ability of our insurance subsidiaries to pay dividends and other amounts to the
parent company. State laws generally provide state insurance regulatory agencies
with broad authority to protect policyholders in their jurisdictions.
Accordingly, there can be no assurance that the regulators will not seek to
assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs.
Our insurance subsidiaries experienced increased lapse rates on annuity
policies during the first nine months of 2002. We believe that the diversity of
the investment portfolios of our insurance subsidiaries and the concentration of
investments in high-quality, liquid securities provide sufficient liquidity to
meet foreseeable cash requirements of our insurance subsidiaries. Although there
is no present need or intent to dispose of such investments, our 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 insurance subsidiaries 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 subsidiary, Conseco Finance, requires cash to originate finance
receivables. Conseco Finance's primary sources of cash are: (i) the collection
of receivable balances; (ii) proceeds from the issuance of debt, certificates of
deposit, bank credit facility, securitizations, warehouse and residual lines,
and sales of loans; and (iii) cash provided by operations. During 2001 and the
first nine months of 2002, Conseco Finance 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.
Conseco Finance's lenders have severely restricted its access to liquidity.
See "Finance Operations - General" within "Management's Discussion and Analysis
of Financial Condition and Results of Operations" for additional discussion. The
liquidity needs of Conseco Finance 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 impair the ability of our customers to meet
their payment obligations. Higher industry levels of repossessed manufactured
homes have affected recovery rates and resulted in decreased cash flows. In
addition, in an economic slowdown or recession, our servicing and litigation
costs generally increase. Any sustained period of increased delinquencies,
foreclosures, losses or increased costs would have an adverse effect on our
liquidity.
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CONSECO, INC. AND SUBSIDIARIES
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The most significant source of liquidity for Conseco Finance has been its
ability to finance the receivables it originates in the secondary markets
through loan securitizations. Under certain securitization structures, Conseco
Finance has provided a variety of credit enhancements, which have taken the form
of corporate guarantees with respect to certain securitizations (although such
guarantees were not provided during 2001 and the first nine months of 2002), and
have also included bank letters of credit, surety bonds, cash deposits and
over-collateralization or other equivalent collateral. The nominal value of
these guarantees is approximately $1.4 billion and without additional liquidity
in the near future, Conseco Finance will be unable to make these guarantee
payments when such payments are required to be made. When choosing the
appropriate structure for a securitization of loans, cash flows unique to each
transaction are analyzed, as well as analyzing the transaction's 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.
During the first nine months of 2002, Conseco Finance completed eight
transactions, securitizing $2.8 billion of finance receivables. Only one
transaction was completed during the three months ended September 30, 2002.
Adverse changes in the securitization market have impaired Conseco Finance's
ability to originate, purchase and sell loans or other assets.
Prior to the third quarter 2002, the market for securities backed by
receivables was a cost-effective source of funds for Conseco Finance. 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, Conseco Finance chose to hold certain
securities rather than sell them to securitization trusts.
The ratings downgrades that followed the recent announcements regarding
Conseco's defaulted debt and restructuring discussions with debt holders (see
the note to consolidated financial statements entitled "Events of Default and
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") have eliminated Conseco Finance's access to the
securitization market. The securitization markets have been Conseco Finance's
main source of funding. The loss of access to the securitization markets has
severely affected Conseco Finance's ability to originate, purchase and sell
loans. It has also affected the value of the retained interests Conseco Finance
holds in securitization trusts, since Conseco Finance relied on these markets to
finance the sale of repossessed manufactured housing units which often helped to
minimize the loss on defaulted loans (compared to selling directly to the
manufactured housing wholesale channel).
Conseco Finance's remaining liquidity sources (excluding its bank
subsidiaries) are a warehouse and a residual facility with Lehman and a credit
facility with U.S. Bank. Conseco Finance's inability to access the
securitization markets and the constrained liquidity under its other funding
sources have had a material adverse effect on its business and results of
operations.
Conseco Finance is currently in violation of several of its financial
covenants required by its warehouse and residual facilities and other credit
facility. Conseco Finance has entered into a forbearance agreement with Lehman
pursuant to which Lehman has agreed to temporarily refrain from exercising any
rights arising from events of default that occurred under the facilities as of
the date of such forbearance agreement, including certain events of default
triggered by Conseco Finance not being in compliance with certain financial
covenants. This forbearance agreement expires on November 29, 2002 and is
subject to various conditions. Conseco Finance is attempting to obtain an
extension of the forbearance agreement or another similar arrangement with
Lehman. In addition, Conseco Finance was not in compliance with various
financial covenants with respect to its bank credit facility. Conseco Finance is
currently in the process of attempting to obtain a forbearance or similar
agreement from U.S. Bank. Absent the forbearance or similar agreement, the
covenant violations give the lender the right to declare all borrowings under
the bank credit facility due and payable ($75.0 million was outstanding pursuant
to this facility at September 30, 2002). Conseco Finance is currently unable to
repay this credit facility. There can be no assurance that Conseco Finance's
negotiations with Lehman or U.S. Bank will result in a forbearance or similar
agreement.
Conseco Finance has obtained a waiver from U.S. Bank in connection with
cross-defaults that have occurred under this credit facility as a result of
Conseco defaulting on its debt obligations. This waiver also provides for
amendments to the credit facility that further restrict Conseco Finance's access
to liquidity by successive step-downs in the size of the facility and for the
termination of the facility and its repayment in full by December 31, 2002.
Conseco Finance has asked U.S. Bank for negotiations to extend the facility
beyond December 31, 2002 and to maintain sufficient access to liquidity
thereunder. There can be no assurance that Conseco Finance will succeed in any
of these efforts.
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Conseco Finance's residual facility is collateralized by retained interests
in securitizations. Conseco Finance is required to maintain collateral based on
current estimated fair values in accordance with the terms of such facility. Due
to the decrease in estimated fair value of its retained interests, Conseco
Finance's collateral was $128.9 million deficient at September 30, 2002 (as
calculated in accordance with the relevant transaction documents). Conseco
Finance has executed a forbearance agreement with Lehman in which, among other
things, Lehman has agreed not to require additional collateral with respect to
the residual facility through November 29, 2002. Under the terms of the
forbearance agreement, Lehman is retaining certain cash flows from Conseco
Finance's retained interests pledged to this facility and applying these cash
flows to the margin deficit. Conseco Finance is currently unable to provide
sufficient additional collateral or repay this credit facility. The value of the
retained interests in the manufactured housing portfolio may also decrease based
on Conseco Finance's inability to continue to effectuate its historical loss
mitigation strategy with respect to the sale of repossessed manufactured housing
units resulting in a reduction of collateral pledged on its residual facility.
Conseco Finance had historically provided financing to retail buyers of
repossessed units and funded that financing through the securitization of those
refinancing loans. Without access to the securitization market, Conseco
Finance's ability to provide financing to purchasers of repossessed manufactured
housing units has been significantly reduced. This will result in significantly
fewer retail sales and a need for Conseco Finance to sell repossessed
manufactured housing units in the wholesale market at significantly reduced
prices, thereby reducing cash flow available to the retained interests.
Additionally, the uncertainty with respect to Conseco Finance's liquidity
position and its ability to continue to provide servicing for the securitized
portfolios has reduced and may further reduce the value of its retained
interests pledged as collateral on the residual facility.
On October 22, 2002, Conseco announced that its board of directors approved
a plan to seek new investors or acquirers for Conseco's finance businesses and
that it had engaged the investment banking firms of Lazard Freres & Co., LLC and
Credit Suisse First Boston to pursue various alternatives, including securing
new investors and/or selling Conseco Finance's three lines of business: (i)
manufactured housing finance; (ii) mortgage services; and (iii) consumer
finance.
In furtherance of this effort, Conseco Finance has initiated a process to
sell Mill Creek Bank and its home equity and private label credit card
businesses. On behalf of Conseco Finance, Credit Suisse First Boston has
received several non-binding indications of interest to acquire Mill Creek Bank.
Non-binding indications of interest have also been received in connection with
the potential acquisition of the home equity and private label businesses.
Although Conseco Finance intends to maximize the value obtainable from any
such restructuring transaction, there can be no assurance that any transaction
involving Mill Creek Bank or the home equity and private label credit card
businesses will be completed or if completed, whether it will satisfy Conseco
Finance's expected liquidity needs.
Conseco Finance is also undertaking efforts to restructure its manufactured
housing business. Originations have been significantly curtailed and Conseco
Finance is analyzing potential approaches to reducing the negative cash flow
that currently results from the servicing of this portfolio and the payment of
guarantees on the B-2 securities issued in connection with securitizations of
manufactured housing receivables. These approaches may require amendments of
documentation with respect to the manufactured housing securitizations and such
amendments may require the approval of a majority or supermajority of the
investors in some or all of the classes of securities issued under those
securitizations on a transaction by transaction basis. There can be no assurance
that Conseco Finance will be successful in receiving such consents, effecting
such amendments, or otherwise restructuring its manufactured housing business.
During the first nine 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
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CONSECO, INC. AND SUBSIDIARIES
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amount of the notes plus accrued interest. The remaining principal amount
outstanding of the medium term notes after giving effect to both tender offers
and other debt repurchases completed prior to the tender offers of $2.7 million
was retired at maturity on September 26, 2002. Since that date, Conseco Finance
has had no outstanding public debt.
Conseco Finance continually investigates and pursues alternative and
supplementary methods to finance its lending operations. In late 1998, Conseco
Finance began issuing certificates of deposit through its bank subsidiaries. At
September 30, 2002, $2.1 billion of such deposits were outstanding, which are
recorded as liabilities related to certificates of deposit. The average annual
rate paid on these deposits was 3.7 percent during the first nine months of
2002. Proceeds from the issuance of the certificates of deposit are used to fund
the origination of certain consumer/credit card finance receivables. To the
extent that Conseco Finance is unable to issue certificates of deposit, loan
origination activities would be adversely affected, which would have additional
material adverse effects on its operations, financial results and cash position.
During the quarter ended September 30, 2002, we changed the assumptions
used to estimate the value of our retained interests to: (i) project higher
rates of default in the future, based on our current expectations; and (ii)
project higher severity losses related to the defaults, reflecting our inability
to finance the sale of repossessed manufactured homes. (See note to the
consolidated financial statements entitled "Finance Receivables and Retained
Interests in Securitization Trusts".) As a result of these assumptions, we
project that payments related to guarantees of certain securities issued in
conjunction with the sales of certain finance receivables will exceed the gross
cash flows from the retained interests by approximately $15 million during the
remainder of 2002, $75 million in 2003, $25 million in 2004 and $1 million in
2005. These projected payments are considered in the projected cash flows we use
to value our retained interests. Without additional capital in the near future,
Conseco Finance will be unable to make these projected guarantee payments when
such payments are required to be made. We project the gross cash flows from the
retained interests will exceed the payments related to guarantees issued in
conjunction with the sales of certain finance receivables by approximately
$1,105 million in all years thereafter.
As explained above, Lehman entered into a forbearance agreement with
Conseco Finance pursuant to which it agreed not to exercise any rights arising
from events of default under the warehouse and the residual facilities which
occurred as of the date of such forbearance agreement. Unless otherwise agreed
to, Lehman will regain the ability to exercise any such rights at the end of the
forbearance period. The forbearance period expires on November 29, 2002.
The forbearance agreement contains additional provisions which: (i)
prohibit Conseco Finance from making any dividend or other payments to the
Company or any affiliates; (ii) during the forbearance period, grants Lehman
rights over cash proceeds resulting from the sale of assets in excess of $25
million; (iii) provide Lehman with the right to consent to amendments to the
documents governing certain of Conseco Finance's securitization facilities; and
(iv) provide Lehman with additional security interests in Conseco Finance's
otherwise unencumbered assets (including, but not limited to, rights on
servicing fees received by Conseco Finance).
In connection with the execution of the forbearance agreement, Conseco
Finance and Lehman amended the warehouse and residual facilities. These
amendments provide for increased liquidity during the forbearance period and
provide Lehman with a security interest in cash flows received by Conseco
Finance from its securitization facilities.
Conseco Finance is seeking to extend the forbearance period. There can be
no assurance that Conseco Finance will be able to obtain such an extension.
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
consolidated 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 which affected the Company's December 31, 2001 liquidity plan
included 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
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CONSECO, INC. AND SUBSIDIARIES
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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 did not request regulatory approval to pay these
proceeds to the parent company as dividends.
In August 2002, A.M. Best further downgraded the ratings of our insurance
companies to "B (fair)." Additionally, as a result of the net loss applicable to
common stock for the nine months ended September 30, 2002 of $6,147.7 million,
including the goodwill impairment and the establishment of a deferred tax
valuation reserve, our shareholders' deficit was $811.8 million at September 30,
2002. The reduction in the shareholders' equity negatively impacted our A.M.
Best ratings prospects and other capital market ratings prospects. The net loss
during 2002, including the establishment of the deferred tax valuation reserve,
resulted in our not meeting various financial covenants in our bank credit
agreement and the guarantees of the D&O loans for which we have a forbearance
agreement through November 26, 2002. All of these developments made it more
difficult to obtain regulatory approvals of certain transactions and/or dividend
payments from our insurance companies and contributed to our decision to pursue
the restructuring of our capital.
As we announced on August 9, 2002, Conseco did not make its August 2002
interest payments on its 6.4% senior notes due 2003, 6.4% guaranteed senior
notes due 2004, 8.75% senior notes due 2004, and 8.75% guaranteed senior notes
due 2005. Since the August 9, 2002 announcement, Conseco has not made any
interest or principal payments on any of its direct corporate obligations, nor
has Conseco made any distributions on its Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts. The failure to make the
interest payments on these notes within the 30-day grace period constituted an
event of default under the notes which gave the holders of the notes the right
to accelerate the maturity of all principal and past due interest. We did not
pay the $224.9 million of principal (plus accrued interest) that was due on
October 15, 2002 under the terms of the 8.5% notes due October 15, 2002.
Conseco's default with respect to the payment of principal on these notes also
resulted in defaults under approximately $4.0 billion principal amount of debt
obligations, approximately $481.3 million principal amount of D&O loans which
Conseco has guaranteed (as further described in the note to our consolidated
financial statements entitled "Guarantees") and approximately $1.9 billion of
trust preferred securities through cross-default provisions contained in the
respective governing instruments. If the holders of such indebtedness or
preferred securities exercised their rights to accelerate the maturity of all
principal and interest due, we would be unable to satisfy these obligations.
The Company is not in compliance with certain covenants under its bank
credit agreement and the guarantees of the D&O loans. Although Conseco received
a waiver of the covenant violations from the relevant lenders, the waiver, as
extended, expired on October 17, 2002. Conseco has obtained forbearance
agreements from the relevant lenders, pursuant to which the lenders have agreed
to temporarily refrain from exercising default-related remedies with respect to
certain specified events of default under the bank credit agreement and the
guarantees of the D&O loans. These forbearance agreements expire on November 27,
2002, and are subject to various conditions.
The Company is currently in negotiations with its senior lenders, the D&O
lenders, certain holders of its senior notes and certain holders of its trust
originated preferred securities with the goal of fundamentally restructuring the
Company's capital. The noteholders have formed an informal committee that has
retained Fried, Frank, Harris, Shriver & Jacobson and Houlihan Lokey Howard &
Zukin Capital as its advisors. The holders of the trust originated preferred
securities have formed an informal committee that has retained Saul Ewing LLP
and Raymond James & Associates as its advisors. The Company and its advisors are
engaged in discussions with these creditors and their representatives regarding
the terms of a potential restructuring plan, including the conversion of a
significant amount of Conseco's debt into common equity. If an agreement on such
a plan is reached, the Company would present the plan for judicial approval
under Chapter 11 of the U.S. Bankruptcy Code, which provides for companies to
reorganize and continue to operate as going concerns. The Company is not
currently in a position to predict the outcome of these discussions. As a result
of our current defaults, certain debt holders of the Company could at any time
file an involuntary petition against the Company under the U.S. Bankruptcy Code
although we are not aware of any current efforts to do so.
We have substantial indebtedness. At September 30, 2002, the par value of
our notes payable was $4.0 billion and the par value of our trust originated
preferred securities was $1.9 billion. We have a recent
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CONSECO, INC. AND SUBSIDIARIES
--------------------
history of net losses. For the first nine months of 2002, on a consolidated
basis, we had a net loss applicable to common stock of $6,149.3 million and
interest expense of $1,113.1 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
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 $2,417.3 million, $617.4
million and $1,602.4 million for the nine months ended September 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. At the present
time, our subsidiaries are unable to make dividend payments to the parent
company.
As described in "Liquidity for insurance and fee-based operations" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", A.M. Best has further downgraded the financial strength ratings of
our primary insurance subsidiaries to "B (fair)". The downgrade has caused sales
of our insurance products to fall and policyholder redemptions and lapses to
increase, which has had a material adverse effect on our financial results.
The Company's financial losses, declining surplus and highly leveraged
position resulted in increased levels of regulatory supervision from various
state insurance regulators. Since the August 2002 announcement of our
restructuring, we have been working closely with insurance regulators in each of
the states in which our insurance subsidiaries are domiciled (Arizona, Illinois,
Indiana, New York, Pennsylvania and Texas) in connection with their monitoring
of the operations and financial status of our insurance subsidiaries. The
Commissioner of Insurance for the State of Texas has acted as the lead regulator
among the foregoing states and has coordinated the oversight and monitoring
efforts associated with our financial restructuring.
On October 30, 2002, Bankers National Life Insurance Company and Conseco
Life Insurance Company of Texas (on behalf of itself and its subsidiaries), our
insurance subsidiaries domiciled in Texas, each entered into consent orders with
the Commissioner of Insurance for the State of Texas whereby they agreed: (i)
not to request any dividends or other distributions before January 1, 2003 and,
thereafter, not to pay any dividends or other distributions to parent companies
outside of the insurance system without the prior approval of the Texas
Insurance Commissioner; (ii) to continue to maintain sufficient capitalization
and reserves as required by the Texas Insurance Code; (iii) to request approval
from the Texas Insurance Commissioner before making any disbursements not in the
ordinary course of business; (iv) to complete any pending transactions
previously reported to the proper insurance regulatory officials prior to and
during Conseco's restructuring, unless not approved by the Texas Insurance
Commissioner; (v) to obtain a commitment from Conseco and CIHC to maintain their
infrastructure, employees, systems and physical facilities prior to and during
Conseco's restructuring; and (vi) to continue to permit the Texas Insurance
Commissioner to examine its books, papers, accounts, records and affairs. The
consent orders do not prohibit the payment of fees in the ordinary course of
business pursuant to existing administrative, investment management and
marketing agreements with our non-insurance subsidiaries.
The ability of our insurance subsidiaries to pay dividends is also 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 nine months of 2002, our insurance
subsidiaries paid dividends to Conseco totaling $240.0 million.
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CONSECO, INC. AND SUBSIDIARIES
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As further described in the note to the consolidated financial statements
entitled "Litigation and Other Legal Proceedings", seven holders of our bank
debt have challenged the validity of the amendment to the credit agreement that
changes provisions related to mandatory prepayments.
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. Conseco
Finance does not have adequate liquidity to permit the movement of cash to the
parent company.
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. The
Company's inability to generate sufficient cash flows from operations, asset
sales or financing transactions to meet all of our long-term debt service
requirements is having a material adverse effect on our 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.
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 September 30, 2002, (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):
2002............................................................... $ 226.7
2003............................................................... 1,791.9
2004............................................................... 463.1
2005............................................................... 99.2
2006............................................................... 515.1
Thereafter......................................................... 2,880.6
--------
Total par value at September 30, 2002.......................... $5,976.6
========
The tables above exclude any amounts related to our guarantees of D&O loans
totaling $481.3 million as of September 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 $166.6 million. We have
established a non-cash reserve for the exposure we have in connection with such
guarantees and interest loans. At September 30, 2002, our reserve for losses on
the loan guarantees and the interest loans totaled $620.0 million based upon the
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CONSECO, INC. AND SUBSIDIARIES
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value of the collateral and the creditworthiness of the participants. At
September 30, 2002, the guaranteed bank loans and interest loans exceeded the
value of the collateral held and the reserve for losses by approximately $90
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 has placed 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 affected the ratings of our insurance company
subsidiaries which in turn has adversely affected their competitive position and
ability to sell products; and (vii) the ability of our finance operations to
finance receivables in the secondary markets through loan securitizations has
been eliminated.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
assure you that we will possess sufficient income and liquidity to meet all of
our long-term debt service requirements and other obligations.
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 October
25, 2002, the credit rating for our senior notes was downgraded to "Ca" by
Moody's, which said its ratings outlook for us is developing. 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. "Ca" is
the eighth best rating out of nine. In its October 25, 2002, release, Moody's
stated that "the Ca senior unsecured rating reflects the heightened uncertainty
surrounding Conseco's liquidity and financial flexibility, and the residual
value of the company, a key determinant of the recovery value for debtholders."
On October 4, 2002, Standard & Poor's lowered our senior debt rating from
"CC" to "D". 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.
On September 9, 2002, our senior debt ratings were lowered from "C" to "D"
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.
As of November 11, 2002, our trust preferred securities were rated "D" by
Standard & Poor's, "D" by Fitch and "C" 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 September 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................................................ $10,974.6 $ 591.2 $478.6 $11,087.2
United States Treasury securities and obligations of
United States government corporations and agencies................ 251.5 26.5 .1 277.9
States and political subdivisions................................... 330.8 25.1 .2 355.7
Debt securities issued by foreign governments....................... 104.8 4.9 2.3 107.4
Mortgage-backed securities ......................................... 6,514.5 357.1 4.1 6,867.5
Below-investment grade (primarily corporate securities)................ 1,305.4 11.0 226.7 1,089.7
--------- -------- ------ ---------
Total actively managed fixed maturities............................. $19,481.6 $1,015.8 $712.0 $19,785.4
========= ======== ====== =========
Equity securities...................................................... $ 156.2 $ 3.4 $ 20.5 $ 139.1
========= ======== ====== =========
Concentration of Corporate Securities
At September 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......................................................... 14.5% 13.7%
Bank/savings and loan............................................................ 10.9 11.6
Energy........................................................................... 8.9 9.5
Electric utility................................................................. 8.3 8.4
Financial institutions........................................................... 8.2 8.0
Insurance ....................................................................... 5.9 5.3
Real estate and real estate investment trusts.................................... 5.1 5.4
With respect to our corporate securities, no other industry accounted for
more than 5.0 percent of amortized cost or estimated fair value.
Below-Investment Grade Securities
At September 30, 2002, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $1,305.4 million, or 6.7
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $1,089.7 million, or 83 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
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CONSECO, INC. AND SUBSIDIARIES
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higher levels of debt and are more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than are investment grade
issuers. The Company attempts to reduce the overall risk in the below-investment
grade portfolio, as in all investments, through careful credit analysis, strict
investment policy guidelines, and diversification by issuer and/or guarantor and
by industry.
Net Realized Investment Losses
During the first nine months of 2002, we recognized net realized investment
losses of $524.9 million, compared to $302.7 million during the comparable
period of 2001. The net realized investment losses during the first nine months
of 2002 included: (i) $489.8 million of writedowns of fixed maturity
investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary; and (ii) $35.1 million of net losses from the sales of
investments (primarily fixed maturities) which generated proceeds of $15.6
billion. At September 30, 2002, fixed maturity securities in default as to the
payment of principal or interest had an aggregate amortized cost of $241.1
million and a carrying value of $227.8 million. The net realized investment
losses during the first nine months of 2001 included: (i) $251.4 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) $51.3 million of net
losses from the sales of investments (primarily fixed maturities).
During the first nine months of 2002, we sold $10.7 billion of fixed
maturity investments which resulted in gross investment losses (before income
taxes) of $168.1 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
nine months of 2002 which had been continuously in an unrealized loss position
exceeding 20 percent of the amortized cost basis prior to the sale for the
period indicated:
At date of sale
---------------
Number of Amortized Fair
Period issuers cost value
------ ------- ---- -----
(Dollars in millions)
Less than 6 months prior to sale............................. 40 $88.3 $48.3
Greater than or equal to 6 and less than 12 months
prior to sale............................................. 13 20.1 9.4
Greater than 12 months
prior to sale............................................. 18 56.1 36.8
Investments with Other-Than-Temporary Losses
During the nine months ended September 30, 2002, we recorded writedowns of
fixed maturity investments, equity securities and other invested assets totaling
$489.8 million. The following is a brief description of the facts and
circumstances that resulted in the other-than-temporary losses.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $124.8 million on securitized investments backed by commercial loans
(referred to herein as "collateralized debt obligations" or "CDOs"). Principal
and interest payments on CDOs are made from cash flows from underlying loans
held by the trusts. The current value of these investments are influenced by a
number of factors, such as the performance of the underlying loans, the current
and future expected economic environment, and the payment priority of our
investment in the securitization structure. In recent periods, general rates of
defaults on commercial loans have increased. In addition, the ratings of several
CDOs which we hold have been downgraded by nationally recognized statistical
rating organizations. Accordingly, we reviewed our CDO portfolio for potential
other-than-temporary impairments in accordance with EITF 99-20.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $73.7 million related to fixed maturity investments issued by a
merchant energy company rated B3/B-. The company's operating results and
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CONSECO, INC. AND SUBSIDIARIES
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liquidity have deteriorated due to lower energy prices, diminished energy
trading profits and higher working capital demands. Although the company has
commenced asset sales in an effort to produce needed liquidity, its debt service
requirements are significant. We concluded the decline in fair value was
other-than-temporary.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $62.7 million on certain lower-rated securities issued by the
non-consolidated securitization trusts which hold loans to purchase manufactured
housing originated and managed by our finance subsidiary. These securities were
acquired by our insurance subsidiaries prior to our acquisition of the finance
subsidiary. As described in the note to our consolidated financial statements
entitled "Guarantees," the scheduled cash payments on these securities are
guaranteed by our finance subsidiary. Due to the performance of the underlying
portfolios, the payments on lower-priority securities are dependent on the
guarantees of our finance subsidiary. Given the current financial condition of
our finance subsidiary, there can be no assurance it will be able to honor its
commitments with respect to such guarantees. Accordingly, we wrote these
investments down to a nominal value (representing estimated fair value).
During the nine months ended September 30, 2002, we recorded writedowns
totaling $29.9 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
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.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $30.2 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
financial statements. The company defaulted in July.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $19.5 million related to holdings of fixed maturity investments in a
retail chain that 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 the subsequent decrease in the estimated fair value of our investment,
subsequent writedowns were taken in 2002.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $23.1 million based upon our analysis of the value of the underlying
collateral of various investments in the airline sector. Many major airlines are
facing significant liquidity issues and we believe the current market value of
the collateral backing these loans is less than the book value of our
investment. Our investment analysts believe that the decline in fair value of
these investments is other-than-temporary.
During the nine months ended September 30, 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 nine months ended September 30, 2002, we recorded writedowns
totaling $9.4 million of fixed maturity investments issued by a global energy
services company. The company is suffering from reduced profitability due to
declining energy prices in key markets plus the effect of above market purchase
contracts. Due to very high financial leverage related to several acquisitions
at high prices and diminished cash flows, our investment analysts believe that
the decline in fair value is other-than-temporary.
During the nine months ended September 30, 2002, we recorded writedowns
totaling $8.5 million related to investments issued by a moving and storage
company. The company failed to make a recent scheduled payment of principal on a
public debt security. The company recently cancelled a proposed offering of
long-term notes. While the company has publicly expressed its intention and
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CONSECO, INC. AND SUBSIDIARIES
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belief that a successful refinancing can be completed, our investment analysts
believe that the decline in market value of this security is
other-than-temporary.
During the nine months ended September 30, 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
low of $0.68 near the end of the second quarter. 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 nine months ended September 30, 2002, in addition to the
specific securities discussed above, we recorded $99.0 million of writedowns
related to various other investments. No other writedowns of a single issuer
exceeded $6.8 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 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.
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CONSECO, INC. AND SUBSIDIARIES
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The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at September
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................................................................... $ 184.7 $ 181.7
Due after one year through five years..................................................... 280.8 248.8
Due after five years through ten years.................................................... 1,248.8 1,080.8
Due after ten years....................................................................... 3,260.1 2,757.1
-------- --------
Subtotal............................................................................... 4,974.4 4,268.4
Mortgage-backed securities (a)............................................................ 89.4 80.5
-------- --------
Total.................................................................................. $5,063.8 $4,348.9
======== ========
- ---------------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $6.9 million and $2.1 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 September 30, 2002:
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------ ---------- ----- ---- ----------
(Dollars in millions)
Less than 6 months (1) 36 $235.1 $88.3 $146.8
Greater than or equal to
6 months and less
than 12 months(2) 8 94.6 42.6 52.0
Greater than 12 months(3) 15 204.3 75.2 129.1
---------------
(1) These investments include: (i) fixed maturity investments in
a diversified paper and forest products manufacturer with a
cost basis of $49.3 million and a fair value of $35.6
million; (ii) fixed maturity investments issued by an
affiliate of a commercial airline with an amortized cost of
$25.6 million and an estimated fair value of $15.4; and
(iii) fixed maturities held by a foreign government with an
amortized cost of $18.4 million and an estimated fair value
of $9.3 million. No other single issuer in this category had
an unrealized loss exceeding $8.6 million. See "Investments
with Unrealized Losses" for additional information.
(2) These investments include an investment in a
telecommunications company with a cost basis of $55.5
million and a fair value of $27.7 million. See "Investments
with Unrealized Losses" for additional information. No other
single issuer in this category exceeded $7.0 million.
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CONSECO, INC. AND SUBSIDIARIES
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(3) These investments include: (i) a fixed maturity investment
issued by a commercial property and casualty insurance
company with a cost basis of $54.0 million and an estimated
fair value of $28.3 million; and (ii) a fixed maturity
investment issued by a regional retail chain with an
amortized cost basis of $29.9 million and a fair value of
$19.2 million. See "Investments with Unrealized Losses" for
additional information. No other single issuer in this
category had an unrealized loss exceeding $7.4 million.
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 September 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 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
September 30, 2002 (unrealized losses which exceed $8.5 million and 20 percent
of the cost basis of the securities by the same issuer):
At September 30, 2002, we held fixed maturity investments issued by a
telecommunications company rated Caa1/CCC+ with an amortized cost basis of $55.5
million and a fair value of $27.7 million. Our investment analysts believe that
based on the completion of certain transactions currently in progress, the
company has sufficient liquidity and the underlying value of the company's
customer base provides sufficient value to cover the existing debt. Therefore,
we concluded that the unrealized loss at September 30, 2002 is temporary.
At September 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 $54.0 million and an estimated fair value of $28.3
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 September 30, 2002, we held secured fixed maturity investments issued by
a commercial airline rated Ba2/BB+ with an amortized cost of $29.2 million and
an estimated fair value of $16.9 million. The company is facing financial
challenges that affect the entire industry, but is implementing a plan to
increase liquidity, reduce debt and reduce costs. Given that the company has
demonstrated that it has sufficient cash flows and liquidity to meet its
obligations, our investment analysts concluded that the unrealized loss at
September 30, 2002 is temporary.
At September 30, 2002, we held fixed maturity investments issued by a
diversified paper and forest products manufacturer rated Ba1/BB+ with an
amortized cost of $49.3 million and an estimated fair value of $35.6 million.
The company is confronting issues related to earnings, cash flows, and asbestos
liabilities. Despite concerns about earnings, the company was able to reverse a
loss from one year ago and post a profit for the third quarter as it cut costs
and curtailed excess production. In addition, the company was able to reduce its
debt significantly during the third quarter. Our analysts believe that the
company's insurance coverage should be available for the next few years to cover
the asbestos liabilities, and that the company's businesses remain excellent
cash generators to manage through the current economic environment. Therefore,
we concluded that the unrealized loss at September 30, 2002 is temporary.
At September 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 $19.2 million. Our investment
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CONSECO, INC. AND SUBSIDIARIES
--------------------
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 76
percent of par at September 30, 2002). We believe that we will recover full
value from this investment and we intend to hold the security to maturity.
At September 30, 2002, we held fixed maturity investments issued by a
Canadian telephone and wireless operator rated Ba1/BBB with an amortized cost
basis of $42.4 million and an estimated fair value of $31.7 million. This
company serves over five million customers and is reducing its union workforce
by approximately 25% to reduce operating costs. The company is very well
positioned in its markets and is more insulated from wire line and wireless
competition than comparable firms in the United States. Our investment analysts
believe that the unrealized loss at September 30, 2002, is temporary.
At September 30, 2002, we held fixed maturity investments issued by an
affiliate of a commercial airline rated Ba3/BB- with an amortized cost of $25.6
million and an estimated fair value of $15.4 million. Our investment analysts
believe the collateral supporting these investments is sufficient, and,
therefore, we concluded that the unrealized loss at September 30, 2002 is
temporary.
At September 30, 2002, we held fixed maturity investments issued by the
government of Brazil with an amortized cost of $18.4 million and an estimated
fair value of $9.3 million. The country is currently facing an acute liquidity
crisis which has been exacerbated by both the increase in risk aversion amongst
the international financial community and contentious presidential elections.
Fears of a win by the left-wing candidate have fueled concerns both within the
country and abroad about potential diversion from the current administration's
economic orthodoxy and led to a depreciation of the currency, a significant rise
in interest rates, and difficulties in rolling over maturing local debt. The IMF
and the World Bank demonstrated their support for the country in August by
engineering a $30 billion support package for the country. Our investment
analysts indicate that the structures we own include political risk insurance
which serves to mitigate any loss in the event that capital controls prohibit
the country from accessing dollars to make its interest payments. Therefore, we
concluded that the unrealized loss at September 30, 2002 is temporary.
At September 30, 2002, we held fixed maturity investments in a diesel
engine and electric power generation manufacturer rated Ba1/BBB- with an
amortized cost of $36.9 million and an estimated fair value of $28.2 million.
The company is suffering from a significant decline in engine and power
generation segments, particularly heavy-duty truck markets. After several years
of record production, demand declined in late 2000, creating an overage of
inventory and used equipment. As the economy has slowed further, shipments of
smaller engines and power generator sets (with significant exposure to the
telecom industry) have slowed. The company has focused on cash flow and has cut
costs effectively. The company has significant market share and competitive
products that should drive operational improvements as economic conditions
improve. Our investment analysts believe that the company has sufficient cash
flow to retire maturing debt and meet the company's financing needs. Therefore,
we concluded that the unrealized loss at September 30, 2002 is temporary.
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CONSECO, INC. AND SUBSIDIARIES
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Mortgage Backed Securities
At September 30, 2002, fixed maturity investments included $6.9 billion of
mortgage-backed securities (or 35 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 September 30, 2002:
Par Amortized Estimated
value cost fair value
----- ---- ----------
(Dollars in millions)
Below 7 percent..................................................................... $5,314.2 $5,270.6 $5,551.1
7 percent - 8 percent............................................................... 1,055.8 1,055.9 1,115.7
8 percent - 9 percent............................................................... 145.1 146.0 153.1
9 percent and above................................................................. 46.8 49.1 49.9
-------- -------- --------
Total mortgage-backed securities (a)......................................... $6,561.9 $6,521.6 $6,869.8
======== ======== ========
- ---------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $7.1 million and $2.3 million,
respectively.
The amortized cost and estimated fair value of mortgage-backed securities
at September 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............ $3,346.6 $3,520.9 18%
Planned amortization classes and accretion-directed bonds................. 2,432.9 2,557.1 13
Commercial mortgage-backed securities..................................... 407.9 436.3 2
Subordinated classes and mezzanine tranches............................... 324.3 347.6 2
Other..................................................................... 9.9 7.9 -
-------- -------- --
Total mortgage-backed securities (a)............................... $6,521.6 $6,869.8 35%
======== ======== ==
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CONSECO, INC. AND SUBSIDIARIES
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- -------------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $7.1 million and $2.3 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".
Mortgage Loans
At September 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 September 30,
2002.
Investment Borrowings
Our investment borrowings averaged approximately $1,226.4 million during
the first nine months of 2002, compared with approximately $608.7 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 1.3 percent and 5.5 percent during the first nine
months of 2002 and 2001, respectively.
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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 $42.2 million and $115.3 million in the first nine
months of 2002 and 2001, respectively. The Company's life insurance subsidiaries
reported the following amounts to regulatory agencies at September 30, 2002,
after appropriate eliminations of intercompany accounts among such subsidiaries
(dollars in millions):
Statutory capital and surplus .................................. $1,160.6
Asset valuation reserve......................................... 29.0
Interest maintenance reserve.................................... 257.1
--------
Total........................................................ $1,446.7
========
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:
September 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).................................... $ 7.1
Preferred and common stock of intermediate holding company............................ 146.4
Other ................................................................................ 2.5
------
Total........................................................................... $156.0
======
- --------------
(a) Total par value, amortized cost and fair value of securities issued by
special purpose entities that 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
$208.2 million, $204.3 million and $203.7 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 nine months of 2002, our insurance
subsidiaries paid dividends to Conseco totaling $240.0 million. As a result of
consent orders entered into with insurance regulators on October 30, 2002, our
insurance subsidiaries may not pay dividends without such regulators' consent.
See "Liquidity of Conseco (parent company)" above for a discussion on dividend
payments from our insurance subsidiaries to Conseco.
NEW ACCOUNTING STANDARDS
See "Cumulative Effect of Accounting Change and Goodwill Impairment" 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," "project,"
"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 the financial affairs of our insurance
companies, 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; and (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 our restructuring activities including the
efforts of Conseco Finance to sell assets. 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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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 and Capital Resources" 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 nine months of 2002 to such risks or our
management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Conseco's Chief Executive Officer and Chief Financial Officer evaluated the
effectiveness of Conseco's disclosure controls and procedures, as defined in
Exchange Act Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as
of a date within 90 days of the filing date of this quarterly report and
concluded that Conseco's disclosure controls and procedures were functioning
properly as of the evaluation date.
Based on this most recent evaluation, there do not appear to have been any
significant changes in Conseco's internal controls or in other factors that
could significantly affect these controls subsequent to the date of this
evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses. The results of this evaluation have been
discussed with Conseco's Audit Committee and with our external auditors.
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PART II - OTHER INFORMATION
ITEM 1. LITIGATION AND OTHER LEGAL PROCEEDINGS.
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. Pretrial discovery
has commenced. 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 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.
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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 has
been 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 initially reserved rights to continue to litigate
coverage. RLI has subsequently settled (for $50,000 paid by certain of the
individual insureds as partial payment of RLI's attorneys' fees incurred in the
coverage litigation), and RLI is no longer continuing to dispute 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 has been 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 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. Because the directors' and officers' liability insurance that
was in force at the time the litigation commenced provides for coverage of $100
million, 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
that the insurance applies to the claims in the securities litigation and that
the two insurers who are continuing to litigate the coverage issue were
obligated to pay their policy limits to fund the settlement, as the other four
carriers have done. Accordingly, $20 million is our best estimate of a probable
loss at September 30, 2002. We have established an estimated liability of $40
million and claim for recovery of $40 million at September 30, 2002. Such
amounts include: (i) $15 million related to the insurer that paid its portion of
the settlement into a fund but reserved its 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 insurer that
paid under a reservation of rights has no right to recoup the payment that it
made, and that the insurer that refused to pay is obligated to do so under its
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CONSECO, INC. AND SUBSIDIARIES
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policy. We believe it is probable that the latter insurer will pay its portion
of the coverage once such determination is made. The ultimate outcome cannot be
predicted with certainty.
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.
Commencing in August 2002 a total of eight purported securities fraud class
action lawsuits have been filed in the United States District Court for the
Southern District of Indiana. The complaints name as defendants the Company,
along with certain current and former officers of the Company, and were filed on
behalf of persons or entities who purchased the Company's common stock on
various dates between October 24, 2001 and August 9, 2002. In each case
Plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934, and allege material omissions and dissemination of
materially misleading statements regarding, among other things, the liquidity of
the Company and alleged problems in the Company's manufactured housing division,
allegedly resulting in the artificial inflation of the Company's stock price in
the marketplace. These cases are expected to be consolidated into one action.
The Company believes 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 were consolidated into one
case, and Conseco Finance appealed them to the South Carolina Supreme Court.
Oral argument was heard on March 21, 2002. On August 26, 2002 the South Carolina
Supreme Court affirmed the arbitration judgments, and Conseco Finance filed a
petition for writ of certiorari with the U.S. Supreme Court on October 23, 2002.
Conseco Finance has posted appellate bonds, including $21 million of cash, for
these cases. Conseco Finance intends to challenge the awards vigorously 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 to 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. (the "State Court
Action"). Plaintiff claims that the Company and Carmel breached an agreement,
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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 (the
"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. By
Stipulation and Order, dated June 14, 2002, the State Court Action was stayed,
pending resolution of the Arbitration. On June 10, 2002, Manager and Trump filed
their Statement of Position which included affirmative defenses and
counterclaims against Carmel and the Company, arising out of the same alleged
breaches of the July 3rd Agreement that had formed the basis of the State Court
Action. The Arbitration was heard by a Panel of three arbitrators in five
hearing days between September 25, 2002 and October 29, 2002, and the parties
filed Post-Hearing Briefs on November 5, 2002. The parties are awaiting a
decision from the Panel. The Company believes that Mr. Trump's lawsuit is
without merit and intends to defend it vigorously. The ultimate outcome cannot
be predicted with certainty.
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. The ultimate outcome cannot be predicted with certainty.
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. In June 2002, the plaintiff holders filed a motion for summary
judgment. The parties began discovery in connection with that motion, and the
Circuit Court scheduled a hearing on the motion for October 4, 2002. However, we
and the plaintiffs subsequently agreed to adjourn that hearing and to postpone
indefinitely all further proceedings in the litigation. Accordingly, there is no
schedule currently in place for the resolution of the plaintiffs' motion or the
litigation generally, although the litigation remains pending. 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 recently been settled as
described above. The Company is cooperating with the SEC staff in this matter.
The Company has been notified that the Alabama Securities Commission is
examining the Company's 1998 Directors/Officers & Key Employees Stock Purchase
Program and the 2000 Employee Stock Purchase Program Work-Down Plan. The Company
is cooperating with the Commissioner's staff in this matter.
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In October, 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSavePlan filed an action
in the United States District Court for the Southern District of Indiana against
the Company, Conseco Services LLC and certain current and former officers of the
Company (Roderick Russell, et al v Conseco, Inc., et al, Case No. 1:02-CV-1639
LJM). The purported class action consists of all individuals whose 401(k)
accounts held common stock of the Company at any time from April 28, 1999
through the present. The complaint alleges, among other things, breaches of
fiduciary duties under ERISA by continuing to permit employees to invest in the
common stock of the Company without full disclosure of the Company's true
financial condition. The Company believes the lawsuit is without merit and
intends to defend it vigorously. The ultimate outcome of the lawsuit cannot be
predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits and arbitrations (including purported class actions)
related to their operations. 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," 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) and an arbitration involving a dispute with a
reinsurer of a block of long term care business. The ultimate outcome of all of
these other legal matters pending against the Company or its subsidiaries cannot
be predicted, and, although such lawsuits are not expected individually to have
a material adverse effect on the Company, such lawsuits could have, in the
aggregate, a material adverse effect on the Company's consolidated financial
condition, cash flows or results of operations.
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ITEM 3. DEFAULTS UPON SENIOR SECURITIES
As described in the note to the consolidated financial statements of the
Company entitled "Events of Default and Liquidity Issues," the Company is
currently in default with respect to interest payments on certain of its
outstanding indebtedness. The following table sets forth for each category of
indebtedness the aggregate principal amount outstanding and the total amount of
accrued indebtedness in default as of the date of this filing (dollars in
millions):
Principal Accrued interest
amount in default
------ ----------
Bank credit facility........................................... $1,493 $34.6
D&O loans...................................................... 481 10.3
Guaranteed senior notes (a).................................... 1,293 47.6
Senior notes (a)............................................... 1,260 64.7
Trust preferred securities (b)................................. 1,930 77.9
- -----------------
(a) Additional detail regarding the different maturities of guaranteed senior
notes and senior notes is set forth in the note to the consolidated financial
statements of the Company entitled "Changes in Direct Corporate
Obligations."
(b) This represents the following preferred securities: 9.44% Trust
Originated Preferred Securities, 8.70% Trust Originated Preferred
Securities, 9.00% Trust Originated Preferred Securities, 8.80% Capital
Securities, 9.16% Trust Originated Preferred Securities, 6.75% Trust
Originated Preferred Securities and 8.96% Capital Trust Pass-through
Securities.
In addition to the defaults identified above in the payment of interest,
the Company defaulted on $224.9 million of principal due on October 15, 2002 on
its 8.5% senior notes due 2002. This principal default resulted in defaults
under the governing instruments for the Company's other indebtedness and trust
preferred securities listed above and has given the holders the right to
accelerate the maturity thereof.
Conseco did not declare or pay the dividend on the Series F Common-Linked
Convertible Preferred Stock that was to have been paid on October 1, 2002 under
its terms. If declared, that dividend would have been payable by the issuance of
an additional 28,555 shares of Series F Preferred Stock to the existing holders
thereof.
ITEM 5. RECENT CHANGES IN EXECUTIVE MANAGEMENT
On October 3, 2002, Gary C. Wendt, Conseco's Chairman and Chief Executive
Officer, resigned his position of Chief Executive Officer. Mr. Wendt remains
Chairman of the Board of Conseco.
On November 7, 2002, Conseco's Board of Directors elected William J. Shea
to serve as Chief Executive Officer of Conseco. Mr. Shea will also continue to
serve as President and Chief Operating Officer.
On November 7, 2002, Conseco's Board of Directors also elected Eugene M.
Bullis to serve as Executive Vice President and Chief Financial Officer of
Conseco. Mr. Bullis replaced Mr. Shea, who had been the Acting Chief Financial
Officer.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a) Exhibits.
3.2 Amended and Restated By-Laws of Conseco, Inc.
4.31.15 Forbearance agreement relating to $1,500,000,000 five-year
credit agreement.
10.1.38 Amended Employment Agreement by and between William J. Shea
and Conseco, Inc., dated as of June 1, 2002
10.1.41 Amendment to Employment and Restricted Stock Agreements by
and between William J. Shea and Conseco, Inc., dated as of
September 16, 2002.
10.1.42 Employment Agreement by and between John R. Kline and
Conseco, Inc., dated as of July 15, 2002.
10.8.37 Forbearance agreement relating to 1997 D&O loans.
10.8.38 Forbearance agreement relating to 1998 D&O loans.
10.8.39 Forbearance agreement relating to 1998 (non-refinanced) D&O
loans.
10.8.40 Forbearance agreement relating to 1999 D&O loans.
10.46.6 Amendment to First Residual Facility (Asset Assignment
Agreement), dated October 9, 2002, by and between Lehman ALI
Inc. and Green Tree Residual Finance Corp. I.
10.46.7 Third Amendment to Master Repurchase Agreement, dated
October 9, 2002, by and between Lehman Commercial Paper Inc.
and Green Tree Finance Corp. - Five
10.46.8 Amended and Restated Forbearance Agreement, dated October 9,
2002, by and among Conseco Finance Corp., Green Tree Finance
Corp. - Five, Green Tree Residual Finance Corp. I, Lehman
Commercial Paper, Inc. and Lehman Brothers, Inc.
10.52.1 Conseco Life Insurance Company of Texas Official Order of
the Commissioner of Insurance of the State of Texas.
10.52.2 Bankers National Life Insurance Company Official Order of
the Commissioner of Insurance of the State of Texas.
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.
A report on Form 8-K dated August 14, 2002, was filed with the
Commission to report under Item 5, a memorandum issued by the
Registrant's Chairman and Chief Executive Officer to the
Company's shareholders and other interested parties summarizing
information about the Company.
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A report on Form 8-K dated August 14, 2002, was filed with the
Commission to report under Item 9, the submission of sworn
statements pursuant to Securities and Exchange Commission Order
No. 4-460.
A report on Form 8-K dated September 12, 2002, was filed with the
Commission to report under Item 5, a memorandum issued by the
Registrant's Chairman and Chief Executive Officer to the
Company's shareholders and other interested parties summarizing
information about the Company.
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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: November 19, 2002 By: /s/ William J. Shea
---------------------------
William J. Shea, President and
Chief Executive Officer
112
CONSECO, INC. AND SUBSIDIARIES
--------------------
CERTIFICATION
I, William J. Shea, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Conseco, Inc.:
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
Registrant as of, and for, the periods presented in this quarterly report;
4. The Registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the Registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the Registrant's auditors and the audit committee of
Registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to
record, process, summarize and report financial data and have
identified for the Registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's
internal controls; and
6. The Registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 19, 2002
/s/ William J. Shea
------------------------------
William J. Shea, President and
Chief Executive Officer
113
CONSECO, INC. AND SUBSIDIARIES
--------------------
CERTIFICATION
I, Eugene M.Bullis, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Conseco, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
Registrant as of, and for, the periods presented in this quarterly report;
4. The Registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the Registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the Registrant's auditors and the audit committee of
Registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to
record, process, summarize and report financial data and have
identified for the Registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's
internal controls; and
6. The Registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 19, 2002
/s/ Eugene M. Bullis
-----------------------------
Eugene M. Bullis, Executive Vice
President and Chief Financial Officer
113