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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[ x ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
[ ] 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.
(Debtor-In-Possession as of December 17, 2002)
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 [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act): Yes [x] No [ ]
Shares of common stock outstanding as of August 8, 2003: 346,007,133
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
June 30, December 31,
2003 2002
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost: 2003 - $19,050.1;
2002 - $18,989.8).................................................................... $20,286.9 $19,417.4
Equity securities at fair value (cost: 2003 - $132.4; 2002 - $161.4)................... 141.0 156.0
Mortgage loans......................................................................... 1,230.1 1,308.3
Policy loans........................................................................... 520.6 536.2
Venture capital investment in AT&T Wireless Services, Inc. at fair value
(cost: 2003 and 2002 - $14.2)....................................................... 33.5 25.0
Other invested assets ................................................................. 386.3 340.8
--------- ---------
Total investments.................................................................. $22,598.4 21,783.7
Cash and cash equivalents:
Held by the parent company............................................................. 29.7 41.9
Held by subsidiaries................................................................... 1,364.4 1,227.0
Accrued investment income................................................................. 394.1 389.8
Cost of policies purchased................................................................ 1,042.3 1,170.0
Cost of policies produced................................................................. 1,902.6 2,014.4
Reinsurance receivables................................................................... 892.0 934.2
Income tax assets......................................................................... 53.4 101.5
Goodwill.................................................................................. 100.0 100.0
Assets held in separate accounts and investment trust .................................... 417.2 447.0
Assets of discontinued operations......................................................... - 17,624.3
Other assets.............................................................................. 745.0 675.2
--------- ---------
Total assets....................................................................... $29,539.1 $46,509.0
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
2
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' DEFICIT
June 30, December 31,
2003 2002
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products.............................................................. $13,126.1 $13,469.5
Traditional products..................................................................... 8,159.9 7,971.4
Claims payable and other policyholder funds.............................................. 901.9 909.2
Liabilities related to separate accounts and investment trust............................ 417.2 447.0
Other liabilities.......................................................................... 982.1 673.5
Liabilities of discontinued operations..................................................... - 17,624.3
Investment borrowings...................................................................... 585.5 669.7
--------- ---------
Total liabilities not subject to compromise.......................................... 24,172.7 41,764.6
--------- ---------
Liabilities subject to compromise.......................................................... 4,971.7 4,873.3
--------- ---------
Total liabilities.................................................................... 29,144.4 46,637.9
--------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts......... 1,921.5 1,921.5
Shareholders' deficit:
Preferred stock............................................................................ 501.7 501.7
Common stock and additional paid-in capital (no par value, 1,000,000,000 shares
authorized, shares issued and outstanding: 2003 and 2002 - 346,007,133).................. 3,497.4 3,497.0
Accumulated other comprehensive income..................................................... 1,143.4 580.6
Retained deficit........................................................................... (6,669.3) (6,629.7)
--------- ---------
Total shareholders' deficit.......................................................... (1,526.8) (2,050.4)
--------- ---------
Total liabilities and shareholders' deficit.......................................... $29,539.1 $46,509.0
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------- -----------------
2003 2002 2003 2002
---- ---- ---- ----
Revenues:
Insurance policy income................................................... $ 813.9 $ 874.5 $1,687.5 $ 1,823.6
Net investment income:
Insurance and fee-based segment general account assets.................. 346.0 390.8 694.3 794.4
Equity-indexed and separate account products............................ 41.5 (55.7) 18.4 (73.7)
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc........................................... 6.0 (23.7) 8.5 (100.0)
Other................................................................... 6.1 3.0 9.2 5.0
Net realized investment gains (losses) ................................... (2.3) (223.6) 10.7 (253.2)
Fee revenue and other income.............................................. 12.8 18.4 26.5 40.6
-------- --------- -------- ---------
Total revenues........................................................ 1,224.0 983.7 2,455.1 2,236.7
-------- --------- -------- ---------
Benefits and expenses:
Insurance policy benefits................................................. 872.6 749.6 1,731.3 1,586.5
Provision for losses...................................................... 15.8 100.0 31.1 140.0
Interest expense (contractual interest of $97.2 and $194.8 for the three
and six months ended June 30, 2003, respectively)....................... 73.5 82.8 147.1 164.3
Amortization.............................................................. 138.6 250.1 296.6 435.0
Other operating costs and expenses........................................ 148.4 141.7 303.3 317.1
Special charges........................................................... - 48.2 - 68.2
Extraordinary gain on extinguishment of debt.............................. - (1.8) - (1.8)
Reorganization items...................................................... 14.4 - 32.5 -
-------- --------- -------- ---------
Total benefits and expenses........................................... 1,263.3 1,370.6 2,541.9 2,709.3
-------- --------- -------- ---------
Loss before income taxes, minority interest, discontinued operations
and cumulative effect of accounting change......................... (39.3) (386.9) (86.8) (472.6)
Income tax expense (benefit):
Tax benefit on period losses.............................................. (16.6) (135.2) (31.2) (161.3)
Valuation allowance for deferred tax assets............................... - 1,003.0 - 1,003.0
-------- --------- -------- ---------
Loss before minority interest, discontinued operations
and cumulative effect of accounting change......................... (22.7) (1,254.7) (55.6) (1,314.3)
Minority interest:
Distributions on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts, net of income taxes................... - 29.2 - 58.4
-------- --------- -------- -----------
Loss before discontinued operations and cumulative
effect of accounting change......................................... (22.7) (1,283.9) (55.6) (1,372.7)
Discontinued operations, net of income taxes................................. 2.1 (49.2) 16.0 (56.3)
Cumulative effect of accounting change for goodwill impairment, net of
income taxes.............................................................. - - - (2,949.2)
-------- --------- -------- ---------
Net loss.............................................................. (20.6) (1,333.1) (39.6) (4,378.2)
Preferred stock dividends.................................................... - .9 - 1.9
-------- --------- -------- ---------
Net loss applicable to common stock................................... $ (20.6) $(1,334.0) $ (39.6) $(4,380.1)
======== ========= ======== =========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2003 2002 2003 2002
---- ---- ---- ----
Loss per common share:
Basic:
Weighted average shares outstanding........................ 346,007,000 346,005,000 346,007,000 345,607,000
=========== =========== =========== ===========
Loss before discontinued operations and cumulative
effect of accounting change.............................. $(.07) $(3.72) $(.16) $ (3.97)
Discontinued operations.................................... .01 (.14) .05 (.16)
Cumulative effect of accounting change..................... - - - (8.54)
----- ------ ----- ------
Net loss................................................. $(.06) $(3.86) $(.11) $(12.67)
===== ====== ===== =======
Diluted:
Weighted average shares outstanding........................ 346,007,000 346,005,000 346,007,000 345,607,000
=========== =========== =========== ===========
Loss before discontinued operations and cumulative
effect of accounting change............................ $(.07) $(3.72) $(.16) $ (3.97)
Discontinued operations.................................... .01 (.14) .05 (.16)
Cumulative effect of accounting change..................... - - - (8.54)
----- ------ ----- ------
Net loss............................................... $(.06) $(3.86) $(.11) $(12.67)
===== ====== ===== =======
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
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, 2003............................. $(2,050.4) $501.7 $3,497.0 $ 580.6 $(6,629.7)
Comprehensive income, net of tax:
Net loss........................................ (39.6) - - - (39.6)
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $26.2)............................. 562.8 - - 562.8 -
---------
Total comprehensive income.................. 523.2
Change in shares for employee benefit plans....... .4 - .4 - -
--------- ------ -------- -------- ---------
Balance, June 30, 2003............................... $(1,526.8) $501.7 $3,497.4 $1,143.4 $(6,669.3)
========= ====== ======== ======== =========
Balance, January 1, 2002............................. $ 4,753.0 $499.6 $3,484.3 $ (439.0) $ 1,208.1
Comprehensive loss, net of tax:
Net loss........................................ (4,378.2) - - - (4,378.2)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $82.4)............................. 143.1 - - 143.1 -
---------
Total comprehensive loss.................... (4,235.1)
Issuance of shares for stock options and for
employee benefit plans.......................... 15.1 - 15.1 - -
Payment-in-kind dividends on convertible
preferred stock................................. 1.9 1.9 - - -
Dividends on preferred stock...................... (1.9) - - - (1.9)
--------- ------- -------- -------- ---------
Balance, June 30, 2002............................... $ 533.0 $501.5 $3,499.4 $ (295.9) $(3,172.0)
========= ====== ======== ======== =========
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Six months ended
June 30,
----------------
2003 2002
---- ----
Cash flows from operating activities:
Insurance policy income........................................................................ $ 1,431.2 $ 1,557.9
Net investment income.......................................................................... 716.5 1,837.1
Fee revenue and other income................................................................... 26.5 158.3
Insurance policy benefits...................................................................... (1,132.7) (1,261.4)
Interest expense............................................................................... - (726.4)
Policy acquisition costs....................................................................... (227.1) (271.0)
Special charges................................................................................ - (33.3)
Reorganization items........................................................................... (10.9) -
Other operating costs.......................................................................... (335.5) (669.4)
Taxes.......................................................................................... 76.3 (114.5)
--------- ---------
Net cash provided by operating activities.................................................... 544.3 477.3
--------- ---------
Cash flows from investing activities:
Sales of investments........................................................................... 4,286.2 11,498.9
Maturities and redemptions of investments...................................................... 1,198.0 766.8
Purchases of investments....................................................................... (5,331.8) (11,764.7)
Cash received from the sale of finance receivables, net of expenses............................ - 619.6
Principal payments received on finance receivables............................................. - 4,323.7
Finance receivables originated................................................................. - (4,423.0)
Other.......................................................................................... (35.9) (105.0)
--------- ----------
Net cash provided by investing activities ................................................... 116.5 916.3
--------- ----------
Cash flows from financing activities:
Amounts received for deposit products.......................................................... 994.9 2,304.2
Withdrawals from deposit products.............................................................. (1,446.3) (2,537.2)
Issuance of notes payable...................................................................... - 4,259.6
Payments on notes payable...................................................................... - (5,434.7)
Ceding commission received on reinsurance transactions......................................... - 83.0
Change in cash held in restricted accounts for settlement of borrowings........................ - 34.5
Investment borrowings.......................................................................... (84.2) (1,637.8)
Dividends on preferred shares and distributions on
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts........... - (56.8)
--------- ----------
Net cash used by financing activities...................................................... (535.6) (2,985.2)
--------- ----------
Net increase (decrease) in cash and cash equivalents....................................... 125.2 (1,591.6)
Cash and cash equivalents, beginning of period.................................................... 1,268.9 3,060.8
--------- ----------
Cash and cash equivalents, end of period.......................................................... $ 1,394.1 $ 1,469.2
========= ==========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2002 Form 10-K of Conseco,
Inc.
PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE
Conseco, Inc. ("CNC") is the top tier holding company for our insurance
business. Our insurance business is operated through subsidiaries owned directly
and indirectly by CIHC, Incorporated ("CIHC"), an intermediate holding company
that is controlled by CNC. Our finance business was operated through Conseco
Finance Corp. ("CFC"), a wholly-owned subsidiary of CIHC, and its subsidiaries.
We accounted for our finance business as a discontinued operation in 2002 once
we formalized plans to sell our finance business and CFC and certain of its
subsidiaries filed petitions under Chapter 11 of Title 11 of the United States
Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court
for the Northern District of Illinois (the "Bankruptcy Court"). We completed a
number of additional steps in 2003 related to CFC's sale and restructuring. On
January 8, 2003, the Bankruptcy Court approved the sale and bidding procedures
that would be followed to conduct an auction for the sale of CFC's businesses
and assets. On March 5, 2003, the auction to sell CFC's businesses was
concluded. A significant condition to the Bankruptcy Court approval and
completion of the sale of CFC was the restructuring of servicing fee
arrangements for CFC's managed portfolio of manufactured housing loans under
more favorable terms. That restructuring was completed and the Bankruptcy Court
entered final orders approving the terms of the sale of CFC on March 14, 2003.
On April 1, 2003, CFC filed its liquidating plan of reorganization with the
Bankruptcy Court. The sale of CFC's business and assets was concluded in the
second quarter of 2003. No proceeds from the sale will be paid to CNC as a
result of its ownership of CFC. As a result of these events, CNC no longer
controls CFC. As of March 31, 2003, CNC no longer includes the assets and
liabilities of CFC in its consolidated balance sheet. Our subsidiaries operate
throughout the United States. We sometimes collectively refer to CNC, together
with its consolidated subsidiaries, as "we," "Conseco" or the "Company."
Our insurance subsidiaries develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. Our finance business historically provided a variety of finance
products including manufactured housing and floor plan loans, home equity
mortgages, home improvement and consumer product loans and private label credit
cards.
On December 17, 2002 (the "Petition Date"), CNC, CIHC, CTIHC, Inc. and
Partners Health Group, Inc. (collectively, the "Debtors") filed voluntary
petitions for reorganization under the Bankruptcy Code in the Bankruptcy Court.
The following discussion provides general background information regarding the
Debtors' Chapter 11 cases, but is not intended to be a comprehensive summary.
The Debtors are currently operating their business as debtors-in-possession
pursuant to the Bankruptcy Code. As debtors-in-possession, the Debtors are
authorized to continue to operate as ongoing businesses, but may not engage in
transactions outside the ordinary course of business without approval of the
Bankruptcy Court, after notice and an opportunity for a hearing. The Company's
insurance subsidiaries are separate legal entities and are not included in the
petitions filed by the Debtors.
Since commencing operations in 1982, CNC pursued a strategy of growth
through acquisitions. Primarily as a result of these acquisitions and the
funding requirements necessary to operate and expand the acquired businesses,
CNC amassed outstanding indebtedness of approximately $6.0 billion as of June
30, 2002. In 2001 and early 2002, we undertook a series of steps designed to
reduce and extend the maturities of our parent company debt. Notwithstanding
these efforts, the Company's financial position continued to deteriorate,
principally due to our leveraged condition, losses experienced by our finance
business and realized losses in certain investments.
As a result of these developments, on August 9, 2002, we announced that we
would seek to fundamentally restructure the Company's capital, and announced
that we had retained legal and financial advisors to assist us in these efforts.
We ultimately decided to seek to reorganize under Chapter 11 of the Bankruptcy
Code.
Under the Bankruptcy Code, actions to collect prepetition indebtedness, as
well as most pending litigation, are stayed and other contractual obligations
against the Debtors generally may not be enforced. Absent an order of the
Bankruptcy Court, substantially all prepetition liabilities are subject to
settlement under a plan of reorganization subject to confirmation by the
Bankruptcy Court. On March 18, 2003, the Bankruptcy Court approved the Debtors'
Second Amended Disclosure
8
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Statement (the "Disclosure Statement"), summarizing the terms of the Debtors'
Second Amended Joint Plan of Reorganization (as subsequently amended, the
"Plan"), as containing adequate information, as such term is defined in Section
1125 of the Bankruptcy Code, to permit the solicitation of votes from creditors
on whether to accept the Plan. The Debtors commenced solicitation on April 4,
2003. The voting record date was set as March 19, 2003 and the deadline for
returning completed ballots, originally set for May 14, 2003, was extended to
June 6, 2003. A hearing to consider confirmation of the Plan began on June 13,
2003. On June 16, 2003, the Debtors filed a Third Amended Joint Plan of
Reorganization. On July 15, 2003, the Debtors filed a Fourth Amended Joint Plan
of Reorganization, principally reflecting modifications to the non-debtor
release provision and related components of the Plan.
On August 2, 2003, the Debtors filed an amended declaration of the voting
agent, which noted that all classes, other than the holders of the
Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts ("Trust Preferred Securities" or "TOPrS"), voted to accept the Plan. On
July 31, 2003, CNC announced that it had reached an agreement-in-principle with
the TOPrS, and the Debtors expect to file a Fifth Amended Joint Plan of
Reorganization incorporating the terms of this settlement. The Debtors will
emerge from bankruptcy if and when the Plan, as amended, is approved by the
Bankruptcy Court, and all conditions to the consummation of the Plan have been
satisfied or waived.
The Debtors previously filed with the Bankruptcy Court schedules of assets
and liabilities of the Debtors as reflected on our books and records. Subject to
certain limited exceptions, the Bankruptcy Court established a bar date of
February 21, 2003, for all prepetition claims against the Debtors. A bar date is
the date by which claims against the Debtors must be filed if the claimants are
to be eligible to receive any distribution in the bankruptcy proceedings. The
Debtors notified all known or potential claimants subject to the February 21,
2003 bar date of their need to file a proof of claim with the Bankruptcy Court.
Approximately 9,000 proofs of claim were filed on or before the February 21,
2003 bar date and the Company has been objecting to claims and otherwise
reconciling claims that differ from the Debtors' records. Any differences that
cannot be resolved through negotiations between the Debtors and the claimant
will be resolved by the Bankruptcy Court. Although the ultimate number and
amount of allowed claims is not presently known, on July 11, 2003, the Debtors
filed a declaration of the claims agent regarding the status of general
unsecured claims.
We have filed several motions in the Chapter 11 Cases pursuant to which the
Bankruptcy Court has granted us authority or approval with respect to various
items required by the Bankruptcy Code and/or necessary for our reorganization
efforts. We have obtained orders providing for, among other things: (i) payment
of prepetition and postpetition employee compensation and benefits; and (ii)
continuing a key-employee retention plan.
Under the priority schedule established by the Bankruptcy Code, certain
postpetition and prepetition liabilities need to be satisfied before unsecured
creditors and holders of CNC's common and preferred stock and Trust Preferred
Securities are entitled to receive any distribution. The Plan sets forth the
Debtors' proposed treatment of claims and equity interests. No assurance can be
given as to what values, if any, will be ascribed in the bankruptcy proceedings
to each of these constituencies. Our Plan would result in holders of CNC's
common stock and preferred stock receiving no value on account of the
cancellation of their interests. In addition, holders of unsecured claims
against the Debtors would, in most cases, receive less than full recovery.
At this time, it is not possible to predict with certainty the effect of
the Chapter 11 Cases on our business or various creditors, or when we will
emerge from Chapter 11. Our future results depend upon our confirming and
successfully implementing, on a timely basis, our plan of reorganization.
DISCONTINUED FINANCE BUSINESS - SALE OF CFC
In October 2002, we announced that we had engaged financial advisors to
pursue various alternatives with respect to our finance business and that CNC's
board of directors had approved a plan to sell or seek new investors for our
finance business. On December 19, 2002, CFC entered into an Asset Purchase
Agreement (the "Asset Purchase Agreement") with CFN Investment Holdings LLC
("CFN"), an affiliate of Fortress Investment Group LLC, J.C. Flowers & Co. LLC
and Cerberus Capital Management, L.P., pursuant to which CFC would, subject to
the satisfaction of certain conditions, sell all or substantially all of its
assets (the "CFC Assets") in a sale pursuant to Section 363 of the Bankruptcy
Code as part of CFC's
9
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Chapter 11 proceedings, subject to the right of CFN to exclude certain assets
from its purchase. In accordance with Section 363 of the Bankruptcy Code and the
terms of the Asset Purchase Agreement, CFC continued to seek alternative
transactions that would provide greater value to CFC and its creditors than the
transactions contemplated by the Asset Purchase Agreement.
As part of CFC's efforts to seek alternative transactions that would
provide greater value to CFC, and in accordance with the bidding procedures
order approved by the Bankruptcy Court, CFC conducted an auction for the sale of
its businesses and assets. Potential bidders were allowed to participate in the
auction if they submitted bids for the purchase of the CFC Assets that, by their
own terms or aggregated with other bids, were for more than the purchase price
payable under the Asset Purchase Agreement, plus the amount of the break-up fee
of $30 million, plus $5 million in expense reimbursements, plus the profit
sharing rights relating to the manufactured housing business. The auction, which
commenced on February 28, 2003, promptly adjourned, and was continued to March
4, 2003, ultimately concluding the morning of March 5, 2003.
At the auction, CFC, with the assistance of its advisors, analyzed each of
the bids presented and determined that CFN's bid of $970 million in cash, plus
the assumption of certain liabilities, represented the highest and best bid. The
terms of the sale included an option for CFC to sell the assets of Mill Creek
Bank, Inc. ("Mill Creek Bank", formerly known as Conseco Bank, Inc.) to General
Electric Capital Corporation ("GE") for approximately $310 million in cash, plus
certain assumed liabilities, which option, if exercised, would provide CFN with
a credit of $270 million to its $970 million bid.
On March 6, 2003, CFC received an offer from Berkadia Equity Holdings,
L.L.C. ("Berkadia") that purported to be a bid in the recently concluded
auction. Concurrently therewith, Berkadia filed an objection to the sale that
the Bankruptcy Court heard, and summarily dismissed, on March 7, 2003. After
further negotiations during the March 7-14, 2003 period, CFN and GE
significantly increased the amount of cash to be paid for the CFC Assets.
Ultimately, each of the major constituencies, including the CFC Committee, the
Ad Hoc Securitization Holders' Committee, U.S. Bank as securitization trustee
for the certificate holders of certain lower-rated securities that are senior in
payment priority to the interest-only securities, and Federal National Mortgage
Association, as a major bond holder, agreed to support the sale of CFC Assets to
CFN and GE. On March 14, 2003, the Bankruptcy Court entered orders approving the
terms of the sale of the CFC Assets free and clear of all liens to each of CFN
and GE. The closing of the sale of the CFC Assets was completed in June 2003. No
proceeds resulting from the sale are available to satisfy the creditors of CNC
or CIHC.
BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared on a
going concern basis, which assumes continuity of operations and realization of
assets and liabilities in the ordinary course of business, and in accordance
with Statement of Position 90-7 "Financial Reporting by Entities in
Reorganization under the Bankruptcy Code" ("SOP 90-7"). Accordingly, all
prepetition liabilities subject to compromise have been segregated in the
consolidated balance sheet and classified as "liabilities subject to compromise"
at the estimated amount of allowable claims.
Pursuant to SOP 90-7, professional fees associated with the Chapter 11
Cases are expensed as incurred and reported as reorganization items. Interest
expense is reported only to the extent that it will be paid during the Chapter
11 Cases or when it is probable that it will be an allowed claim. During the
first six months of 2003, the Company recognized a charge of $32.5 million
associated with the Chapter 11 Cases for fees payable to professionals to assist
with the filing of the Chapter 11 Cases.
We are currently operating under the jurisdiction of Chapter 11 of the
Bankruptcy Code and the Bankruptcy Court, and continuation as a going concern is
contingent upon our ability to obtain confirmation of the Plan, return to
profitability, generate sufficient cash flows from operations and many other
bankruptcy considerations and risks related to our business and financial
condition. These matters raise substantial doubt about Conseco's ability to
continue as a going concern. The accompanying consolidated financial statements
do not include any adjustments relating to the recoverability and classification
of recorded asset amounts or the amounts and classification of liabilities that
might result from the outcome of these uncertainties. Additionally, our Plan
will materially change amounts reported in the consolidated financial
statements, which do not give effect to all adjustments of the carrying value of
assets and liabilities that are necessary as a consequence of a reorganization
under Chapter 11 of the Bankruptcy Code.
10
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly our financial position and
results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2003 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.
During the third quarter of 2002, CNC entered into an agreement to sell
Conseco Variable Insurance Company ("CVIC"), its wholly owned subsidiary and the
primary writer of its variable annuity products. The sale was completed in
October 2002. The operating results of CVIC have been reported as discontinued
operations in all periods presented in the accompanying consolidated statement
of operations. See the note to the consolidated financial statements entitled
"Discontinued Operations."
During 2001, we stopped renewing a large portion of our major medical lines
of business. These lines of business are referred to herein as the "major
medical business in run-off".
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, certain investments, assets and liabilities related
to income taxes, goodwill, liabilities for insurance and asset accumulation
products, liabilities related to litigation, guaranty fund assessment accruals
and liabilities related to guarantees of bank loans and the related interest
loans to certain current and former directors, officers and key employees. If
our future experience differs from these estimates and assumptions, our
financial statements would be materially affected.
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
The Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets"
("SFAS 142"), in June 2001. Under the new rule, intangible assets with an
indefinite life are no longer amortized in periods subsequent to December 31,
2001, but are subject to annual impairment tests (or more frequent under certain
circumstances), effective January 1, 2002. The Company determined that all of
its goodwill had an indefinite life and was therefore subject to the new rules.
The Company adopted SFAS 142 on January 1, 2002.
Pursuant to the transitional rules of SFAS 142, we completed the two-step
impairment test during 2002 and, as a result of that test, we recorded the
cumulative effect of the accounting change for the goodwill impairment charge of
$2,949.2 million. The impairment charge is reflected as the cumulative effect of
an accounting change in the accompanying consolidated statement of operations
for the six months ended June 30, 2002. Subsequent impairment tests will be
performed on an annual basis, or more frequently if circumstances indicate a
possible impairment. Subsequent impairment charges are classified as an
operating expense.
11
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Changes in the carrying amount of goodwill for the six months ended June
30, 2003 and 2002, are as follows:
Six months ended
June 30,
------------------
2003 2002
---- ----
(Dollars in millions)
Goodwill balance, beginning of period....................................... $100.0 $ 3,695.4
Cumulative effect of accounting change...................................... - (2,949.2)
Reduction of tax valuation contingencies established at acquisition date
for acquired companies.................................................. - (146.2)
------ ---------
Goodwill balance, end of period............................................. $100.0 $ 600.0
====== =========
LIABILITIES SUBJECT TO COMPROMISE
Under the Bankruptcy Code, actions by creditors to collect indebtedness
owed prior to the Petition Date are stayed and certain other prepetition
contractual obligations may not be enforced against the Debtors. We have
received approval from the Bankruptcy Court to pay certain prepetition
liabilities including employee salaries and wages, benefits and other employee
obligations. All other prepetition liabilities have been classified as
"liabilities subject to compromise" in the accompanying consolidated balance
sheet.
The following table summarizes the components of the liabilities included
in the line "liabilities subject to compromise" in our consolidated balance
sheet (dollars in millions):
June 30, December 31,
2003 2002
-------- ------------
Other liabilities:
Liability for guarantee of bank loans to current and former
directors, officers and key employees to purchase
CNC common stock................................................... $ 483.3 $ 480.8
Interest payable...................................................... 237.1 171.6
Accrual for distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts............... 90.1 90.1
Liability for retirement benefits pursuant to executive
employment agreements.............................................. 22.6 22.6
Liability for deferred compensation................................... 2.1 2.3
Other liabilities..................................................... 9.0 48.8
-------- --------
Total other liabilities subject to compromise...................... 844.2 816.2
Notes payable - direct corporate obligations.............................. 4,127.5 4,057.1
-------- --------
Total liabilities subject to compromise............................ $4,971.7 $4,873.3
======== ========
12
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
The following table summarizes condensed consolidating financial
information segregating such information between the Debtors and non-Debtor
subsidiaries.
Condensed Consolidating Balance Sheet as of June 30, 2003
(Dollars in millions)
Conseco and Subsidiaries Conseco, Inc.
subsidiaries in not in and subsidiaries
reorganization reorganization Eliminations consolidated
-------------- -------------- ------------ ------------
ASSETS
Cash and cash equivalents...................................... $ 28.5 $ 1,365.6 $ - $ 1,394.1
Investments.................................................... 6.2 22,592.2 - 22,598.4
Investment in wholly-owned subsidiaries
(eliminated in consolidation).............................. 6,179.1 1,239.0 (7,418.1) -
Receivable from affiliates
(eliminated in consolidation).............................. 1,257.8 1,164.4 (2,422.2) -
Income tax assets.............................................. 91.2 25.1 (62.9) 53.4
Other assets................................................... 72.7 5,420.7 (.2) 5,493.2
--------- ---------- --------- ---------
Total assets......................................... $ 7,635.5 $31,807.0 $(9,903.4) $29,539.1
========= ========= ========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Liabilities:
Liabilities for insurance and asset accumulation products.. $ - $22,605.1 $ - $22,605.1
Payables to subsidiaries (eliminated in consolidation)..... 8.2 1,288.0 (1,296.2) -
Other liabilities.......................................... 23.0 1,544.6 - 1,567.6
Liabilities subject to compromise.......................... 4,971.7 - - 4,971.7
Affiliated liabilities subject to compromise
(eliminated in consolidation)........................... 1,177.4 - (1,177.4) -
--------- --------- --------- ---------
Total liabilities.................................... 6,180.3 25,437.7 (2,473.6) 29,144.4
--------- --------- --------- ---------
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts........................... 1,921.5 - - 1,921.5
Shareholders' equity (deficit):
Preferred stock............................................ 1,654.6 - (1,152.9) 501.7
Common stock and additional paid-in capital (no par value,
1,000,000,000 shares authorized, shares issued and
outstanding: 2003 and 2002 - 346,007,133)............... 3,497.7 6,346.1 (6,346.4) 3,497.4
Accumulated other comprehensive income..................... 1,143.4 1,143.4 (1,143.4) 1,143.4
Retained earnings (deficit)................................ (6,762.0) (1,120.2) 1,212.9 (6,669.3)
--------- --------- --------- ---------
Total shareholders' equity (deficit)................. (466.3) 6,369.3 (7,429.8) (1,526.8)
--------- --------- --------- ---------
Total liabilities and shareholders' equity (deficit). $ 7,635.5 $31,807.0 $(9,903.4) $29,539.1
========= ========= ========= =========
13
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Condensed Consolidating Balance Sheet as of December 31, 2002
(Dollars in millions)
Conseco and Subsidiaries Conseco, Inc.
subsidiaries in not in and subsidiaries
reorganization reorganization Eliminations consolidated
-------------- -------------- ------------ ------------
ASSETS
Cash and cash equivalents.................................... $ 41.5 $ 1,227.4 $ - $ 1,268.9
Investments.................................................. 5.9 21,777.8 - 21,783.7
Investment in wholly-owned subsidiaries
(eliminated in consolidation)............................ 5,521.5 1,239.0 (6,760.5) -
Receivable from affiliates
(eliminated in consolidation)............................ 1,280.3 1,153.7 (2,434.0) -
Income tax assets............................................ 77.8 23.7 - 101.5
Other assets................................................. 66.8 5,663.8 - 5,730.6
Assets of discontinued operations............................ 17,624.3 - - 17,624.3
--------- --------- --------- ---------
Total assets....................................... $24,618.1 $31,085.4 $(9,194.5) $46,509.0
========= ========= ========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Liabilities:
Liabilities for insurance and asset accumulation products $ - $22,797.1 $ - $22,797.1
Payables to subsidiaries (eliminated in consolidation)... 4.8 1,298.3 (1,303.1) -
Other liabilities........................................ - 1,343.2 1,343.2
Liabilities of discontinued operations................... 17,624.3 - - 17,624.3
Liabilities subject to compromise........................ 4,873.3 - - 4,873.3
Affiliated liabilities subject to compromise
(eliminated in consolidation)......................... 1,177.4 - (1,177.4) -
--------- --------- --------- ---------
Total liabilities.................................. 23,679.8 25,438.6 (2,480.5 46,637.9
--------- --------- --------- ---------
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts......................... 1,921.5 - - 1,921.5
Shareholders' equity (deficit):
Preferred stock.......................................... 1,644.7 - (1,143.0) 501.7
Common stock and additional paid-in capital (no par
value, 1,000,000,000 shares authorized, shares issued
and outstanding: 2002 - 346,007,133).................. 3,497.3 6,393.4 (6,393.7) 3,497.0
Accumulated other comprehensive income................... 580.6 470.0 (470.0) 580.6
Retained earnings (deficit).............................. (6,705.8) (1,216.6) 1,292.7 (6,629.7)
--------- --------- --------- ---------
Total shareholders' equity (deficit)............... (983.2) 5,646.8 (6,714.0) (2,050.4)
--------- --------- --------- ---------
Total liabilities and shareholders' equity (deficit) $24,618.1 $31,085.4 $(9,194.5) $46,509.0
========= ========= ========= =========
14
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Condensed Consolidating Statement of Operations
for the three months ended June 30, 2003
(Dollars in millions)
Conseco and Subsidiaries Conseco, Inc.
subsidiaries in not in and subsidiaries
reorganization reorganization Eliminations consolidated
-------------- -------------- ------------ ------------
Revenues:
Insurance policy income....................................... $ - $ 813.9 $ - $ 813.9
Net investment income......................................... 1.6 392.0 - 393.6
Net investment income from venture capital investments........ - 6.0 - 6.0
Fee and interest income - affiliated
(eliminated in consolidation).............................. .2 9.2 (9.4) -
Net investment losses......................................... (.3) (2.0) - (2.3)
Fee revenue and other income.................................. .1 12.7 - 12.8
------ -------- ------ --------
Total revenue........................................... 1.6 1,231.8 (9.4) 1,224.0
------ -------- ------ --------
Expenses:
Insurance policy benefits..................................... - 872.6 - 872.6
Provision for losses.......................................... 1.3 14.5 - 15.8
Interest expense.............................................. 69.8 3.7 - 73.5
Interest expense - affiliated (eliminated in consolidation)... - 7.6 (7.6) -
Amortization.................................................. - 138.6 - 138.6
Operating costs and expenses - affiliated
(eliminated in consolidation).............................. 2.6 - (2.6) -
Operating costs and expenses.................................. (29.9) 178.3 - 148.4
Reorganization items.......................................... 14.4 - - 14.4
------ -------- ------ --------
Total expenses.......................................... 58.2 1,215.3 (10.2) 1,263.3
------ -------- ------ --------
Income (loss) before income taxes, equity in undistributed
earnings of subsidiaries and distributions on Company-
obligated mandatorily redeemable preferred securities
of subsidiary trusts................................. (56.6) 16.5 .8 (39.3)
Income tax benefit on period income........................... (9.9) (6.7) - (16.6)
------ -------- ------ --------
Income (loss) before equity in undistributed earnings
of subsidiaries and discontinued operations........ (46.7) 23.2 .8 (22.7)
Equity in undistributed earnings of subsidiaries before
discontinued operations (eliminated in consolidation).... 29.3 - (29.3) -
------ -------- ------ --------
Income (loss) before discontinued operations............ (17.4) 23.2 (28.5) (22.7)
Discontinued operations....................................... - 2.1 - 2.1
------ -------- ------ --------
Net income (loss)....................................... (17.4) 25.3 (28.5) (20.6)
Preferred stock dividends - affiliated........................ 6.6 - (6.6) -
------ -------- ------ --------
Income (loss) applicable to common stock................ $(24.0) $ 25.3 $(21.9) $ (20.6)
====== ======== ====== ========
15
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Condensed Consolidating Statement of Operations
for the six months ended June 30, 2003
(Dollars in millions)
Conseco and Subsidiaries Conseco, Inc.
subsidiaries in not in and subsidiaries
reorganization reorganization Eliminations consolidated
-------------- -------------- ------------ ------------
Revenues:
Insurance policy income..................................... $ - $1,687.5 $ - $1,687.5
Net investment income....................................... 3.0 718.9 - 721.9
Net investment income from venture capital investments...... - 8.5 - 8.5
Fee and interest income - affiliated
(eliminated in consolidation)............................ .4 18.5 (18.9) -
Net investment gains (losses)............................... (.3) 11.0 - 10.7
Fee revenue and other income................................ .3 26.2 - 26.5
------- -------- ------ --------
Total revenue......................................... 3.4 2,470.6 (18.9) 2,455.1
------- -------- ------ --------
Expenses:
Insurance policy benefits................................... - 1,731.3 - 1,731.3
Provision for losses........................................ 2.5 28.6 - 31.1
Interest expense............................................ 140.6 6.5 - 147.1
Interest expense - affiliated (eliminated in consolidation). - 15.2 (15.2) -
Amortization................................................ - 296.6 - 296.6
Operating costs and expenses - affiliated
(eliminated in consolidation)............................ 5.3 - (5.3) -
Operating costs and expenses................................ (26.4) 329.7 - 303.3
Reorganization items........................................ 32.5 - - 32.5
------- -------- ------ --------
Total expenses........................................ 154.5 2,407.9 (20.5) 2,541.9
------- -------- ------ --------
Income (loss) before income taxes, equity in
undistributed earnings of subsidiaries and
distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary
trusts............................................. (151.1) 62.7 1.6 (86.8)
Income tax benefit on period income......................... (13.5) (17.7) - (31.2)
------- -------- ------ --------
Income (loss) before equity in undistributed earnings
of subsidiaries and discontinued operations...... (137.6) 80.4 1.6 (55.6)
Equity in undistributed earnings of subsidiaries before
discontinued operations (eliminated in consolidation).. 94.6 - (94.6) -
------- -------- ------ --------
Income (loss) before discontinued operations.......... (43.0) 80.4 (93.0) (55.6)
Discontinued operations..................................... - 16.0 - 16.0
------- -------- ------ --------
Net income (loss)..................................... (43.0) 96.4 (93.0) (39.6)
Preferred stock dividends - affiliated...................... 13.2 - (13.2) -
------- -------- ------ --------
Income (loss) applicable to common stock.............. $ (56.2) $ 96.4 $(79.8) $ (39.6)
======= ======== ====== ========
16
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Condensed Consolidating Statement of Cash Flows
for the six months ended June 30, 2003
(Dollars in millions)
Conseco and Subsidiaries Conseco, Inc.
subsidiaries in not in and subsidiaries
reorganization reorganization Eliminations consolidated
-------------- -------------- ------------ ------------
Net cash provided (used) by operating activities............ $(10.9) $ 556.0 $ (.8) $ 544.3
Net cash provided (used) by investing activities............ (1.9) 127.2 (8.8) 116.5
Net cash provided (used) by financing activities............ (.2) (545.0) 9.6 (535.6)
------ -------- ---- --------
Net increase (decrease) in cash and cash equivalents........ (13.0) 138.2 - 125.2
Cash and cash equivalents, beginning of period.............. 41.5 1,227.4 - 1,268.9
------ -------- ---- --------
Cash and cash equivalents, end of period................. $ 28.5 $1,365.6 $ - $1,394.1
====== ========= ==== ========
Certain creditors have filed claims substantially in excess of amounts
reflected in the Debtors' records. Consequently, the amount included in the
consolidated balance sheet at June 30, 2003, as "liabilities subject to
compromise" may be adjusted.
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).
Accumulated other comprehensive income is primarily comprised of unrealized
gains on actively managed fixed maturity investments. Such amounts, included in
shareholders' equity (deficit) as of June 30, 2003, and December 31, 2002, were
as follows:
June 30, December 31,
2003 2002
---- ----
(Dollars in millions)
Unrealized gains on investments....................................................... $1,196.5 $448.1
Adjustments to cost of policies purchased and cost of policies produced............... (267.2) (95.3)
Deferred income tax benefit........................................................... 223.4 249.6
Other................................................................................. (9.3) (21.8)
-------- ------
Accumulated other comprehensive income........................................... $1,143.4 $580.6
======== ======
17
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
At June 30, 2003, our venture capital investments consisted of 4.1 million
shares of AT&T Wireless Services, Inc. ("AWE") with a value of $33.5 million.
Our investment in AWE is carried at estimated fair value, with changes in fair
value recognized as investment income (loss). We recognized venture capital
investment income (losses) of $6.0 million and $(23.7) million in the second
quarters of 2003 and 2002, respectively, related to this investment. Our venture
capital investment income (losses) related to this investment were $8.5 million
and $(100.0) million in the first six months of 2003 and 2002, respectively.
COST OF POLICIES PRODUCED
The costs that vary with, and are primarily related to, producing new
insurance business are referred to as cost of policies produced. We amortize
these costs (using the interest rate credited to the underlying policy for
universal life or investment-type products and the projected investment earnings
rate for other products): (i) in relation to the estimated gross profits for
universal life-type and investment-type products; or (ii) in relation to future
anticipated premium revenue for other products.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the cost of
policies produced for the change in amortization that would have been recorded
if actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income (loss)
within shareholders' deficit.
When we replace an existing insurance contract with another insurance
contract with substantially different terms, all unamortized cost of policies
produced related to the replaced contract is immediately written off. When we
replace an existing insurance contract with another insurance contract with
substantially similar terms, we continue to defer the cost of policies produced
associated with the replaced contract.
We regularly evaluate the recoverability of the unamortized balance of the
cost of policies produced. We consider estimated future gross profits or future
premiums, expected mortality or morbidity, interest earned and credited rates,
persistency and expenses in determining whether the balance is recoverable. If
we determine a portion of the unamortized balance is not recoverable, it is
charged to amortization expense.
COST OF POLICIES PURCHASED
The cost assigned to the right to receive future cash flows from contracts
existing at the date of an acquisition is referred to as the cost of policies
purchased. We also defer renewal commissions paid in excess of ultimate
commission levels related to the purchased policies in this account. The balance
of this account is amortized, evaluated for recovery, and adjusted for the
impact of unrealized gains (losses) in the same manner as the cost of policies
produced described above.
The discount rate we use to determine the value of the cost of policies
purchased is the rate of return we need to earn in order to invest in the
business being acquired. In determining this required rate of return, we
consider many factors including: (i) the magnitude of the risks associated with
each of the actuarial assumptions used in determining expected future cash
flows; (ii) the cost of our capital required to fund the acquisition; (iii) the
likelihood of changes in projected future cash flows that might occur if there
are changes in insurance regulations and tax laws; (iv) the acquired company's
compatibility with other Conseco activities that may favorably affect future
cash flows; (v) the complexity of the acquired company; and (vi) recent prices
(i.e., discount rates used in determining valuations) paid by others to acquire
similar blocks of business.
The amortization related to the cost of policies purchased was $83.3
million and $98.1 million in the first six months of 2003 and 2002,
respectively. The Company expects to amortize approximately 12 percent of the
December 31, 2002 balance of cost of policies purchased in 2003, 11 percent in
2004, 9 percent in 2005, 8 percent in 2006 and 7 percent in 2007.
18
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
EARNINGS PER SHARE
A reconciliation of net loss and shares used to calculate basic and diluted
loss per share is as follows:
Three months ended Six months ended
June 30, June 30,
------------------ ------------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions and shares in thousands)
Net loss.......................................................... $(20.6) $(1,333.1) $(39.6) $(4,378.2)
Preferred stock dividends......................................... - (.9) - (1.9)
------ --------- ------ ---------
Net loss applicable to common ownership
for basic earnings per share............................... $(20.6) $(1,334.0) $(39.6) $(4,380.1)
====== ========= ====== =========
Shares:
Weighted average shares outstanding
for basic and diluted earnings per share..................... 346,007 346,005 346,007 345,607
======= ======= ======= =======
There were no dilutive common stock equivalents during the 2003 and 2002
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 six months ended June 30, 2003 and 2002, because doing so would have
been antidilutive in the periods presented.
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2003 2002 2003 2002
---- ---- ---- ----
(Shares in thousands)
Equivalent common shares that were antidilutive during the period:
Stock options..................................................... - 3,351 - 2,914
Employee benefit plans............................................ 874 889 874 907
Assumed conversion of convertible preferred stock................. 29,129 28,414 29,129 28,273
------ ------ ------ ------
Antidilutive equivalent common shares........................... 30,003 32,654 30,003 32,094
====== ====== ====== ======
BUSINESS SEGMENTS
We have historically managed 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. CFC historically provided a variety of finance products
including: (i) loans for the purchase of manufactured housing, home improvements
and various consumer products; (ii) home equity loans; and (iii) private label
credit card programs. As a result of the formalization of the plan to sell the
finance business and the filing of petitions under
19
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
the Bankruptcy Code by the Finance Company Debtors, the finance business was
accounted for as a discontinued business in Conseco's consolidated financial
statements in 2002. As of March 31, 2003, Conseco no longer includes the assets
and liabilities of CFC in its consolidated financial statements.
Corporate and other segment. Our corporate segment includes certain
investment activities, such as our venture capital investment in AWE. 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.
Operating information regarding the insurance and corporate segments was as
follows:
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Revenues:
Insurance and fee-based segment:
Insurance policy income:
Annuities............................................... $ 29.7 $ 34.5 $ 68.5 $ 63.0
Supplemental health..................................... 572.9 564.1 1,148.9 1,137.3
Life.................................................... 146.8 133.2 300.5 315.0
Other................................................... 17.5 28.8 37.7 59.3
Net investment income (a)................................. 385.2 330.3 706.6 710.2
Fee revenue and other income (a).......................... 12.8 23.3 26.2 50.0
Net realized investment gains (losses) (a)................ (2.3) (223.6) 10.7 (253.2)
-------- -------- -------- --------
Total insurance and fee-based segment revenues........ 1,162.6 890.6 2,299.1 2,081.6
-------- -------- -------- --------
Corporate and other:
Net investment income..................................... 6.1 3.0 9.2 5.0
Venture capital gain (loss) related to investment in AWE.. 6.0 (23.7) 8.5 (100.0)
Revenue from the major medical business in run-off........ 49.3 118.8 138.3 259.8
-------- -------- -------- --------
Total corporate segment revenues...................... 61.4 98.1 156.0 164.8
-------- -------- -------- --------
Eliminations................................................ - (5.0) - (9.7)
-------- -------- -------- --------
Total revenues........................................ 1,224.0 983.7 2,455.1 2,236.7
-------- -------- -------- --------
Expenses:
Insurance and fee-based segment:
Insurance policy benefits................................. 834.5 665.8 1,619.4 1,415.8
Amortization.............................................. 130.6 232.9 279.2 395.0
Interest expense on investment borrowings................. 3.8 3.3 6.4 10.3
Other operating costs and expenses........................ 148.9 121.7 292.1 257.9
Special charges........................................... - 36.7 - 39.7
-------- -------- -------- ---------
Total insurance and fee-based segment expenses.......... 1,117.8 1,060.4 2,197.1 2,118.7
-------- -------- -------- ---------
(continued on the following page)
20
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Corporate and other:
Interest expense on corporate debt........................ 69.8 79.5 140.7 154.0
Provision for losses and interest expense related to stock
purchase plan........................................... 15.8 100.0 31.1 140.0
Expenses from the major medical business in run-off....... 49.3 118.8 138.3 259.8
Other corporate expenses, less charges to subsidiaries for
services provided....................................... (3.8) 7.2 2.2 19.8
Extraordinary gain on extinguishment of debt.............. - (1.8) - (1.8)
Reorganization items...................................... 14.4 - 32.5 -
Special charges........................................... - 11.5 - 28.5
-------- -------- -------- --------
Total corporate segment expenses........................ 145.5 315.2 344.8 600.3
-------- -------- -------- --------
Eliminations................................................ - (5.0) - (9.7)
-------- -------- -------- --------
Total expenses.......................................... 1,263.3 1,370.6 2,541.9 2,709.3
-------- -------- -------- --------
Income (loss) before income taxes, minority interest and
cumulative effect of accounting change:
Insurance and fee-based operations........................ 44.8 (169.8) 102.0 (37.1)
Corporate interest expense and other items................ (84.1) (217.1) (188.8) (435.5)
-------- -------- -------- --------
Loss before income taxes, minority interest,
discontinued operations and cumulative effect of
accounting change................................... $ (39.3) $ (386.9) $ (86.8) $ (472.6)
======== ======== ======== ========
- --------------------
(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 $39.4 million and $52.2 million
in the first six months of 2003 and 2002, 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 $57.8 million and $(18.3) million in the first
six months of 2003 and 2002, 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 $80.0 million and $32.8 million at
June 30, 2003 and December 31, 2002, 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
21
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Financial Accounting Standards No. 138, "Accounting for Certain Derivative
Instruments and Certain Hedging Activities". 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 $319.9 million
and $274.0 million at June 30, 2003 and December 31, 2002, respectively.
If the counterparties for the derivatives we hold fail to meet their
obligations, Conseco may have to recognize a loss. Conseco limits its exposure
to such a loss by diversifying among several counterparties believed to be
strong and creditworthy. At June 30, 2003, all of the counterparties were rated
"A" or higher by Standard & Poor's Corporation.
GUARANTEES
We have guaranteed $481.3 million principal amount of bank loans to current
and former directors, officers and key employees (the "D&O loans"). Conseco
defaulted on certain notes, which resulted in the immediate maturity of the D&O
loans through cross-acceleration and cross-default provisions contained in the
governing instruments. 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. These
shares have been held by the D&O lenders as collateral for the loans. In
addition, as of June 30, 2003, Conseco had provided loans to participants for
interest on the D&O loans totaling $207.8 million.
Under the terms of the Plan, certain eligible participants would have their
initial D&O loan amounts reduced in settlement of certain claims they may have
against the Company. These eligible participants currently collectively owe less
than 10 percent of the entire amount due under the stock purchase program.
Conseco also granted a security interest in most of its assets in conjunction
with the guarantee of a portion of the bank loans. During the first six months
of 2003, we established a noncash provision in connection with these guarantees
and loans of $31.1 million. At June 30, 2003, the reserve for losses on the loan
guarantees and on the loans held by Conseco totaled $691.1 million. During 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
(including accrued interest, the balance on these loans was $59.3 million at
June 30, 2003). At June 30, 2003, the guaranteed bank loans and interest loans
exceeded the value of the collateral held and the reserve for losses by
approximately $60 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.
CIHC was the guarantor of certain obligations of CFC. The exposure under
the guarantees was limited to the balance of certain credit facilities not to
exceed $250 million. If the Plan is confirmed, CIHC will have no additional
exposure as guarantor of these facilities.
In accordance with the terms of the Company's former Chief Executive
Officer's employment agreement, Bankers Life and Casualty Company, a
wholly-owned subsidiary of the Company, is the guarantor of the former
executive's nonqualified supplemental retirement benefit. The liability for such
benefit at June 30, 2003 was $17.2 million and is included in the caption "Other
liabilities" in the liability section of the consolidated balance sheet.
REINSURANCE
The cost of reinsurance ceded totaled $149.9 million and $188.1 million in
the first six months of 2003 and 2002, 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
$137.3 million and $166.0 million in the first six months of 2003 and 2002,
respectively. Reinsurance premiums assumed totaled $46.2 million and $45.1
million in the first six months of 2003 and 2002, respectively.
INCOME TAXES
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting bases of assets and
liabilities, capital loss carryforwards and net operating loss carryforwards. In
assessing the realization of deferred income tax assets, we consider whether it
is more likely than not that the deferred income tax assets
22
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
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 has been provided for the entire balance of net
deferred income tax assets at June 30, 2003, 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. This conclusion was greatly
influenced by recent unfavorable developments affecting the Company such as
rating downgrades that decreased the Company's likelihood to generate adequate
future taxable income to realize the tax benefits.
The projected ordinary loss carryforwards and capital loss carryforwards
are $1.9 billion and $428.0 million, respectively, as of June 30, 2003. The
ordinary loss carryforwards include amounts attributed to losses incurred as a
result of our prior ownership of CFC and losses from the operation of our other
businesses. The losses are subject to change due to actual results varying from
estimates, income tax examinations, disposition of certain businesses, and the
conclusion of bankruptcy proceedings. Approximately $2.3 million of the ordinary
loss carryforwards will expire in 2003 if not utilized. The reorganization will
result in an "ownership change" for purposes of Section 382 of the Internal
Revenue Code of 1986, as amended, which may limit the use of ordinary loss
carryforwards and capital loss carryforwards.
At June 30, 2003, Conseco had $428.0 million of capital loss carryforwards.
These carryforwards will expire as follows: $23.2 million in 2006, $299.2
million in 2007 and $105.6 million in 2008.
A reconciliation of the U.S. statutory corporate income tax rate to the
effective rate reflected in the consolidated statement of operations is as
follows:
Six months ended
June 30,
------------------
2003 2002
---- ----
U.S. statutory corporate rate.................................................................. (35.0)% (35.0)%
Valuation allowance............................................................................ - 212.2
Income tax credits............................................................................. (2.2) (.5)
Other nondeductible expenses................................................................... .9 1.1
State taxes.................................................................................... .4 .3
---- -----
Effective tax rate...................................................................... (35.9)% 178.1%
===== =====
23
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
CHANGES IN DIRECT CORPORATE OBLIGATIONS
This note contains information regarding the following notes payable that
were direct corporate obligations of CNC as of June 30, 2003 and December 31,
2002:
June 30, December 31,
2003 2002
---- ----
(Dollars in millions)
$1.5 billion Senior Credit Facility.......................................... $ 1,594.2 $ 1,531.4
8.5% senior notes due 2002................................................... 224.9 224.9
8.5% guaranteed senior notes due 2003........................................ 1.0 1.0
8.125% senior notes due 2003................................................. 63.5 63.5
6.4% senior notes due 2003................................................... 234.1 234.1
6.4% guaranteed senior notes due 2004........................................ 14.9 14.9
10.5% senior notes due 2004.................................................. 24.5 24.5
8.75% senior notes due 2004.................................................. 423.7 423.7
8.75% guaranteed senior notes due 2006....................................... 364.3 364.3
6.8% senior notes due 2005................................................... 99.2 99.2
6.8% guaranteed senior notes due 2007........................................ 150.8 150.8
9.0% senior notes due 2006................................................... 150.8 150.8
9.0% guaranteed senior notes due 2008........................................ 399.2 399.2
10.75% senior notes due 2008................................................. 37.6 37.6
10.75% guaranteed senior notes due 2009...................................... 362.4 362.4
--------- ---------
Total principal amount.................................................. 4,145.1 4,082.3
Unamortized net discount related to issuance of notes payable ............... (25.5) (34.0)
Unamortized fair market value of terminated interest rate swap agreements.... 7.9 8.8
--------- ---------
Less amounts subject to compromise........................................... (4,127.5) (4,057.1)
--------- ---------
Direct corporate obligations............................................ $ - $ -
========= =========
CNC has not made any interest or principal payments on any of its direct
corporate obligations since its August 9, 2002 announcement that it intended to
effectuate a fundamental restructuring of the Company's capital structure. As a
result of its failure to make such payments and the filing of the Chapter 11
Cases, CNC has defaulted on its 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. CNC is also not in compliance with certain covenants under its bank
credit agreement and the guarantees of the D&O loans. During the bankruptcy
proceedings, the Debtors are not subject to the restrictions contained in the
bank credit agreement and the guarantees of the D&O loans, and the Bankruptcy
Code automatically stays any collection of prepetition claims.
CNC has a $1.5 billion credit facility (the "Senior Credit Facility") with
Bank of America, N.A., as administrative agent, and various other lending
institutions. The Senior Credit Facility was scheduled to mature on December 31,
2003. During 2003, $62.8 million of accrued and unpaid interest was added to the
outstanding principal amount of the Senior Credit Facility pursuant to a waiver
dated September 8, 2002.
In 1993, CNC issued $200 million of 8.125% senior notes due February 15,
2003 (the "93 Notes"). In 1994, CCP Insurance, Inc. ("CCP") issued $200 million
of 10.5% senior notes due December 15, 2004 (the "94 Notes"). CNC acquired CCP
by merger on August 31, 1995 and assumed CCP's obligations under the 94 Notes in
connection with the merger.
We sometimes refer to the 93 Notes and the 94 Notes collectively as the
"93/94 Notes." The 93/94 Notes are secured by the stock of CIHC, Conseco Capital
Management, Inc. (a registered investment advisor and wholly-owned subsidiary of
24
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
CNC), CFC and certain of its subsidiaries and certain intercompany notes.
Certain of the assets of CFC have been pledged to the holders of the 93/94
Notes. The Plan proposes that CFC pay the 93/94 Notes.
Effective September 9, 2002, we were subject to the default interest rate
on the Senior Credit Facility. Such rate is based on the prime rate plus a
margin of 3.75 percent (such rate averaged 8.0 percent during the first six
months of 2003). 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.
CHANGES IN COMMON STOCK
Changes in the number of shares of common stock outstanding were as
follows:
Six months ended
June 30,
-------------------
2003 2002
---- ----
(Shares in thousands)
Balance, beginning of period............................................................. 346,007 344,743
Stock options exercised............................................................... - 5
Shares issued under employee benefit compensation plans............................... - 1,259
------- -------
Balance, end of period................................................................... 346,007 346,007
======= =======
RECENTLY ISSUED ACCOUNTING STANDARDS
The FASB's Derivative Implementation Group issued SFAS No. 133
Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance
Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that
are Unrelated or Only Partially Related to the Creditworthiness of the Obligor
of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific
circumstances under which bifurcation of an instrument into a host contract and
an embedded derivative is required. DIG B36 requires the bifurcation of a
derivative from the receivable or payable related to a modified coinsurance
agreement, where the yield on the receivable and payable is based on a return of
a specified block of assets rather than the creditworthiness of the ceding
company. The effective date of the implementation guidance is October 1, 2003.
We have determined that certain of our reinsurance payable balances contain
embedded derivatives that will be required to be bifurcated pursuant to DIG B36.
While we have not yet determined the fair value of the embedded derivatives, we
do not believe that accounting for them in accordance with DIG B36 will have a
material impact on the Company's consolidated financial position or cash flows.
The FASB issued Financial Accounting Standards No. 149 "Amendment of SFAS
No. 133 on Derivative Instruments and Hedging Activities" ("SFAS 149") in April
2003. SFAS 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities." Except for
certain implementation guidance included in SFAS 149 which is already effective,
the new guidance is effective for: (i) contracts entered into or modified after
June 30, 2003; and (ii) hedging relationships designated after June 30, 2003.
The adoption of SFAS 149 did not have a material impact on the Company's
consolidated financial statements.
The FASB issued Financial Accounting Standards No. 150, "Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity" ("SFAS 150") in May 2003. SFAS 150 establishes standards for classifying
and measuring certain financial instruments that embody obligations of the
issuer and have characteristics of both liabilities and equity. For example,
mandatorily redeemable preferred stock is required to be classified as
liabilities pursuant to SFAS 150. SFAS 150 is effective immediately for
financial instruments entered into or modified after May 31, 2003, and for all
other financial instruments beginning with the third quarter of 2003. Our
Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts, with an aggregate carrying value of $1,921.5 million at June 30, 2003,
will be reclassified to liabilities pursuant to the provisions of SFAS 150.
Amounts previously classified as distributions on these instruments will be
recorded
25
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
as interest expense on a prospective basis upon adoption of SFAS 150. The
adoption of SFAS 150 will not impact net income applicable to common stock or
earnings per share.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants issued Statement of Position 03-1 "Accounting and
Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration
Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01
provides guidance on several insurance company disclosure and accounting matters
including: (i) presentation of separate accounts; (ii) accounting for any
interest in separate accounts held by the company; (iii) accounting for
transfers of assets from the general investment account to a separate account;
(iv) valuations of certain contract features such as guaranteed minimum death
benefits; (v) accounting for sales inducements; and (vi) other provisions. The
Company recently sold most of its separate account business and does not believe
the new guidance related to separate accounts will have a material impact on the
Company's consolidated financial position, results of operations or cash flows.
The guidance related to sales inducement will require us to change our
classification of these amounts, but will not materially change how we account
for them. We are currently evaluating the impact of the adoption of several
other provisions of SOP 03-01 on our consolidated financial position and results
of operations. SOP 03-01 is required to be adopted in the first quarter of 2004.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"), which requires expanded disclosures for
and, in some cases, consolidation of significant investments in variable
interest entities ("VIE"). A VIE is an entity in which the equity investors do
not have the characteristics of a controlling financial interest, or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. Under FIN 46, a
company is required to consolidate a VIE if it is the primary beneficiary of the
VIE. FIN 46 defines primary beneficiary as the party which will absorb a
majority of the VIE's expected losses or receive a majority of the VIE's
expected residual returns, or both. FIN 46 is effective immediately for VIEs
created after January 31, 2003. For VIEs acquired before February 1, 2003, the
additional disclosure requirements are effective for financial statements issued
after January 31, 2003 and the consolidation requirements must be applied not
later than the fiscal year or interim period beginning after June 15, 2003.
The Company has investments in various types of VIEs, some of which require
additional disclosure under FIN 46, and several of which will require
consolidation under FIN 46. As further discussed in the note to the consolidated
financial statements entitled "Investments in Variable Interest Entities",
certain of our investments in VIEs are already consolidated in our financial
statements. We have identified one additional VIE investment in which we are the
primary beneficiary and, accordingly, will require consolidation in our
financial statements beginning with our September 30, 2003 financial statements.
The additional liabilities, which will be recognized as a result of
consolidating the VIE, do not represent claims on the general assets of the
Company. Likewise, the additional assets, which will be recognized upon
consolidation, are collateral for the additional recognized liabilities.
Consequently, the adoption of the consolidation requirements of FIN 46 is not
expected to have a material impact on our financial condition or results of
operations. The note entitled "Investments in Variable Interest Entities"
includes the expanded disclosures required by FIN 46.
The FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("FIN 45") in November 2002. FIN 45 requires certain
guarantees to be recognized as liabilities at fair value. In addition, it
requires a guarantor to make new disclosures regarding its obligations. We
implemented the new disclosure requirements as of December 31, 2002. FIN 45's
liability recognition requirement is effective on a prospective basis for
guarantees issued or modified after December 31, 2002. We do not expect that FIN
45 will materially impact the Company's results of operations or financial
condition.
The FASB issued Statement of Financial Accounting Standards No. 146,
"Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146
addresses financial accounting and reporting for costs that are associated with
exit and disposal activities and supersedes Emerging Issues Task Force Issue No.
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)"
("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal
activities that are initiated after December 31, 2002. The provisions of EITF
94-3 shall continue to apply for an exit activity initiated prior to the
adoption of SFAS 146. SFAS 146 requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of commitment to an exit or disposal plan. The Company adopted the provisions of
SFAS 146 on January 1, 2003. The initial adoption of SFAS 146 did not have a
material impact on the Company's consolidated financial statements.
26
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
The FASB issued Statement of Financial Accounting Standards No. 145,
"Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No.
13, and Technical Corrections" ("SFAS 145") in April 2002. Under previous
guidance all gains and losses resulting from the extinguishment of debt were
required to be aggregated and, if material, classified as an extraordinary item,
net of related income tax effect. SFAS 145 rescinds that guidance and requires
that gains and losses from extinguishments of debt be classified as
extraordinary items only if they are both unusual and infrequent in occurrence.
SFAS 145 also amends previous guidance to require certain lease modifications
that have economic effects similar to sale-leaseback transactions to be
accounted for in the same manner as sale-leaseback transactions. The Company
adopted SFAS 145 on January 1, 2003. Prior period amounts related to
extraordinary gains on the extinguishment of debt have been reclassified in
accordance with the new guidance.
The FASB issued 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 followed this standard in determining when it
was appropriate to recognize impairments on assets we decided to sell as part of
our efforts to raise cash. We also followed this standard in determining that
our variable annuity business line and CFC should be presented as discontinued
operations in our consolidated financial statements (see the note to the
consolidated financial statements entitled "Discontinued Operations").
27
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
DISCONTINUED OPERATIONS
As previously described in the notes to the consolidated financial
statements entitled "Discontinued Finance Business - Sale of CFC" and "Basis of
Presentation", the operations of CFC and CVIC were classified as discontinued
operations in the 2002 consolidated statement of operations. The following
summarizes selected financial information of CFC and CVIC:
Three months ended Six months ended
June 30, 2002 June 30, 2002
------------------ ----------------
(dollars in millions)
CFC CVIC Total CFC CVIC Total
--- ---- ----- --- ---- -----
Insurance policy income.......................... $ - $ 10.0 $ 10.0 $ - $ 18.1 $ 18.1
Net investment income............................ 556.6 (62.9) 493.7 1,113.9 (96.7) 1,017.2
Fee revenue and other income..................... 63.1 - 63.1 131.2 .2 131.4
Total revenues................................... 629.9 (89.7) 540.2 1,262.5 (116.1) 1,146.4
Provision for losses............................. 158.3 - 158.3 316.7 - 316.7
Insurance policy benefits........................ - (67.1) (67.1) - (108.8) (108.8)
Interest expense................................. 283.4 .5 283.9 570.2 .9 571.1
Amortization..................................... - 6.6 6.6 - 17.9 17.9
Other operating costs and expenses............... 145.7 3.1 148.8 298.1 10.9 309.0
Special charges.................................. 9.3 73.9 83.2 56.5 73.9 130.4
Extraordinary (gain) loss on extinguishment
of debt...................................... .2 - .2 (6.2) - (6.2)
Total expenses................................... 596.9 17.0 613.9 1,235.3 (5.2) 1,230.1
Income (loss) before income tax
expense (benefit)............................ $ 33.0 $(106.7) $(73.7) $ 27.2 $(110.9) $ (83.7)
Income tax (expense) benefit..................... 12.6 (37.1) (24.5) 10.3 (37.7) (27.4)
------ ------- ------ -------- ------- --------
Net income (loss) classified as discontinued
operations................................... $ 20.4 $ (69.6) $(49.2) $ 16.9 $ (73.2) $ (56.3)
====== ======= ====== ======== ======= ========
In addition, in the six months of 2002, CVIC recognized a $43.8 million
cumulative effect of accounting change for goodwill impairment pursuant to the
adoption of SFAS 142.
During 2002, we recognized estimated losses related to the ultimate sale
and disposition of the aforementioned discontinued businesses, including
estimated costs to sell and costs related to the resolution of contingencies.
During the six months ended June 30, 2003, we reduced the accrual for such
estimated costs by $16.0 million (after income taxes of $.7 million) to reflect
our current estimate. We recorded the reduction of such accrual as income from
discontinued operations.
LITIGATION AND OTHER LEGAL PROCEEDINGS
As described in the note to the consolidated financial statements entitled
"Proceedings under Chapter 11 of the Bankruptcy Code", CNC and several of its
subsidiaries filed voluntary petitions for reorganization under Chapter 11 of
the Bankruptcy Code in the Bankruptcy Court. The Company's insurance
subsidiaries and other subsidiaries that did not file petitions are separate
legal entities and are not included in the petitions filed by the parent. The
Debtors retain control of the insurance subsidiaries and related subsidiaries
and are authorized to operate these businesses as debtors-in-possession while
being subject to the jurisdiction of the Bankruptcy Court. As of the Petition
Date, pending litigation against the Debtors is stayed, and absent further order
of the Bankruptcy Court, substantially all prepetition liabilities of the
Debtors are subject to settlement under a plan of reorganization. Based on the
Plan of the Debtors, liabilities subject to compromise against CNC exceed the
fair value of the Debtors' assets, and unsecured claims will be satisfied at
less than 100 percent of their fair value.
28
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
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.
Securities Litigation
A total of forty-five suits filed in 2000 against CNC in the United States
District Court for the Southern District of Indiana 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 CNC and Conseco Financing Trust VII. These cases were
ultimately settled for $120 million, $20 million of which was paid by Conseco
and $100 million of which was paid by certain of the Company's directors' and
officers' liability insurance carriers, subject to certain modifications
approved by the Bankruptcy Court and Indiana District Court. The Company had
previously provided a liability of $40 million related to these cases due to
disputes with certain insurance carriers. During the quarter ending June 30,
2003, these disputes were resolved without any payment and the liability was
released.
Since we announced our intention to restructure our capital on August 9,
2002, a total of eight purported securities fraud class action lawsuits have
been filed in the United States District Court for the Southern District of
Indiana. The complaints name CNC as a defendant, along with certain current and
former officers of CNC. These lawsuits were filed on behalf of persons or
entities who purchased CNC'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 CNC and alleged problems in CFC's manufactured
housing division, allegedly resulting in the artificial inflation of CNC's stock
price. On March 13, 2003, all of these cases were consolidated into one case in
the United States District Court for the Southern District of Indiana, captioned
"Franz Schleicher, et al. v. Conseco, Inc., et al.," File No. 02-CV-1332
DFH-TAB. CNC believes these lawsuits are without merit and intends to defend
them vigorously. The ultimate outcome of these lawsuits cannot be predicted with
certainty. CNC has filed an adversary proceeding to extend the automatic stay
provided for by the Bankruptcy Code to this litigation as it pertains to current
and former officers and directors of CNC.
Derivative Litigation
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 CNC (in one case), and, alleging aiding and abetting liability,
certain banks that made loans in relation to CNC's "Stock Purchase Plan" (in
three cases). CNC 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 CFC, and engaged in
corporate waste by causing CNC to guarantee loans that certain officers,
directors and key employees of CNC 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). CNC believes that these lawsuits are without merit and intends
to defend them vigorously. The cases filed in Hamilton County have been stayed
pending resolution of the derivative suits filed in the United States District
Court. CNC asserts that these lawsuits are assets of the estate pursuant to
section 541(a) of the Bankruptcy Code and does not currently intend to pursue
them postpetition because they are meritless. The ultimate outcome of these
lawsuits cannot be predicted with certainty.
29
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Other Litigation
In October 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSave Plan filed an
action in the United States District Court for the Southern District of Indiana
against CNC, Conseco Services, LLC and certain current and former officers of
CNC (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 CNC 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 CNC's common stock
without full disclosure of the Company's true financial condition. CNC believes
the lawsuit is without merit and intends to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty. CNC has filed an
adversary proceeding to extend the automatic stay provided for by the Bankruptcy
Code to this litigation as it pertains to current and former officers and
directors of CNC.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against CNC, 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 CNC 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. CNC believes the heirs' claims are without merit and will defend the
action vigorously. The maximum exposure to the Company for this lawsuit is
estimated to be $33 million. The heirs did not file a proof of claim in the
Bankruptcy Court. Subject to dispositive motions which are yet to be filed, the
matter will continue to trial against Conseco Services, LLC and the other
co-defendants on September 13, 2004. The ultimate outcome cannot be predicted
with certainty.
On June 27, 2001, two suits against the Company's subsidiary, Philadelphia
Life Insurance Company, both purported nationwide class actions seeking
unspecified damages, were consolidated in the U.S. District Court, Middle
District of Florida (In Re PLI Sales Litigation, Cause No. 01-MDL-1404),
alleging among other things, fraudulent sales and a "vanishing premium" scheme.
Philadelphia Life filed a motion for summary judgment against both named
plaintiffs, which motion was granted in June 2002. Plaintiffs appealed to the
11th Circuit. The 11th Circuit, in July 2003, affirmed in part and reversed in
part, allowing two fraud counts with respect to one plaintiff to survive. The
plaintiffs have asked for a rehearing with respect to this decision.
Philadelphia Life believes this lawsuit is without merit and intends to defend
it vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New Mexico
(Robert Atencio and Theresa Atencio, for themselves and all other similarly
situated v. Manhattan National Life Insurance Company, an Ohio corporation,
Cause No. D-0101-CV-2000-2817), alleging among other things fraud by
non-disclosure of additional charges for those policyholders wishing to pay
premium modes other than annual. This matter was stayed until recently while a
similar suit against another insurance carrier was allowed to pursue an appeal
in the New Mexico Appellate Court system. Manhattan National Life believes this
lawsuit is without merit and intends to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
On December 19, 2001, four of the Company's subsidiaries were named in a
purported nationwide class action seeking unspecified damages in the District
Court of Adams County, Colorado (Jose Medina and others similarly situated v.
Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers
National Life Insurance Company and Bankers Life and Casualty Company, Cause No.
01-CV-2465), alleging among other things breach of contract regarding alleged
non-disclosure of additional charges for those policy holders wishing to pay
premium modes other than annual. On July 14 and 15, 2003 the plaintiff's motion
for class certification was heard and the Court took the matter under
advisement. The defendants believe this lawsuit is without merit and intends to
defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted
with certainty.
On July 31, 2001, the Company's subsidiary, Conseco Senior Health Insurance
Company was named in an action filed by the State of Texas in the District Court
of Travis County, Texas (State of Texas v. Conseco Senior Health Insurance
30
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Company, Cause No. GV102103), alleging among other things a violation of the
Deceptive Trade Practices Act related to allegations of failure to adequately
notify policyholders that premium rates could increase. Conseco Senior is
pursuing settlement discussions with the State of Texas, however in the event a
settlement is not reached, it intends to defend this matter vigorously as it
believes the lawsuit is without merit. The ultimate outcome of this 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. 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.
On June 13, 2003, the Company and an affiliate of Donald Trump reached an
agreement on a long-standing dispute over control and distribution of profits
related to investments in the General Motors Building (the "GM Building"). See
the note to the consolidated financial statements entitled "Investment in
General Motors Building" for additional information on this investment and the
Company's plans to sell it.
Other Proceedings
The Company has been notified that the staff of the SEC has obtained a
formal order of investigation in connection with an inquiry that relates to
events in and before the spring of 2000, including CFC's accounting for its
interest-only securities and servicing rights. These issues were among those
addressed in 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 fully 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 Commission's staff in this matter.
31
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows:
Six months ended
June 30,
----------------
2003 2002
---- ----
(Dollars in millions)
Cash flows from operating activities:
Net loss................................................................................. $ (39.6) $(4,378.2)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Interest-only securities investment income........................................... - (10.0)
Cash received from interest-only securities, net..................................... - (30.5)
Servicing income..................................................................... - (36.2)
Cash received from servicing activities.............................................. - 22.7
Provision for losses................................................................. 31.1 448.7
Gain on sale of finance receivables.................................................. - (17.4)
Amortization and depreciation........................................................ 316.0 492.1
Income taxes......................................................................... 45.8 668.5
Insurance liabilities................................................................ 284.5 83.8
Accrual and amortization of investment income........................................ 43.9 121.7
Deferral of cost of policies produced and purchased.................................. (227.1) (271.0)
Special charges...................................................................... - 169.2
Reorganization items................................................................. 21.6 -
Cumulative effect of accounting change............................................... - 2,949.2
Minority interest.................................................................... - 89.8
Net investment (gains) losses........................................................ (10.7) 290.8
Discontinued operations.............................................................. (16.7) -
Extraordinary gain on extinguishment of debt......................................... - (8.1)
Other................................................................................ 95.5 (107.8)
------- --------
Net cash provided by operating activities.......................................... $ 544.3 $ 477.3
======= ========
Six months ended
June 30,
----------------
2003 2002
---- ----
(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................. $.4 $15.1
Issuance of convertible preferred shares............................................... - 1.9
INVESTMENTS IN VARIABLE INTEREST ENTITIES
The Company has investments in various types of special purpose entities
and other entities, some of which are VIEs under FIN 46. The following are
descriptions of our significant investments in VIEs:
Brickyard Trust
In 1998, the Company invested in an investment trust known as the Brickyard
Loan Trust ("Brickyard"). Brickyard is a collateralized debt obligation trust
which participates in an underlying pool of commercial loans. The initial
capital structure of
32
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Brickyard consisted of $575 million of senior financing provided by unrelated
third party investors and $127 million of notes and certificates owned by the
Company and others. As a result of our 85 percent ownership interest in the
subordinated certificates, we are the primary beneficiary of Brickyard. In
accordance with ARB 51 "Consolidated Financial Statements", Brickyard is
consolidated in our financial statements, because: (i) our investment management
subsidiary, Conseco Capital Management, Inc. was the investment manager; and
(ii) we own a significant interest in the subordinated certificates. Included in
"Assets held in separate accounts and investment trust" were $379.9 million and
$410.2 million at June 30, 2003 and December 31, 2002, respectively, of assets
which serve as collateral for Brickyard's obligations. These amounts are offset
by a corresponding liability account, the value of which fluctuates in relation
to changes in the values of the investments. During the second quarter of 2003,
we recognized a loss of $11.1 million to record the commercial loans at their
estimated fair value as we intend to sell them and use the proceeds to repay the
senior financing. The sale is expected to be completed in the third quarter of
2003. At June 30, 2003, the net carrying value of our investment was $52.8
million, which is also the maximum loss we could recognize if the loans held in
the trust experience significant defaults. The senior note obligations have no
recourse to the general credit of the Company.
Other Investment Trusts
In December 1998, the Company formed three investment trusts which were
special purpose entities formed to hold various fixed maturity, limited
partnership and other types of investments. The initial capital structure of
each of the trusts consisted of: (i) approximately 96 percent
principal-protected senior notes; (ii) approximately 3 percent subordinated
junior notes; and (iii) 1 percent equity. The senior principal-protected notes
are collateralized by zero coupon treasury notes with par values and maturities
matching the par values and maturities of the principal-protected senior notes.
Conseco's life insurance subsidiaries own 100 percent of the senior
principal-protected notes. Certain of Conseco's non-life insurance subsidiaries
own all of the subordinated junior notes, which have a preferred return equal to
the total return on the trusts' assets in excess of principal and interest on
the senior notes. The equity of the trusts is owned by unrelated third parties.
The three investment trusts are VIEs under FIN 46 because the trusts'
equity represents significantly less than 10 percent of total capital and the
subordinated junior notes were intended to absorb expected losses and receive
virtually all expected residual returns. Based on our 100 percent ownership of
the subordinated junior notes, we are the primary beneficiary of the investment
trusts. All three trusts are consolidated in our financial statements. The
carrying value of the total invested assets in the three trusts was
approximately $398 million and $382 million at June 30, 2003 and December 31,
2002, respectively, which also represents Conseco's maximum exposure to loss as
a result of our ownership interests in the trusts. The trusts have no
obligations or debt to outside parties.
Investment in General Motors Building
In 1998, Conseco invested in a partnership which was formed to acquire and
own the 50 story office building in New York City known as the GM Building. The
partnership acquired the GM Building for approximately $878 million. The initial
capital structure of the partnership consisted of: (i) a $700 million senior
mortgage; (ii) $200 million of subordinated debt with a stated fixed return of
12.7 percent payable-in-kind, and the opportunity to earn an additional residual
return; and (iii) $30 million of partnership equity, owned 50 percent by Conseco
and 50 percent by an affiliate of Donald Trump. A Trump affiliate also served as
general manager of the acquired building. We own 100 percent of the subordinated
debt. The partnership is a VIE under FIN 46 because the $30 million of equity
represents significantly less than 10 percent of total partnership capital and
the subordinated debt was intended to absorb virtually all expected losses and
receive a significant portion of expected residual returns. Based on our 100
percent ownership of the subordinated debt, we are the primary beneficiary of
the GM Building partnership. Accordingly, the partnership will be consolidated
in our financial statements beginning in the third quarter 2003. We do not
expect the consolidation of the GM Building partnership to have a material
impact on our financial condition or results of operations. The real estate
asset, which will be added to our balance sheet as a result of consolidation,
collateralizes the partnership's senior mortgage obligation. The existing senior
mortgage obligation, which would also be added to our balance sheet as a result
of consolidation, is not guaranteed by Conseco and does not have recourse
against Conseco's general credit. The existing senior mortgage was recently
extended and matures on February 1, 2004. The Company previously announced its
intention to sell its interest in the GM Building. On June 13, 2003, the Company
and Mr. Trump reached an agreement on a long-standing dispute over control and
distribution of profits which was hindering Conseco's ability to sell its
interest. The building is currently being marketed for sale.
33
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
At both June 30, 2003 and December 31, 2002, actively managed fixed
maturities at fair value included $277.8 million of subordinated debt and
accrued interest in the GM Building partnership. Other invested assets included
our $15 million equity investment at both June 30, 2003, and December 31, 2002.
The investments in subordinated debt and equity represent our maximum exposure
to investment loss as a result of our involvement in the partnership.
Other Investments in Variable Interest Entities
Certain limited partnerships and other entities, which are part of our
non-traditional investment portfolio, are VIEs. However, our investments in each
of those entities are not significant and, therefore, the disclosure and
consolidation requirements of FIN 46 are not applicable. In each case, the
carrying value included in other invested assets represents the Company's
maximum exposure to loss as a result of its involvement with the entity.
SPECIAL CHARGES
2002
The following table summarizes the special charges incurred by the Company
during the three and six months ended June 30, 2002, which are further described
in the paragraphs which follow (dollars in millions):
Three months ended Six months ended
June 30, 2002 June 30, 2002
------------------ ----------------
Loss related to reinsurance transaction and businesses sold to raise cash $27.0 $27.0
Costs related to refinancing transactions.................................. 12.4 17.4
Expenses related to the termination of the former chief financial officer - 6.5
Other items................................................................ 8.8 17.3
----- -----
Special charges before income tax benefit.............................. $48.2 $68.2
===== =====
34
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Loss related to reinsurance transaction and businesses sold to raise cash
During the second quarter of 2002, we ceded a block of graded benefit life
insurance policies to an unaffiliated company pursuant to a modified coinsurance
agreement. We received a ceding commission of $83.0 million. The cost of
policies purchased and the cost of policies produced were reduced by $123.0
million and we recognized a loss of $39.0 million related to the transaction.
In addition, we completed other asset sales (including the sale of
Manhattan National Life Insurance Company) in the second quarter of 2002, which
resulted in net gains of $12.0 million.
Costs related to refinancing transactions
In conjunction with the refinancing transactions (including the debt
exchange offer completed in April 2002) entered into in the first and second
quarters of 2002, we incurred costs of $17.4 million which are not permitted to
be deferred pursuant to GAAP.
Expenses related to termination of the former chief financial officer
The employment of the Company's chief financial officer was terminated in
the first quarter of 2002. As a result, the vesting provisions associated with
the restricted stock issued to the chief financial officer pursuant to his
employment agreement were accelerated. We recognized a charge of $5.1 million
related to the immediate vesting of such restricted stock in the first quarter
of 2002. In addition, the Company recognized severance benefits of $1.4 million
associated with the termination of our chief financial officer.
Other items
Other items include expenses incurred: (i) in conjunction with the transfer
of certain customer service and backroom operations to our India subsidiary;
(ii) severance benefits related to the transfer of such operations; and (iii)
for other items which are not individually significant. The Company sold its
India subsidiary in the fourth quarter of 2002 and has significantly reduced the
customer service and backroom operations conducted there.
CONDENSED FINANCIAL INFORMATION AND GUARANTEES OF CIHC, INCORPORATED
CIHC has guaranteed the following debt: (i) Conseco's current bank credit
facilities which had a principal balance of $1,594.2 million at June 30, 2003;
(ii) up to $481.3 million of D&O loans; and (iii) $1,292.6 million aggregate
principal amount of guaranteed senior notes (the "Exchanged Notes") which were
exchanged in April 2002 for certain outstanding senior unsecured notes. The
guarantees of Exchanged Notes rank junior in right of payment to CIHC's
guarantee of Conseco's current bank credit facilities and CIHC's guarantee of
the D&O loans.
35
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
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
June 30,
2003
--------
(Dollars in millions)
Cash and cash equivalents..................................................... $ 11.6
Other invested assets......................................................... 6.1
Investment in wholly owned subsidiaries
(eliminated in consolidation)............................................. 5,654.0
Receivable from subsidiaries (eliminated in consolidation).................... 1,276.4
Other assets.................................................................. 6.1
---------
Total assets........................................................ $ 6,954.2
=========
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities:
Payable to subsidiaries (eliminated in consolidation)..................... $ 8.1
Other liabilities......................................................... .5
Income tax liability...................................................... 8.3
Liabilities subject to compromise......................................... 7.4
Affiliated liabilities subject to compromise (eliminated in consolidation) 1,029.9
---------
Total liabilities................................................... 1,054.2
---------
Shareholder's equity:
Preferred stock........................................................... 278.6
Common stock and additional paid-in capital............................... 8,718.8
Accumulated other comprehensive income.................................... 1,143.4
Accumulated deficit....................................................... (4,240.8)
---------
Total shareholder's equity.......................................... 5,900.0
---------
Total liabilities and shareholder's equity.......................... $ 6,954.2
=========
36
CONSECO, INC. AND SUBSIDIARIES
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002)
Notes to Consolidated Financial Statements
--------------------------
Three months ended Six months ended
June 30, 2003 June 30, 2003
------------- -------------
(Dollars in millions)
Revenues:
Net investment income....................................................... $ .2 $ .4
Interest and other income from subsidiaries
(eliminated in consolidation)............................................ (.1) .1
----- ------
Total revenues........................................................ .1 .5
----- ------
Expenses:
Reorganization items........................................................ .4 3.3
Operating costs and expenses................................................ 7.2 7.5
----- ------
Total expenses........................................................ 7.6 10.8
----- ------
Loss before income taxes, equity in undistributed earnings
of subsidiaries and discontinued operations........................ (7.5) (10.3)
Income tax expense.............................................................. 5.4 8.3
----- ------
Loss before equity in undistributed earnings
of subsidiaries and discontinued operations........................ (12.9) (18.6)
Equity in undistributed earnings of subsidiaries (eliminated in consolidation).. (4.9) 35.3
----- ------
Net income (loss) before discontinued operations......................... (17.8) 16.7
Discontinued operations of subsidiaries, net of tax............................. 2.1 16.0
------ ------
Net income (loss)........................................................ (15.7) 32.7
Preferred stock dividends (eliminated in consolidation)......................... 6.6 13.4
------ ------
Income (loss) applicable to common stock................................. $(22.3) $ 19.3
====== ======
37
CONSECO, INC. AND SUBSIDIARIES
--------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at June 30, 2003, and the consolidated results of operations for the three and
six months ended June 30, 2003 and 2002, and, where appropriate, factors that
may affect future financial performance. Please read this discussion in
conjunction with the accompanying consolidated financial statements and notes.
CAUTIONARY STATEMENT REGARDING 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 within the meaning of 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) the ability of Conseco to develop, prosecute, confirm
and consummate one or more plans of reorganization with respect to the Chapter
11 Cases under the Bankruptcy Code filed by Conseco and some of its
subsidiaries, including CFC and CIHC; (ii) the potential adverse impact of the
Chapter 11 Cases on Conseco's operations, management and employees; (iii)
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,
the market value of Conseco's investments and the lapse rate and profitability
of policies; (iv) Conseco's ability to achieve anticipated synergies and levels
of operational efficiencies and to achieve the goals of recent restructuring
initiatives undertaken at Conseco Insurance Group; (v) customer response to new
products, distribution channels, marketing initiatives and the Chapter 11 Cases;
(vi) mortality, morbidity, usage of health care services and other factors which
may affect the profitability of Conseco's insurance products; (vii) performance
of our investments; (viii) changes in the Federal income tax laws and
regulations which may affect the relative tax advantages of some of Conseco's
products; (ix) increasing competition in the sale of insurance and annuities;
(x) regulatory changes or actions, including those relating to regulation of the
financial affairs of our insurance companies, regulation of the sale,
underwriting and pricing of products, and health care regulation affecting
health insurance products; (xi) actions by rating agencies and the effects of
past or future actions by these agencies on Conseco's business, including the
impact of recent rating downgrades; (xii) the ultimate outcome of lawsuits filed
against Conseco; (xiii) the risk factors or uncertainties listed from time to
time in Conseco's filings with the SEC and with the Bankruptcy Court in
connection with the Chapter 11 Cases; (xiv) our ability to continue as a going
concern; and (xv) our ability to obtain Bankruptcy Court approval with respect
to motions in the Chapter 11 proceedings from time to time. Other factors and
assumptions not identified above are also relevant to the forward-looking
statements, and if they prove incorrect, could also cause actual results to
differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
These and other factors, including the terms of the Plan, will affect the
value of our various prepetition liabilities, Trust Preferred Securities and
preferred and common stock.
Our Plan would result in holders of CNC's common stock and preferred stock
(other than Series F Preferred Stock) receiving no value and the holders of
CNC's Trust Preferred Securities and Series F Preferred Stock receiving little
value on account of the cancellation of their interests. In addition, holders of
unsecured claims against the Debtors would, in most cases, receive less than
full recovery for the cancellation of their interests.
38
CONSECO, INC. AND SUBSIDIARIES
--------------------
OVERVIEW
Since commencing operations in 1982, CNC pursued a strategy of growth
through acquisitions. Primarily as a result of these acquisitions and the
funding requirements necessary to operate and expand the acquired businesses,
CNC amassed outstanding indebtedness of approximately $6.0 billion as of June
30, 2002. In 2001 and early 2002, we undertook a series of steps designed to
reduce and extend the maturities of our parent company debt. Notwithstanding
these efforts, the Company's financial position continued to deteriorate,
principally due to our leveraged condition, losses experienced by our finance
business and losses in the value of our investment portfolio.
As a result of these developments, on August 9, 2002, we announced that we
would seek to fundamentally restructure the Company's capital, and announced
that we had retained legal and financial advisors to assist us in these efforts.
We ultimately decided to seek judicial reorganization under Chapter 11 of the
Bankruptcy Code.
Under Chapter 11 we are operating as a debtor-in-possession. As of the
Petition Date, actions to collect prepetition indebtedness of the Debtors as
well as other pending litigation involving the Debtors, are stayed and other
contractual obligations generally may not be enforced against the Debtors.
Information regarding the Chapter 11 Cases appears in the note to the
consolidated financial statements entitled "Proceedings Under Chapter 11 of the
Bankruptcy Code". Pleadings filed in the Bankruptcy Court are available at
www.bmccorp.net/conseco.
At this time, it is not possible to predict with certainty the effect of
the Chapter 11 Cases on our business or various creditors, or when we will
emerge from Chapter 11. Our future results depend upon our confirming and
successfully implementing, on a timely basis, a plan of reorganization.
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. Our
Plan will materially change amounts reported in the financial statements, which
do not give effect to all adjustments of the carrying value of assets and
liabilities that are necessary as a consequence of reorganization.
The ability of Conseco to continue as a going concern is predicated upon
many issues, including various bankruptcy considerations and risks related to
our business and financial condition. See "Cautionary Statement Regarding
Forward-Looking Information" above.
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2002 Annual Report on
Form 10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements.
RISK FACTORS
Conseco and its businesses are subject to a number of risks including: (i)
bankruptcy related risk factors; and (ii) general business and financial risk
factors. Any or all of such factors, which are enumerated below, could have a
material adverse effect on the business, financial condition or results of
operations of Conseco. Also see "Cautionary Statement Regarding Forward-Looking
Statements" above. For additional risk factors specific to the Chapter 11 Cases,
readers of this report should refer to the Disclosure Statement, which was filed
with the SEC on March 21, 2003 as an exhibit to CNC's Current Report on Form 8-K
dated March 18, 2003.
Certain Bankruptcy Considerations
The Bankruptcy Filing May Further Disrupt Our Operations and the Operations
of Our Subsidiaries.
The impact that the Chapter 11 Cases may have on our operations and the
operations of our subsidiaries cannot be accurately predicted or quantified.
Since the announcement of our intention to seek a restructuring of our capital
in August 2002 and the filing of the Chapter 11 Cases, we have suffered
significant disruptions in our operations. Insurance regulators in each of the
states in which our insurance subsidiaries are domiciled have been monitoring
the Company's activities associated with its financial restructuring. Bankers
National Life Insurance Company and Conseco Life Insurance Company of Texas, our
insurance subsidiaries domiciled in Texas, each entered into consent orders with
the Commissioner of Insurance
39
CONSECO, INC. AND SUBSIDIARIES
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for the State of Texas, which, among other things, has limited their ability to
pay dividends without regulatory approval and to make disbursements other than
in the ordinary course of business. Conseco Life Insurance Company of Texas is
the parent of all of the Company's insurance subsidiaries, except for Bankers
National Life Insurance Company. In August 2002, A.M. Best further downgraded
the financial strength ratings of our primary insurance subsidiaries to "B
(Fair)." Rating downgrades and other adverse publicity concerning the Company's
financial condition have caused sales of our insurance products to decline and
policyholder redemptions and lapses to increase. In some cases, we have
experienced defections among our sales force of agents and/or have increased
commissions in order to retain them.
The continuation of the Chapter 11 Cases, particularly if the Plan is not
approved or confirmed in the time frame currently contemplated, could further
adversely affect our operations and relationship with our customers, employees,
regulators, distributors and agents. If confirmation and consummation of the
Plan do not occur expeditiously, the Chapter 11 Cases could result in, among
other things, increased costs for professional fees and similar expenses. In
addition, prolonged Chapter 11 Cases may make it more difficult to retain and
attract management and other key personnel and would require senior management
to spend a significant amount of time and effort dealing with our financial
reorganization instead of focusing on the operation of our business.
We May Not Be Able to Obtain Confirmation of the Plan.
We currently anticipate that we will receive the requisite acceptances to
confirm the Plan. However, even if we receive the requisite acceptances, we
cannot assure you that the Bankruptcy Court will confirm the Plan. The
Bankruptcy Court could also decline to confirm the Plan if it found that any of
the statutory requirements for confirmation had not been met, including that the
terms of the Plan are fair and equitable to non-accepting holders of claims.
Section 1129 of the Bankruptcy Code sets forth the requirements for confirmation
and requires, among other things, (i) a finding by the Bankruptcy Court that the
Plan "does not unfairly discriminate" and is "fair and equitable" with respect
to any non-accepting holders of claims, (ii) confirmation of the Plan is not
likely to be followed by a liquidation or a need for further financial
reorganization and (iii) the value of distributions to non-accepting holders of
claims and interests within a particular class under the Plan will not be less
than the value of distributions such holders would receive if the Company were
liquidated under Chapter 7 of the Bankruptcy Code. While there can be no
assurance that these requirements will be met, we believe that the Plan will not
be followed by a need for further financial reorganization and that
non-accepting holders within each class under the Plan will receive
distributions at least as great as would be received following a liquidation
under Chapter 7 of the Bankruptcy Code when taking into consideration all
administrative claims and costs associated with any such Chapter 7 case. We
believe that holders of equity interests in Conseco would receive no
distribution under either a liquidation pursuant to Chapter 7 or Chapter 11.
The confirmation and consummation of the Plan are also subject to various
conditions. If the Plan is not confirmed, it is unclear whether a restructuring
of Conseco could be implemented and what distributions holders of claims or
equity interests ultimately would receive with respect to their claims or equity
interests. If an alternative reorganization could not be agreed to, it is
possible that we would have to liquidate our assets, in which case it is likely
that holders of claims and equity interests would receive substantially less
favorable treatment than they would receive under the Plan.
Risks Related To Our Business And Financial Condition
Our Degree of Leverage May Limit Our Financial and Operating Activities.
We will have significant indebtedness even if the Plan is consummated.
Furthermore, our historical capital requirements have been significant and our
future capital requirements could vary significantly and may be affected by
general economic conditions, industry trends, performance, and many other
factors that are not within our control. We cannot assure you that we will be
able to obtain financing in the future. Even if the Plan is approved and
consummated, we cannot assure you that we will not experience losses. Our
profitability and ability to generate cash flow will likely depend upon our
ability to successfully implement our business strategy. However, we cannot
assure you that we will be able to accomplish the results included in our Plan.
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CONSECO, INC. AND SUBSIDIARIES
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A Failure to Improve and Maintain the Financial Strength Ratings of Our
Insurance Subsidiaries Could Negatively Impact Our Operations and Financial
Results.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. In July
2002, A.M. Best downgraded the financial strength ratings of Conseco's primary
insurance subsidiaries to "B++ (Very Good)" and placed the ratings "under review
with negative implications." On August 14, 2002, A.M. Best further lowered the
financial strength ratings of our primary insurance subsidiaries from "B++ (Very
Good)" to "B (Fair)". The A.M. Best downgrades caused sales of our insurance
products to decline and policyholder redemptions and lapses to increase. In some
cases, the downgrades also caused defections among our agent sales force or
increases in the commissions or sales incentives we must pay. These events have
had a material adverse effect on our operations, financial results and
liquidity.
Although our Plan contemplates that our insurance subsidiaries will achieve
a category "A" rating by the end of 2004, we cannot assure you that we will be
able to achieve or maintain this rating. If we fail to achieve and maintain a
category "A" rating, sales of our insurance products could continue to fall and
additional existing policyholders may redeem or lapse their policies, adversely
affecting our future operations, financial results and liquidity.
The Covenants in the New Credit Facility Restrict Our Activities and
Require Us to Meet or Maintain Various Financial Ratios and Minimum
Insurance Ratings.
Our Plan contemplates that we will enter into a senior secured credit
facility (the "New Credit Facility") with our lenders in connection with our
reorganization. We have agreed to a number of covenants and other provisions
that restrict our ability to engage in various financing transactions and pursue
certain operating activities without the prior consent of the lenders under the
New Credit Facility. We have also agreed to meet or maintain various financial
ratios and minimum financial strength ratings for our insurance subsidiaries.
For instance, if we experience a ratings downgrade following confirmation of the
Plan, if we fail to achieve an "A-" rating by a specified date following
confirmation of the Plan or if we experience a ratings downgrade after achieving
an "A-" rating, we will suffer an event of default under the New Credit
Facility. Our ability to meet these financial and ratings covenants may be
affected by events beyond our control. Although we expect to be in compliance
with these requirements as of the date the Company emerges from bankruptcy,
these requirements represent significant restrictions on the manner in which we
may operate our business. If we default under any of these requirements, the
lenders could declare all outstanding borrowings, accrued interest and fees to
be due and payable. If that were to occur, we cannot assure you that we would
have sufficient liquidity to repay or refinance this indebtedness or any of our
other debts.
CNC and CIHC are Holding Companies and Depend on their Subsidiaries for
Cash.
CNC and CIHC are holding companies with no business operations of their
own; they depend on their operating subsidiaries for cash to make principal and
interest payments on debt, and to pay administrative expenses and income taxes.
The cash CNC and CIHC receive from insurance subsidiaries consists of fees for
services, tax sharing payments, dividends and distributions, and from our
non-insurance subsidiaries, loans and advances. A deterioration in the financial
condition, earnings or cash flow of the significant subsidiaries of CNC or CIHC
for any reason could limit such subsidiaries' ability to pay cash dividends or
other disbursements to CNC and/or CIHC, which, in turn, would limit CNC's and/or
CIHC's ability to meet debt service requirements and satisfy other financial
obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. 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 or net income for the prior year; or
(ii) 10 percent of capital and surplus as of the end of the preceding year. Any
dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department. As described under
the caption "Statutory Information" within "Management's Discussion and Analysis
of Financial Condition and Results of Operations", Bankers National Life
Insurance Company and Conseco Life Insurance Company of Texas (on behalf of
itself and its subsidiaries), entered into consent orders with the Commissioner
of Insurance for the State of Texas on October 30, 2002. These consent orders,
among other things, limit the ability of our insurance subsidiaries to pay
dividends. In addition, actions that we may need to take to improve the
authorized control level risk based capital ("ACLRBC") ratios of our insurance
subsidiaries could affect the ability of our insurance subsidiaries to pay
dividends.
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CONSECO, INC. AND SUBSIDIARIES
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Our results for future periods are subject to numerous uncertainties. We
may encounter liquidity problems, which could affect our ability to meet our
obligations while attempting to meet competitive pressures or adverse economic
conditions following the confirmation of the Plan.
The Obligations of CNC and CIHC are Structurally Subordinated to the
Obligations of CNC's and CIHC's Subsidiaries.
Because our operations are conducted through subsidiaries, claims of the
creditors of those subsidiaries (including policyholders) will rank senior to
claims to distributions from the subsidiaries, which we depend on to make
payments on our obligations. CIHC's subsidiaries, excluding CFC, had
indebtedness for borrowed money (including capitalized lease obligations but
excluding indebtedness to affiliates), policy reserves and other liabilities of
approximately $24.1 billion at June 30, 2003. The obligations of CNC and CIHC,
as parent holding companies, will rank effectively junior to these liabilities.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted under the insurance laws of its state of domicile by such
state's insurance regulator as the receiver with respect to such insurer's
property and business. In the event of a default on our debt or our insolvency,
liquidation or other reorganization, our creditors and stockholders will not
have the right to proceed against the assets of our insurance subsidiaries or to
cause their liquidation under federal and state bankruptcy laws.
Our Insurance Business Performance May Decline if Our Premium Rates Are Not
Adequate.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. In setting premium rates, we consider historical
claims information, industry statistics, the rates of our competitors and other
factors. If our actual claims experience proves to be less favorable than we
assumed and we are unable to raise our premium rates, our financial results may
be adversely affected. Our estimates of insurance liabilities assume we will be
able to raise rates if future experience results in blocks of our health
insurance business becoming unprofitable. We generally cannot raise our health
insurance premiums in any state unless we first obtain the approval of the
insurance regulator in that state. We review the adequacy of our premium rates
regularly and file rate increases on our products when we believe existing
premium rates are too low. It is possible that we will not be able to obtain
approval for premium rate increases from currently pending requests or requests
filed in the future. If we are unable to raise our premium rates because we fail
to obtain approval for a rate increase in one or more states, our net income may
decrease. If we are successful in obtaining regulatory approval to raise premium
rates due to unfavorable actual claims experience, the increased premium rates
may reduce the volume of our new sales and cause existing policyholders to allow
their policies to lapse. This could result in anti-selection if healthier
policyholders allow their policies to lapse. This would reduce our premium
income and profitability in future periods. Increased lapse rates also could
require us to expense all or a portion of the deferred policy costs relating to
lapsed policies in the period in which those policies lapse, adversely affecting
our financial results in that period.
The loss ratios for our long-term care products have increased in recent
periods and exceeded 110 percent during the three month period ended June 30,
2003. We will have to raise rates or take other actions with respect to certain
of these policies or this business will continue to be unprofitable and our
financial results will be adversely affected.
We May Not Achieve the Goals of Certain Initiatives We Have Undertaken With
Respect to the Restructuring of Our Principal Insurance Business.
Several of our principal insurance businesses have experienced substantial
recent losses in their investment portfolio, declining sales and expense levels
that do not match product pricing. We have adopted several initiatives designed
to improve these operations, including focusing sales efforts on higher margin
products; reducing operating expenses by eliminating or reducing the costs of
marketing certain products; personnel reductions and streamlined administrative
procedures; stabilizing the profitability of inforce business, particularly
long-term care policies; combining certain legal insurance entities to reduce
burdens associated with statutory capital requirements; and improving the
performance of investments by reducing exposure to credit events and certain
types of higher risk assets. We have only recently adopted these initiatives and
we cannot assure you that they will be successfully implemented.
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CONSECO, INC. AND SUBSIDIARIES
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Our Reserves for Future Insurance Policy Benefits and Claims May Prove To
Be Inadequate, Requiring Us To Increase Liabilities and Resulting In
Reduced Net Income and Shareholders' Equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on assumptions made by our actuaries. For our
health insurance business, we establish an active life reserve plus a liability
for due and unpaid claims, claims in the course of settlement, and incurred but
not reported claims, as well as a reserve for the present value of amounts not
yet due on claims. Many factors can affect these reserves and liabilities, such
as economic and social conditions, inflation, hospital and pharmaceutical costs,
regulatory actions (including those related to the pricing of our policies),
changes in doctrines of legal liability, and extra-contractual damage awards.
Therefore, the reserves and liabilities we establish are necessarily based on
extensive estimates, assumptions and prior years' statistics. Establishing
reserves is an uncertain process, and it is possible that actual claims will
materially exceed our reserves and have a material adverse effect on our results
of operations and financial condition. Our financial performance depends
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in setting our reserves and pricing our
policies. If our assumptions with respect to future claims are incorrect, and
our reserves are insufficient to cover our actual losses and expenses, we would
be required to increase our liabilities resulting in an adverse effect to our
financial results and financial position.
Our Insurance Subsidiaries May be Required to Pay Assessments to Fund
Policyholder Losses or Liabilities; This May Have a Material Adverse Effect
on Our Results of Operations.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments (up to certain
prescribed limits) to fund policyholder losses or liabilities of insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Any future assessments may have a material adverse effect on our
financial results and financial position.
We are Subject to Further Risk of Loss Notwithstanding Our Reinsurance
Arrangements.
We transfer exposure to certain risks to others through reinsurance
arrangements. Under these arrangements, other insurers assume a portion of our
losses and expenses associated with reported and unreported claims in exchange
for a portion of policy premiums. The availability, amount and cost of
reinsurance depend on general market conditions and may vary significantly.
Furthermore, we face credit risk with respect to reinsurance. When we obtain
reinsurance, we are still liable for those transferred risks if the reinsurer
cannot meet its obligations. Therefore, the inability of our reinsurers to meet
their financial obligations could materially affect our operations and financial
condition.
We Are Subject to Extensive Regulation.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate, which is primarily for the benefit and
protection of our customers, and not for the benefit of our investors or
creditors. Our insurance subsidiaries are subject to state insurance laws that
establish supervisory agencies with broad administrative powers relative to
granting and revoking licenses to transact business, regulating sales and other
practices, licensing agents, approving policy forms, setting reserve and
solvency requirements, determining the form and content of required statutory
financial statements, limiting dividends and prescribing the type and amount of
investments.
We have been operating under heightened scrutiny from state insurance
regulators. As described under the caption "Statutory Information" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", our insurance subsidiaries domiciled in Texas, Bankers National
Life Insurance Company and Conseco Life Insurance Company of Texas (on behalf of
itself and its subsidiaries), entered into consent orders with the Commissioner
of Insurance for the State of Texas on October 30, 2002.
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CONSECO, INC. AND SUBSIDIARIES
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In Certain Circumstances, Regulatory Authorities May Place Our Insurance
Subsidiaries Under Regulatory Control.
Our insurance subsidiaries are subject to risk-based capital requirements.
These requirements were designed to evaluate the adequacy of statutory capital
and surplus in relation to investment and insurance risks associated with: asset
quality; mortality and morbidity; asset and liability matching; and other
business factors. The requirements are used by states as an early warning tool
to discover potential weakly-capitalized companies for the purpose of initiating
regulatory action. Generally, if an insurer's ACLRBC falls below specified
levels, the insurer would be subject to different degrees of regulatory action
depending upon the magnitude of the deficiency. Possible regulatory actions
range from requiring the insurer to propose actions to correct the ACLRBC
deficiency to placing the insurer under regulatory control. The 2002 statutory
annual statements filed with the state insurance regulators of each of our
insurance subsidiaries reflected total adjusted capital in excess of levels
subjecting the subsidiary to any regulatory action. The 2002 audited financial
statements of our insurance subsidiaries were completed in June 2003. Two of our
subsidiaries' ACLRBC ratios, based on the capital balances reflecting audit
adjustments, were less than 250 percent. As a result of the audit adjustments, a
regulation of the domiciliary state of one of the subsidiaries requires a filing
of an amended 2002 annual statement, which will subject the subsidiary to the
trend test. The result of the trend test indicates a trended total adjusted
capital of less than 190 percent of its ACLRBC, which requires the subsidiary to
prepare a comprehensive plan proposing corrective actions aimed at improving its
capital position. See the information described under the caption "Statutory
Information" within "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
Recently Enacted and Pending or Future Legislation Could Also Affect the
Financial Performance of Our Insurance Operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and legislative proposals relating to healthcare
reform contain features that could severely limit or eliminate our ability to
vary our pricing terms or apply medical underwriting standards with respect to
individuals which could have the effect of increasing our loss ratios and have
an adverse effect on our financial results. In particular, Medicare reform and
legislation concerning prescription drugs could affect our ability to price or
sell our products.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards for inclusion in all long-term care
policies, including: guaranteed premium rates; protection against inflation;
limitations on waiting periods for pre-existing conditions; setting standards
for sales practices for long-term care insurance; and guaranteed consumer access
to information about insurers (including lapse and replacement rates for
policies and the percentage of claims denied). Enactment of any of these
proposals could adversely affect our financial results.
In addition, the federal government may seek to regulate the insurance
industry, and recent government regulation may increase competition in the
insurance industry and may affect our insurance subsidiaries' current sales
methods. Although the federal government generally does not directly regulate
the insurance industry, federal initiatives often have a direct impact on the
insurance business. Current and proposed measures that may significantly affect
the insurance business generally include limitations on antitrust immunity and
minimum solvency requirements.
Changing Interest Rates May Adversely Affect Our Results of Operations.
Our profitability may be directly affected by the level of and fluctuations
in interest rates. While we monitor the interest rate environment and have
previously employed hedging strategies designed to mitigate the impact of
changes in interest rates, our financial results could be adversely affected by
changes in interest rates. Our spread-based insurance and annuity business is
subject to several inherent risks arising from movements in interest rates,
especially if we fail to anticipate or respond to such movements. First,
interest rate changes can cause compression of our net spread between interest
earned on investments and interest credited on customer deposits, thereby
adversely affecting our results. Second, if interest rate changes produce an
unanticipated increase in surrenders of our spread-based products, we may be
forced to sell invested assets at a loss in order to fund such surrenders. At
June 30, 2003, approximately 20 percent of our total insurance liabilities (or
approximately $4.4 billion) could be surrendered by the policyholder without
penalty. The profits from many non-spread-based insurance products, such as
long-term care policies will be adversely affected if interest rates decline.
Finally, changes
44
CONSECO, INC. AND SUBSIDIARIES
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in interest rates can have significant effects on the performance of our
mortgage-backed securities portfolio, including collateralized mortgage
obligations, as a result of changes in the prepayment rate of the loans
underlying such securities. We follow asset/liability strategies that are
designed to mitigate the effect of interest rate changes on our profitability.
However, there can be no assurance that management will be successful in
implementing such strategies and achieving adequate investment spreads.
In addition, the projections and valuations included in our Plan were
prepared based in part on interest rate levels prevailing in December 2002.
Changes in interest rates may materially impact the value of the Company and our
ability to achieve the projections included in the Plan.
Litigation and Regulatory Investigations May Harm Our Financial Strength
and Reduce Our Profitability.
Insurance companies historically have been subject to substantial
litigation resulting from claims disputes and other matters. In addition to the
traditional policy claims associated with their businesses, insurance companies
are increasingly facing policyholder suits, class action suits and disputes with
reinsurers. The class action and policyholder suits are often in connection with
insurance sales practices, policy and claims administration practices and other
market conduct issues. State insurance departments are increasingly focusing on
sales practices and product issues in their market conduct examinations.
Negotiated settlements of class action and other lawsuits have had a material
adverse effect on the business, financial condition and results of operations of
insurance companies. As a result of these trends, we are, in the ordinary course
of our business, a plaintiff or defendant in actions arising out of our
insurance business and investment operations, including class actions and
reinsurance disputes, and, from time to time, are also involved in various
governmental and administrative proceedings. Such litigation and proceedings may
harm our financial strength and reduce our profitability. We cannot assure you
that such litigation will not adversely affect our future business, financial
condition or results of operations.
A Delay in Selling Our Interest in the GM Building May Adversely Affect Our
Ability to Fund Our Business Plan.
As described in the note to the consolidated financial statements entitled
"Investment in General Motors Building", we plan to sell our interest in the GM
Building. Our Plan presumes that our interest in the GM Building will be
monetized in the first quarter of 2004, although timing of the actual sale of
the building is dependent on many factors beyond our control and therefore is
not certain. The mortgage on the GM Building, which totals $700 million, was
recently extended and now matures on February 1, 2004. If we are unable to sell
the GM Building, we may not be able to achieve our Plan.
The Markets in Which We Compete Are Highly Competitive.
Each of the markets in which we operate is highly competitive. Competitors
include other life insurers, commercial banks, thrifts, mutual funds and
broker-dealers. Many of our competitors in different segments and regions are
larger companies that have greater capital, technological and marketing
resources, and have access to capital at a lower cost. Because the actual cost
of products is unknown when they are sold, we are subject to competitors who may
sell a product at a price that does not cover its actual cost. Agents placing
insurance business with our insurance subsidiaries generally are compensated on
a commission basis. There are many life and health insurance companies in the
U.S. Some of these companies may pay higher commissions and charge lower premium
rates, and many companies have more substantial resources than we do. Publicity
about our recent financial difficulties have caused agents to place business
with other insurers.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among financial services companies
for efficient sales representatives. We compete with other financial services
companies for sales representatives primarily on the basis of our financial
position, support services and compensation and product features. Our
competitiveness for such agents also depends upon the relationships we develop
with these agents. If we are unable to attract and retain sufficient numbers of
sales representatives to sell our products, our ability to compete and our
revenues would suffer.
Tax Law Changes Could Adversely Affect Our Insurance Product Sales and
Profitability.
We sell deferred annuities and some forms of life insurance products which
are attractive to purchasers, in part, because policyholders generally are not
subject to United States federal income tax on increases in policy values until
some form of distribution is made. Recently, Congress enacted legislation to
lower marginal tax rates, reduce the federal estate tax gradually over a
ten-year period, with total elimination of the federal estate tax in 2010 and
increase contributions which may
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CONSECO, INC. AND SUBSIDIARIES
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be made to individual retirement accounts and 401(k) accounts. While these tax
law changes will sunset at the beginning of 2011 absent future congressional
action, they could in the interim diminish the appeal of our annuity and life
insurance products. Additionally, Congress has considered, from time to time,
other possible changes to the U.S. tax laws, including elimination of the tax
deferral on the accretion of value within certain annuities and life insurance
products. There can be no assurance that further tax legislation will not be
enacted which would contain provisions with possible adverse effects on our
annuity and life insurance products.
The Impact of Recent Terrorist Attacks and the Instability in the Middle
East May Adversely Affect the Insurance Industry and Financial Markets.
Terrorist attacks in New York City and Washington, D.C. on September 11,
2001 adversely affected commerce throughout the United States and resulted in
significant disruption to the insurance industry and significant declines and
volatility in financial markets. The continued threat of terrorism within the
United States and abroad, and the military action and heightened security
measures in response to that threat may cause additional disruptions to the
insurance industry, reduced economic activity and continued volatility in
markets throughout the world, which may adversely impact our financial results.
RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND
2002
The following tables and narratives summarize our operating results for the
three and six months ended June 30, 2003 and 2002. Please read this discussion
in conjunction with the accompanying consolidated financial statements and
notes.
Three months ended Six months ended
June 30, June 30,
------------------ ---------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Earnings (losses) before taxes:
Insurance and fee-based segment earnings.................................... $ 44.8 $(169.8) $ 102.0 $ (37.1)
Holding company activities:
Corporate expenses, less charges to subsidiaries for
services provided....................................................... 3.8 (7.2) (2.2) (19.8)
Interest expense on corporate debt, net of corporate investment income.... (63.7) (76.5) (131.5) (149.0)
Venture capital income (loss)............................................. 6.0 (23.7) 8.5 (100.0)
Provision for losses...................................................... (15.8) (100.0) (31.1) (140.0)
Special charges........................................................... - (11.5) - (28.5)
Extraordinary gain on extinguishment of debt.............................. - 1.8 - 1.8
Reorganization items...................................................... (14.4) - (32.5) -
------ ------- ------- -------
Loss before income taxes, minority interest, discontinued operations and
cumulative effect of accounting change.................................. $(39.3) $(386.9) $ (86.8) $(472.6)
====== ======= ======= =======
46
CONSECO, INC. AND SUBSIDIARIES
--------------------
Insurance and fee-based operations
Three months ended Six months ended
June 30, June 30,
------------------- -----------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Premiums and asset accumulation product collections:
Annuities............................................................... $ 315.0 $ 261.0 $ 610.2 $ 533.7
Supplemental health..................................................... 596.0 596.2 1,166.3 1,206.3
Life.................................................................... 140.5 157.1 282.7 371.2
Group major medical..................................................... 63.0 74.8 123.5 164.4
--------- --------- --------- ---------
Collections on insurance products from continuing lines
of business...................................................... 1,114.5 1,089.1 2,182.7 2,275.6
Individual major medical in run-off..................................... .8 27.4 2.4 72.6
Discontinued operations................................................. - 70.0 - 188.6
--------- --------- --------- ---------
Total collections on insurance products............................. 1,115.3 1,186.5 2,185.1 2,536.8
Deposit type contracts.................................................. 94.9 79.7 202.6 159.3
Deposit type contracts - discontinued operations........................ - 2.4 - 4.5
Mutual funds............................................................ 54.0 38.0 135.1 126.5
--------- --------- --------- ---------
Total premiums and asset accumulation product collections........... $ 1,264.2 $ 1,306.6 $ 2,522.8 $ 2,827.1
========= ========= ========= =========
Average liabilities for insurance and asset accumulation products (excluding
discontinued operations and our major medical business in run-off):
Annuities:
Mortality based..................................................... $ 255.6 $ 235.9 $ 254.8 $ 250.1
Equity-linked....................................................... 1,683.7 2,232.3 1,722.7 2,343.9
Deposit based....................................................... 7,344.0 8,080.2 7,371.4 8,076.5
Separate accounts and investment trust liabilities.................. 454.9 658.9 466.0 730.3
Health................................................................ 5,926.3 5,337.2 5,883.9 5,305.4
Life:
Interest sensitive.................................................. 4,259.2 4,017.4 4,259.4 4,017.5
Non-interest sensitive.............................................. 1,656.1 2,204.3 1,660.7 2,189.7
--------- --------- --------- ---------
Total average liabilities for insurance and asset
accumulation products, net of reinsurance ceded................. $21,579.8 $22,766.2 $21,618.9 $22,913.4
========= ========= ========= =========
Revenues:
Insurance policy income................................................. $ 766.9 $ 760.6 $ 1,555.6 $ 1,574.6
Net investment income:
General account invested assets....................................... 343.7 386.0 688.2 783.9
Equity-indexed products based on the change in
value of the S&P 500 Call Options................................... 41.5 (54.4) 18.4 (70.5)
Separate account assets............................................... - (1.3) - (3.2)
Fee revenue and other income............................................ 12.8 23.3 26.2 50.0
--------- --------- --------- ---------
Total revenues (a).................................................. 1,164.9 1,114.2 2,288.4 2,334.8
--------- --------- --------- ---------
Expenses:
Insurance policy benefits............................................... 666.1 565.9 1,333.2 1,177.7
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below....................................... 115.3 126.1 233.9 256.5
Equity-indexed products based on S&P 500 Index........................ 53.1 (24.9) 52.3 (15.2)
Separate account liabilities.......................................... - (1.3) - (3.2)
Amortization related to operations...................................... 131.0 235.3 279.0 397.1
Interest expense on investment borrowings............................... 3.8 3.3 6.4 10.3
Other operating costs and expenses...................................... 148.9 121.7 292.1 257.9
--------- --------- --------- ---------
Total benefits and expenses (a)..................................... 1,118.2 1,026.1 2,196.9 2,081.1
--------- --------- --------- ---------
Income before net investment gains (losses), special charges, income
taxes, minority interest, discontinued operations and
cumulative effect of accounting change............................ 46.7 88.1 91.5 253.7
Net investment gains (losses), including related costs and amortization.... (1.9) (221.2) 10.5 (251.1)
Special charges............................................................ - (36.7) - (39.7)
--------- --------- --------- ---------
Income (loss) before income taxes, minority interest, discontinued
operations and cumulative effect of accounting change.................. $ 44.8 $ (169.8) $ 102.0 $ (37.1)
========= ========= ========= =========
(continued)
47
CONSECO, INC. AND SUBSIDIARIES
--------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- ----------------
2003 2002 2003 2002
---- ---- ---- ----
(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)............... 3.47% 4.43% 3.36% 4.50%
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 (c)................................... 2.82% 2.20% 2.76% 2.32%
Health loss ratios:
All health lines:
Insurance policy benefits................................... $503.0 $445.9 $999.7 $917.1
Loss ratio.................................................. 85.20% 75.19% 84.24% 76.64%
Medicare Supplement:
Insurance policy benefits................................... $168.1 $164.0 $348.2 $329.8
Loss ratio.................................................. 65.90% 65.75% 67.88% 65.97%
Long-Term Care:
Insurance policy benefits................................... $250.5 $200.2 $492.9 $417.1
Loss ratio.................................................. 110.73% 90.32% 108.92% 92.79%
Interest-adjusted loss ratio................................ 85.63% 68.59% 84.19% 71.64%
Specified Disease:
Insurance policy benefits................................... $71.2 $61.1 $134.9 $126.6
Loss ratio.................................................. 77.77% 65.53% 73.56% 67.35%
Other:
Insurance policy benefits................................... $13.2 $20.6 $23.7 $43.6
Loss ratio.................................................. 75.49% 71.58% 62.79% 73.49%
- --------------------
(a) Revenues exclude net investment gains (losses); benefits and expenses
exclude amortization related to realized gains.
(b) Investment income includes income from general account assets only. Average
insurance liabilities exclude liabilities related to separate accounts,
investment trust and reinsurance ceded.
(c) 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.
48
CONSECO, INC. AND SUBSIDIARIES
--------------------
Collections on insurance products from continuing operations were $1.1
billion in the second quarter of 2003, up 2.3 percent from 2002. Collections on
insurance products from continuing operations were $2.2 billion in the first six
months of 2003, down 4.1 percent from 2002. Collections on all products
excluding annuities, were lower in the 2003 periods. Annuity premium collections
were positively impacted by sales inducements provided to purchasers of our
annuities, sales incentives to our career agents and by the attractive minimum
guaranteed rates on certain of these products. Our premium collections have been
negatively impacted by the A.M. Best ratings downgrade to "B (Fair)." See
"Premium and Asset Accumulation Product Collections" for further analysis.
Average liabilities for insurance and asset accumulation products, net of
reinsurance receivables, were $21.6 billion in the second quarter of 2003, down
5.2 percent from 2002. Average liabilities for insurance and asset accumulation
products, net of reinsurance receivables, were $21.6 billion in the first six
months of 2003, down 5.6 percent from 2002. The decrease in such liabilities is
primarily due to the increase in policyholder redemptions and lapses following
the downgrade of our A.M. Best financial strength rating to "B (Fair)". 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 $343.7 million in the second quarter of 2003, down
11 percent from the same period in 2002 and was $688.2 million in the first six
months of 2003, down 12 percent from 2002. The average balance of general
account invested assets in the second quarter of 2003 decreased 5.8 percent to
$22.1 billion compared to the same period in 2002. The yield on these assets was
6.2 percent in 2003 and 6.6 percent in 2002. The average balance of general
account invested assets decreased by 7.9 percent in the first six months of 2003
to $22.1 billion compared to the same period in 2002. The yield on these assets
decreased by .3 percentage points to 6.2 percent during the first six months of
2003. The decrease in yield reflects general decreases in market interest rates
between periods.
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 $20.2 million and $27.4 million in the second quarters of 2003 and
2002, respectively, and $39.4 million and $52.2 million in the first six months
of 2003 and 2002, 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 $61.7 million and $(27.0) million in the second quarters of
2003 and 2002, respectively, and $57.8 million and $(18.3) million in the first
six months of 2003 and 2002, respectively. Such amounts were partially offset by
the corresponding charge (credit) to amounts added to policyholder account
balances for equity-indexed products of $53.1 million and $(24.9) million in the
second quarters of 2003 and 2002, respectively, and $52.3 million and $(15.2)
million in the first six months of 2003 and 2002, respectively. Such income and
related charge fluctuate 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 six months ended June 30, 2002,
this amount included $5.2 million and $9.9 million, respectively, of affiliated
fee revenue earned by our subsidiary in India. Such revenue is eliminated in
consolidation. Excluding such affiliated income, fee revenue and other income
decreased in the 2003 periods primarily as a result of a decrease in the market
value of investments managed for others, upon which these fees are
49
CONSECO, INC. AND SUBSIDIARIES
--------------------
based. The Company sold its India subsidiary in the fourth quarter of 2002 and
has substantially eliminated the customer service and backroom operations
conducted there.
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 ratios on our Medicare supplement products increased slightly in
the 2003 periods, although they have generally been within our range of
expectations. Governmental regulations generally require us to attain and
maintain a loss ratio, after three years, of not less than 65 percent on these
products.
Our loss experience on long-term care products has been worse than we
expected. Although we anticipated a higher level of benefits to be paid out on
these products as the policies age, the paid claims have exceeded our
projections. We are aggressively seeking rate increases and pursuing other
actions on certain long-term care policies issued by independent agents. We are
experiencing adverse developments on policies issued in certain areas of Florida
and other states (primarily policies issued by certain of our subsidiaries prior
to their acquisitions). This adverse experience is reflected in the higher loss
ratios in 2003.
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.
The loss ratio for our specified disease products reflects higher than
expected incurred claims on certain cancer insurance policies. These policies
generally provide fixed or limited benefits. Payments under cancer insurance
policies are generally made directly to, or at the direction of, the
policyholder following diagnosis of, or treatment for a covered type of cancer.
These benefit expenses increased in the second quarter of 2003 resulting in the
increase to the loss ratio.
The loss ratios on our other products fluctuate due to the smaller size of
these blocks of business. The loss ratios on this business have generally been
within our expectations.
Amounts added to policyholder account balances for annuity products
decreased by 8.6 percent in the second quarter of 2003 to $115.3 million, and by
8.8 percent in the first six months of 2003 to $233.9 million as compared to the
same periods in the prior year. This decrease is primarily due to: (i) a smaller
block of annuity business inforce; and (ii) a decrease in the weighted average
crediting rates. The weighted average crediting rates for these products was 4.1
percent and 4.4 percent for the first six months of 2003 and 2002, respectively.
Amounts added to equity-indexed products and separate account liabilities
correspond to the related investment income accounts described above.
Amortization related to operations includes amortization of the cost of
policies produced and the cost of policies purchased. 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)" in August of 2002. When
redemptions are greater than our previous assumptions, we are required to
accelerate the amortization of our cost of policies produced and cost of
policies purchased to write off the balance associated with the redeemed
policies. Amortization in recent periods has fluctuated as a result of the
acceleration of the amortization of our cost of policies produced and cost of
policies purchased associated with policy redemptions and changes in future
lapse assumptions with respect to the policies in force. In the second quarter
of 2002, we changed the lapse assumptions used to determine the amortization of
the cost of policies produced and the cost of policies purchased related to
certain universal life products and our annuities to reflect our then current
estimates of future lapses. For certain universal life products, we changed the
ultimate lapse assumption from: (i) a range of 6 percent to 7 percent; to (ii) a
tiered assumption based on the level of funding of the policy of a range of 2
percent to 10 percent. In the second quarter of 2002, we recorded additional
amortization of $101.7 million related to higher redemptions and changes to our
lapse assumptions. Policyholder redemptions during the six months ended June 30,
2003 have generally been consistent with our revised lapse assumptions.
50
CONSECO, INC. AND SUBSIDIARIES
--------------------
Interest expense on investment borrowings decreased along with our
investment borrowing activities. Average investment borrowings were $704.9
million during the first six months of 2003 compared to $1,298.0 million during
the same period of 2002. The weighted average interest rates on such borrowings
were 1.8 percent and 1.6 percent during the first six months of 2003 and 2002,
respectively.
Other operating costs and expenses increased by 22 percent in the second
quarter of 2003 to $148.9 million. Such expenses increased 13 percent in the
first six months of 2003, to $292.1 million, as compared to the first six months
of 2002. Such increase is primarily related to increased costs which were
non-deferrable. 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 was 2.82 percent and
2.76 percent for the three and six months ended June 30, 2003, respectively,
compared to 2.20 percent and 2.32 percent for the three and six months ended
June 30, 2002, respectively.
Net investment gains (losses), including related costs and amortization
fluctuate from period to period. During the first six months of 2003, we
recognized net investment gains (losses) of $10.7 million, compared to $(253.2)
million during the comparable period of 2002. During the first six months of
2003, the net investment gains included: (i) $45.2 million of net gains from the
sales of investments (primarily fixed maturities); net of (ii) $34.5 million of
writedowns of fixed maturity investments 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 six months of 2002
included: (i) $209.5 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) $43.7 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 an increase (decrease)
in the amortization of the cost of policies purchased and the cost of policies
produced of $(.5) million and $(2.4) million in the second quarters of 2003 and
2002, respectively, and $.2 million and $(2.1) million in the first six months
of 2003 and 2002, 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
$5.2 million ($2.2 million of which was recognized in the second quarter of
2002) primarily related to severance benefits and costs incurred with the
transfer of certain customer service and backroom operations to our India
subsidiary. These charges are described in greater detail in the note to the
accompanying consolidated financial statements entitled "Special Charges".
51
CONSECO, INC. AND SUBSIDIARIES
--------------------
Corporate operations
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Corporate operations:
Interest expense on corporate debt, net of investment income.. $(63.7) $ (76.5) $(131.5) $(149.0)
Provision for losses and interest expense related to stock
purchase plan............................................... (15.8) (100.0) (31.1) (140.0)
Venture capital income (loss) related to investment in
AWE, net of related expenses................................ 6.0 (23.7) 8.5 (100.0)
Other items................................................... 3.8 (7.2) (2.2) (19.8)
Special charges............................................... - (11.5) - (28.5)
Extraordinary gain on extinguishment of debt.................. - 1.8 - 1.8
Reorganization items.......................................... (14.4) - (32.5) -
------ ------- ------- -------
Loss before income taxes and minority interest............ $(84.1) $(217.1) $(188.8) $(435.5)
====== ======= ======= =======
Interest expense on corporate debt, net of investment income has decreased
primarily as a result of our ceasing to accrue interest on notes payable
(excluding the Senior Credit Facility, the Exchanged Notes and the 93/94 Notes).
Provision for losses and interest expense related to stock purchase plan
represents the non-cash provision we established in connection with our
guarantees of bank loans to current and former directors, officers and key
employees and our related loans for interest. The funds from the bank loans were
used by the participants to purchase approximately 18.0 million shares of
Conseco common stock. In the six months ended June 30, 2003 and 2002, we
increased our reserve by $31.1 million and $140.0 million, respectively, in
connection with these guarantees and loans. We determine the reserve based upon
the value of the collateral held by the banks (primarily the purchased stock).
At June 30, 2003, the reserve for losses on the loan guarantees totaled $691.1
million. The outstanding principal balance on the bank loans was $481.3 million.
In addition, Conseco has provided loans to participants for interest on the bank
loans totaling $207.8 million. During 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 (including accrued interest, the
balance on these loans was $59.3 million at June 30, 2003). The guarantees of
the bank loans are discussed in greater detail in the note to the accompanying
consolidated financial statements entitled "Guarantees".
Venture capital income (loss) relates to our investment in AWE, a company
in the wireless communication business. Our investment in AWE is carried at
estimated fair value, with changes in fair value recognized as investment
income.
Other items include general corporate expenses, net of amounts charged to
subsidiaries for services provided by the corporate operations. During the
quarter ended June 30, 2003, disputes with certain of our insurance carriers
were resolved and a previously established liability of $40 million was
released. This amount was substantially offset by increases to various
litigation reserves of $30 million.
Special charges in corporate operations for 2002 include: (i) $17.4 million
related to refinancing transactions (of which $12.4 million was recognized in
the second quarter of 2002); (ii) other items totaling $18.6 million (of which
$6.6 million was recognized in the second quarter of 2002); partially offset by
(iii) net gains of $7.5 million related to the sale of certain non-core assets
(all of which was recognized in the second quarter of 2002). These charges are
described in greater detail in the note to the accompanying consolidated
financial statements entitled "Special Charges".
Reorganization items are professional fees associated with CNC's bankruptcy
proceedings which are expensed as incurred in accordance with SOP 90-7.
52
CONSECO, INC. AND SUBSIDIARIES
--------------------
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 downgraded
the financial strength ratings of our primary insurance subsidiaries from "A-
(Excellent)" to "B++ (Very Good)" and placed the ratings "under review with
negative implications." In August 2002, A.M. Best further 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 superior 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 a fair ability in A.M. Best's opinion to meet
their current obligations to policyholders, but are financially vulnerable to
adverse changes in underwriting and economic conditions. The rating 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. S&P 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 S&P's view, an insurer
rated "B" has weak financial security characteristics and adverse business
conditions will likely impair its ability to meet financial commitments.
These ratings downgrades caused sales of our insurance products to decline
and policyholder redemptions and lapses to increase. In some cases, the
downgrades also caused defections among our independent agent sales force or
increases in the commissions we had to pay to retain them. These events have had
a material adverse effect on our financial results. Further downgrades by A.M.
Best or S&P would likely have further material and adverse effects on our
financial results and liquidity.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. In setting premium rates, we consider historical
claims information, industry statistics, the rates of our competitors and other
factors. If our actual claims experience proves to be less favorable than we
assumed and we are unable to raise our premium rates, our financial results may
be adversely affected. Our estimates of insurance liabilities assume we will be
able to raise rates if future experience results in blocks of our health
insurance business becoming unprofitable. We generally cannot raise our health
insurance premiums in any state unless we first obtain the approval of the
insurance regulator in that state. We review the adequacy of our premium rates
regularly and file rate increases on our products when we believe existing
premium rates are too low. It is possible that we will not be able to obtain
approval for premium rate increases from currently pending requests or requests
filed in the future. If we are unable to raise our premium rates because we fail
to obtain approval for a rate increase in one or more states, our net income may
decrease. If we are successful in obtaining regulatory approval to raise premium
rates due to unfavorable actual claims experience, the increased premium rates
may reduce the volume of our new sales and cause existing policyholders to allow
their policies to lapse. This could result in anti-selection if healthier
policyholders allow their policies to lapse. This would reduce our premium
income and profitability in future periods. Increased lapse rates also could
require us to expense all or a portion of the deferred policy costs relating to
lapsed policies in the period in which those policies lapse, adversely affecting
our financial results in that period.
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 contact 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
53
CONSECO, INC. AND SUBSIDIARIES
--------------------
distribution channel is engaged primarily in the sale of "graded benefit life"
insurance policies which are sold directly from the Company to the policyholder.
Total premiums and accumulation product collections were as follows:
Three months ended Six months ended
June 30, June 30,
----------------- ----------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Premiums collected by our insurance subsidiaries:
Annuities:
Equity-indexed (first-year)..................................... $ 13.5 $ 58.7 $ 33.6 $ 123.4
Equity-indexed (renewal)........................................ 5.0 7.6 10.0 17.6
-------- -------- -------- --------
Subtotal - equity-indexed annuities........................... 18.5 66.3 43.6 141.0
-------- -------- -------- --------
Other fixed (first-year)........................................ 288.4 185.8 551.8 375.4
Other fixed (renewal)........................................... 8.1 8.9 14.8 17.3
-------- -------- -------- --------
Subtotal - other fixed annuities.............................. 296.5 194.7 566.6 392.7
-------- -------- -------- --------
Total annuities............................................... 315.0 261.0 610.2 533.7
-------- -------- -------- --------
Supplemental health:
Medicare supplement (first-year)................................ 28.9 40.8 56.4 84.0
Medicare supplement (renewal)................................... 225.1 206.0 447.2 424.7
-------- -------- -------- --------
Subtotal - Medicare supplement................................ 254.0 246.8 503.6 508.7
-------- -------- -------- --------
Long-term care (first-year)..................................... 20.0 25.4 39.2 50.7
Long-term care (renewal)........................................ 208.2 201.8 407.9 402.2
-------- -------- -------- --------
Subtotal - long-term care..................................... 228.2 227.2 447.1 452.9
-------- -------- -------- --------
Specified disease (first-year).................................. 7.5 9.7 14.9 19.4
Specified disease (renewal)..................................... 88.2 83.2 165.1 166.6
-------- -------- -------- --------
Subtotal - specified disease.................................. 95.7 92.9 180.0 186.0
-------- -------- -------- --------
Other health (first-year)....................................... 3.7 3.6 7.3 7.1
Other health (renewal).......................................... 14.4 25.7 28.3 51.6
-------- -------- -------- --------
Subtotal - other health....................................... 18.1 29.3 35.6 58.7
-------- -------- -------- --------
Total supplemental health..................................... 596.0 596.2 1,166.3 1,206.3
-------- -------- -------- --------
Life insurance:
First-year...................................................... 16.4 24.7 32.9 53.4
Renewal......................................................... 124.1 132.4 249.8 317.8
-------- -------- -------- --------
Total life insurance.......................................... 140.5 157.1 282.7 371.2
-------- -------- -------- --------
Group major medical:
Group (first-year).............................................. - .1 - .4
Group (renewal)................................................. 63.0 74.7 123.5 164.0
-------- -------- -------- --------
Total group major medical..................................... 63.0 74.8 123.5 164.4
-------- -------- -------- --------
Collections on insurance products from continuing lines of business:
Total first-year premium collections on insurance products...... 378.4 348.8 736.1 713.8
Total renewal premium collections on insurance products......... 736.1 740.3 1,446.6 1,561.8
-------- -------- -------- --------
Total collections on insurance products....................... $1,114.5 $1,089.1 $2,182.7 $2,275.6
======== ======== ======== ========
Mutual funds (excludes variable annuities)........................... $ 54.0 $ 38.0 $ 135.1 $ 126.5
======== ======== ======== ========
Deposit type contracts............................................... $ 94.9 $ 79.7 $ 202.6 $ 159.3
======== ======== ======== ========
(continued)
54
CONSECO, INC. AND SUBSIDIARIES
--------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
----------------- ----------------
2003 2002 2003 2002
---- ---- ---- ----
(Dollars in millions)
Premiums collected from major medical business in run-off
and discontinued operations:
Major medical in run-off:
Individual (first-year)........................................... $ - $ 4.3 $ - $ 13.9
Individual (renewal).............................................. .8 23.1 2.4 58.7
---- ----- ---- ------
Total major medical in run-off.................................. .8 27.4 2.4 72.6
---- ----- ---- ------
Discontinued operations:
Annuities:
Fixed (first year)................................................ - 1.8 - 5.8
Fixed (renewal)................................................... - 1.5 - 3.1
---- ----- ---- ------
Subtotal other fixed annuities.................................. - 3.3 - 8.9
---- ----- ---- ------
Variable (first year)............................................. - 50.8 - 142.0
Variable (renewal)................................................ - 15.8 - 37.4
---- ----- ---- ------
Subtotal variable annuities..................................... - 66.6 - 179.4
---- ----- ---- ------
Total annuities................................................. - 69.9 - 188.3
---- ----- ---- ------
Life insurance:
First-year........................................................ - .1 - .3
Renewal........................................................... - - - -
---- ----- ---- ------
Total life insurance............................................ - .1 - .3
---- ----- ---- ------
Collections on insurance products from major medical business
in run-off and discontinued operations.............................. $ .8 $97.4 $2.4 $261.2
==== ===== ==== ======
Deposit type contracts - discontinued operations....................... $ - $ 2.4 $ - $ 4.5
==== ===== ==== ======
Continuing operations
Annuities include equity-indexed annuities and other fixed annuities sold
through both career agents and professional independent producers. Pursuant to
our initiatives to increase capital and focus on the sale of products that
result in less strain on our statutory capital and surplus, we took actions to
de-emphasize the sales of annuity products through professional independent
producers. Total annuity sales through professional independent producers
declined to $61.3 million in the six months period ended June 30, 2003, from
$240.1 million in the same period of 2002. For annuity sales through career
agents, we have provided sales inducements to purchasers and sales incentives to
our agents for sales through May 2003. Total annuity collections from career
agents increased to $548.9 million in the six months ended June 30, 2003, from
$293.6 million in the same period of 2002.
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 $18.5 million in the second quarter of 2003 compared with
$66.3 million in the
55
CONSECO, INC. AND SUBSIDIARIES
--------------------
second quarter of 2002 and were $43.6 million in the first six months of 2003
compared with $141.0 million in the first six months of 2002. 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)."
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 products increased by 52
percent, to $296.5 million, in the second quarter of 2003, and by 44 percent, to
$566.6 million in the first six months of 2003, as compared to the same periods
in 2002. The annuity premiums collected in 2003 were primarily from sales
through our career agency force, which were favorably impacted by the sales
inducements and incentives discussed above. In addition, the minimum guaranteed
crediting rates on certain of our annuity products were very attractive. We
recently introduced new annuity products which have lower minimum guaranteed
crediting rates. Given the elimination of the sales inducements and incentives
and the lower minimum guaranteed crediting rates, sales of fixed rate annuity
products may decline in future periods.
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 inforce, investment yields, claim experience and expense
management.
Collected premiums on Medicare supplement policies increased by 2.9
percent, to $254.0 million, in the second quarter of 2003, and decreased by 1.0
percent, to $503.6 million in the first six months of 2003, as compared to the
same periods in 2002. Collected premiums have been affected by the decrease in
new sales.
Premiums collected on long-term care policies increased by .4 percent, to
$228.2 million, in the second quarter of 2003, and decreased by 1.3 percent, to
$447.1 million in the first six months of 2003, as compared to the same periods
in 2002. Collected premiums have been affected by the decrease in new sales. We
ceased selling new long-term care policies through professional independent
producers in the second quarter of 2003.
Premiums collected on specified disease products increased by 3.0 percent
to $95.7 million in the second quarter of 2003, and decreased by 3.2 percent, to
$180.0 million in the first six months of 2003, as compared to the same periods
in 2002.
Other health products include disability income, dental and various other
health insurance products. We have discontinued the sale of most of these
products. The disability income and dental products have been marketed to school
systems located in nearly all states. Premiums collected decreased by 38 percent
to $18.1 million in the second quarter of 2003, and by 39 percent, to $35.6
million in the first six months of 2003, as compared to the same periods in
2002.
Life products are sold through career agents, professional independent
producers and direct response distribution channels. Life premiums collected
decreased by 11 percent, to $140.5 million in the second quarter of 2003, and by
24 percent, to $282.7 million in the first six months of 2003, as compared to
the same periods in 2002. 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 have recently discontinued the sale of certain life products
through the professional independent producer channel.
Group major medical premiums decreased by 16 percent, to $63.0 million, in
the second quarter of 2003, and by 25 percent, to $123.5 million in the first
six months of 2003, as compared to the same periods in the prior year. We no
longer actively market new sales of these products.
Mutual fund sales increased by 42 percent to $54.0 million in the second
quarter of 2003, and by 6.8 percent, to $135.1 million in the first six months
of 2003, as compared to the same periods in the prior year. Mutual fund sales
have been favorably affected by the recent performance of the stock market
partially offset by our decreased marketing efforts.
56
CONSECO, INC. AND SUBSIDIARIES
--------------------
Deposit type contracts include guaranteed interest contracts, supplemental
contracts without life contingencies and short-term deposit funds. Amounts
collected from deposit type contracts increased by 19 percent, to $94.9 million,
in the second quarter of 2003, and by 27 percent, to $202.6 million in the first
six months of 2003, 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 and small groups. In the second half of 2001, we stopped
renewing a large portion of our major medical lines of business. In early 2002,
we decided to stop renewing all inforce individual and small group business and
discontinue new sales. Individual health premiums collected in the second
quarter of 2003 decreased by 97 percent, to $.8 million, and by 97 percent, to
$2.4 million in the first six months of 2003, as compared to the same periods in
the prior year.
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. Profits on variable annuities are earned from the
fees charged to contract holders. We sold our variable annuity business 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 June 30, 2003 and
December 31, 2002, reflect: (i) our net loss for the six months ended June 30,
2003; (ii) changes in the fair value of actively managed fixed maturity
securities; and (iii) the effect of the sale of CFC.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' deficit. At June 30, 2003, we increased the
carrying value of such investments by $1,196.5 million as a result of this fair
value adjustment. The fair value adjustment resulted in a $448.1 million
increase in carrying value at year-end 2002.
June 30, December 31,
2003 2002
---- ----
(Dollars in millions)
Total capital:
Corporate notes payable................................................ $4,127.5 $4,057.1
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts..................................... 1,921.5 1,921.5
Shareholders' deficit:
Preferred stock..................................................... 501.7 501.7
Common stock and additional paid-in capital......................... 3,497.4 3,497.0
Accumulated other comprehensive income.............................. 1,143.4 580.6
Accumulated deficit................................................. (6,669.3) (6,629.7)
-------- --------
Total shareholders' deficit...................................... (1,526.8) (2,050.4)
-------- --------
Total capital.................................................... $4,522.2 $3,928.2
======== ========
Corporate notes payable increased during the first three months of 2003
primarily due to the capitalization of accrued interest on our Senior Credit
Facility. Pursuant to SOP 90-7, all corporate notes payable have been classified
as "liabilities subject to compromise".
57
CONSECO, INC. AND SUBSIDIARIES
--------------------
Shareholders' deficit decreased by $523.6 million in the first six months
of 2003, to $1,526.8 million. The significant components of the decrease were
the increase in accumulated other comprehensive income of $562.8 million
(principally related to the increase in the unrealized gains of our insurance
companies' investment portfolio) partially offset by our net loss for the six
months ended June 30, 2003, of $39.6 million.
Book value (deficit) per common share outstanding decreased to $(5.86) at
June 30, 2003, from $(7.38) at December 31, 2002. Such change was primarily
attributable to the increase in accumulated other comprehensive income partially
offset by our net loss for the six months ended June 30, 2003.
The following table summarizes certain financial ratios as of and for the
six months ended June 30, 2003, and as of and for the year ended December 31,
2002:
June 30, December 31,
2003 2002
---- ----
Book value (deficit) per common share........................................................... $(5.86) $(7.38)
Ratio of earnings to fixed charges.............................................................. (f) (d)
Ratio of earnings to fixed charges, preferred dividends and distributions
on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts.............................................................. (g) (e)
Rating agency ratios (a) (b) (c):
Corporate debt to total capital.............................................................. 122% 121%
Corporate debt and Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts to total capital...................................................... 178% 178%
- ----------------------
(a) Excludes accumulated other comprehensive income (loss).
(b) Excludes investment borrowings of the insurance segment.
(c) These ratios are calculated in a manner discussed with rating agencies.
(d) For such ratio, adjusted earnings were $1,634.0 million less than fixed
charges. Adjusted earnings for the year ended December 31, 2002, included:
(i) special charges and reorganization items totaling $110.9 million; (ii)
goodwill impairment charges of $500.0 million; and (iii) provision for
losses related to loan guarantees of $240.0 million, as described in
greater detail in the notes to the accompanying consolidated financial
statements.
(e) For such ratio, adjusted earnings were $1,810.4 million less than fixed
charges. Adjusted earnings for the year ended December 31, 2002, included:
(i) special charges and reorganization items totaling $110.9 million; (ii)
goodwill impairment charges of $500.0 million; and (iii) provision for
losses related to loan guarantees of $240.0 million, as described in
greater detail in the notes to the accompanying consolidated financial
statements.
(f) For such ratio, adjusted earnings were $86.8 million less than fixed
charges. Adjusted earnings for the six months ended June 30, 2003,
included: (i) reorganization items totaling $32.5 million; and (ii)
provision for losses related to loan guarantees of $31.1 million, as
described in greater detail in the notes to the accompanying consolidated
financial statements.
(g) For such ratio, adjusted earnings were $86.8 million less than fixed
charges. Adjusted earnings for the six months ended June 30, 2003,
included: (i) reorganization items totaling $32.5 million; and (ii)
provision for losses related to loan guarantees of $31.1 million, as
described in greater detail in the notes to the accompanying consolidated
financial statements.
58
CONSECO, INC. AND SUBSIDIARIES
--------------------
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.
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 superior 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 a fair ability in A.M. Best's opinion to meet their current
obligations to policyholders, but are financially vulnerable to adverse changes
in underwriting and economic conditions. The rating 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. S&P 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 S&P's view, an insurer rated "B" has weak
financial security characteristics and adverse business conditions will likely
impair its ability to meet financial commitments.
The ratings downgrades have generally caused sales of our insurance
products to decline and policyholder redemptions and lapses to increase. In some
cases, the downgrades have also caused defections among our independent agent
sales force and increases in the commissions we must pay. These events have had
a material adverse effect on our financial results. Further downgrades by A.M.
Best or S&P could have further material and adverse effects on our financial
results and liquidity.
As more fully described under the caption "Statutory Information" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", 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 half of 2003 and during 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. Our insurance subsidiaries could readily liquidate portions of
their investments, if lapses continue at current levels.
Liquidity of the Debtors
The liquidity and capital resources of the Debtors are significantly
affected by the Chapter 11 Cases. Our bankruptcy proceedings have resulted in
various restrictions on our activities, limitations on financing and a need to
obtain Bankruptcy Court approval for various matters. As a result of our
bankruptcy filing, the Debtors are not permitted to make any payments on their
prepetition liabilities. At June 30, 2003, the Debtors held cash of $28.5
million. In addition, our other non-life insurance companies held cash of
approximately $107.8 million.
Under the priority schedule established by the Bankruptcy Code, certain
postpetition and prepetition liabilities need to be satisfied before unsecured
creditors and holders of CNC's common and preferred stock and Trust Preferred
Securities are entitled to receive any distribution. The Plan sets forth the
Debtors' proposed treatment of claims and equity interests. No assurance can be
given as to what values, if any, will be ascribed in the bankruptcy proceedings
to each of these constituencies. Our Plan would result in holders of CNC's
common stock and preferred stock receiving no value and the holders of CNC's
Trust Preferred Securities receiving little value on account of the cancellation
of their interests. In addition,
59
CONSECO, INC. AND SUBSIDIARIES
--------------------
holders of unsecured claims against the Debtors would, in most cases, receive
less than full recovery for the cancellation of their interests.
At this time, it is not possible to predict with certainty the effect of
the Chapter 11 cases on our business or various creditors, or when we will
emerge from Chapter 11. Our future results depend upon our confirming and
successfully implementing, on a timely basis, a plan of reorganization.
CNC and CIHC are holding companies with no business operations of their
own; they depend on their operating subsidiaries for cash to make principal and
interest payments on debt, and to pay administrative expenses and income taxes.
The cash CNC and CIHC receive from insurance subsidiaries consists of fees for
services, tax sharing payments, dividends and distributions, and from our
non-insurance subsidiaries, loans and advances. A further deterioration in the
financial condition, earnings or cash flow of the material subsidiaries of CNC
or CIHC for any reason could further limit such subsidiaries' ability to pay
cash dividends or other disbursements to CNC and/or CIHC, which, in turn, would
limit CNC's and/or CIHC's ability to meet debt service requirements and satisfy
other financial obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. 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 or net income for the prior year; or
(ii) 10 percent of capital and surplus as of the end of the preceding year. Any
dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department. As described under
the caption "Statutory Information" within "Management's Discussion and Analysis
of Financial Condition and Results of Operations", Bankers National Life
Insurance Company and Conseco Life Insurance Company of Texas (on behalf of
itself and its subsidiaries), entered into consent orders with the Commissioner
of Insurance for the State of Texas on October 30, 2002. These consent orders,
among other things, limit the ability of our insurance subsidiaries to pay
dividends.
The continuation of the Chapter 11 Cases, particularly if the Plan is not
approved or confirmed in the time frame currently contemplated, could further
adversely affect our operations and relationship with our customers, employees,
regulators, distributors and agents. If confirmation and consummation of the
Plan do not occur expeditiously, the Chapter 11 Cases could result in, among
other things, increased costs for professional fees and similar expenses. In
addition, prolonged Chapter 11 Cases may make it more difficult to retain and
attract management and other key personnel and would require senior management
to spend a significant amount of time and effort dealing with our financial
reorganization instead of focusing on the operation of our business. However, we
currently expect that our current cash resources and additional cash flows from
the operations of our non-life subsidiaries will be adequate to complete our
financial reorganization if the Plan is approved in the time frame currently
contemplated.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
assure you that we will possess sufficient income and liquidity to meet all of
our liquidity requirements and other obligations. Although we believe that
amounts required for us to meet our financial and operating obligations will be
available from our subsidiaries and from funds currently held by CNC and CIHC,
our results for future periods are subject to numerous uncertainties. We may
encounter liquidity problems, which could affect our ability to meet our
obligations while attempting to meet competitive pressures or adverse economic
conditions.
Because our operations are conducted through subsidiaries, claims of the
creditors of those subsidiaries (including policyholders) will rank senior to
claims to distributions from the subsidiaries, which we depend on to make
payments on our obligations. CIHC's subsidiaries, excluding CFC, had
indebtedness for borrowed money (including capitalized lease obligations but
excluding indebtedness to affiliates), policy reserves and other liabilities of
approximately $24.1 billion at June 30, 2003. The obligations of CNC and CIHC,
as parent holding companies, will rank effectively junior to these liabilities.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted under the insurance law of its state of domicile by such
state's insurance regulator as the receiver with respect to such insurer's
property and business. In the event of a default on our debt or our insolvency,
liquidation or other reorganization, our creditors and stockholders will not
have the right to proceed against the assets of our insurance subsidiaries or to
cause their liquidation under federal and state bankruptcy laws.
60
CONSECO, INC. AND SUBSIDIARIES
--------------------
We will have significant indebtedness even if the Plan is consummated.
Further, our historical capital requirements have been significant and our
future capital requirements could vary significantly and may be affected by
general economic conditions, industry trends, performance, and many other
factors that are not within our control. We cannot assure you that we will be
able to obtain financing in the future. Even if the Plan is approved and
consummated, we cannot assure you that we will not continue to experience losses
in the future. Our profitability and ability to generate cash flow will likely
depend upon our ability to successfully implement our business strategy.
However, we cannot assure you that we will be able to accomplish these results.
Our Plan contemplates that we will enter into the New Credit Facility with
our lenders in connection with our reorganization. We have agreed to a number of
covenants and other provisions that restrict our ability to engage in various
financing transactions and pursue certain operating activities without the prior
consent of the lenders under the New Credit Facility. We have also agreed to
meet or maintain various financial ratios and minimum financial strength ratings
for our insurance subsidiaries. For instance, if we experience a ratings
downgrade following confirmation of the Plan, if we fail to achieve an "A-"
rating by a specified date following confirmation of the Plan or if we
experience a ratings downgrade after achieving an "A-" rating, we will suffer an
event of default under the New Credit Facility. Our ability to meet these
financial and ratings covenants may be affected by events beyond our control.
Although we expect to be in compliance with these requirements as of the
Effective Date, these requirements represent significant restrictions on the
manner in which we may operate our business. If we default under any of these
requirements, the lenders could declare all outstanding borrowings, accrued
interest and fees to be due and payable. If that were to occur, we cannot assure
you that we would have sufficient liquidity to repay or refinance this
indebtedness or any of our other debts.
INVESTMENTS
At June 30, 2003, 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................................................ $10,385.3 $ 981.0 $111.4 $11,254.9
United States Treasury securities and obligations of
United States government corporations and agencies................ 811.5 39.1 2.2 848.4
States and political subdivisions................................... 499.2 28.2 3.7 523.7
Debt securities issued by foreign governments....................... 81.0 11.2 - 92.2
Mortgage-backed securities ......................................... 6,041.8 313.2 3.3 6,351.7
Below-investment grade (primarily corporate securities)................ 1,231.3 66.2 81.5 1,216.0
--------- -------- ------ ---------
Total actively managed fixed maturities............................. $19,050.1 $1,438.9 $202.1 $20,286.9
========= ======== ====== =========
Equity securities...................................................... $132.4 $12.8 $4.2 $141.0
====== ===== ==== ======
61
CONSECO, INC. AND SUBSIDIARIES
--------------------
Concentration of Corporate Securities
At June 30, 2003, 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......................................................... 12.7% 12.5%
Bank/savings and loan............................................................ 11.4 11.2
Electric utility................................................................. 9.7 9.5
Energy........................................................................... 8.3 7.8
Insurance ....................................................................... 7.2 7.6
Real estate and real estate investment trusts.................................... 7.0 7.0
Financial institutions........................................................... 5.9 6.0
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 June 30, 2003, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $1,231.3 million, or 6.5
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $1,216.0 million, or 99 percent of the
amortized cost. The value of these securities varies based on the economic terms
of the securities, structural considerations and the credit worthiness of the
issuer of the securities. Recently a number of large, highly leveraged issuers
have experienced significant financial difficulties, which resulted in our
recognition of other-than-temporary impairments. These impairments have had a
material adverse effect on us.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of loss upon default by the
borrower is significantly greater with respect to below-investment grade
securities than with other corporate debt securities. Below-investment grade
securities are generally unsecured and are often subordinated to other creditors
of the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and are more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than are investment grade
issuers. 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 Gains (Losses)
During the first six months of 2003, we recognized net realized investment
gains of $10.7 million, compared to net realized investment losses of $253.2
million during the comparable period of 2002. The net realized investment gains
during the first six months of 2003 included: (i) $45.2 million of net gains
from the sales of investments (primarily fixed maturities) which generated
proceeds of $4.3 billion; net of (ii) $34.5 million of writedowns of fixed
maturity investments as a result of conditions which caused us to conclude a
decline in fair value of the investment was other than temporary. At June 30,
2003, fixed maturity securities in default as to the payment of principal or
interest had an aggregate amortized cost of $17.3 million and a carrying value
of $24.7 million. Net realized investment losses during the first six months of
2002 included: (i) $209.5 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) $43.7 million of net losses from the sales of investments
(primarily fixed maturities).
During the first six months of 2003, we sold $1.6 billion of fixed maturity
investments which resulted in gross investment losses (before income taxes) of
$43.9 million. Securities sold at a loss are sold for a number of reasons
including: (i) changes in the investment environment; (ii) expectation that the
market value could deteriorate further; (iii) desire to reduce our exposure to
an issuer or an industry; (iv) changes in credit quality; and (v) our analysis
indicating there is a high probability that the security is
other-than-temporarily impaired.
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The following summarizes the investments sold at a loss during the first
six months of 2003 which had been continuously in an unrealized loss position
exceeding 20 percent of the amortized cost basis prior to the sale for the
period indicated:
At date of sale
---------------
Number of Amortized Fair
Period issuers cost value
------ ------- ---- -----
(Dollars in millions)
Less than 6 months prior to sale............................... 15 $31.5 $23.7
Greater than or equal to 6 and less than 12 months
prior to sale............................................. 7 33.9 20.6
Greater than 12 months
prior to sale............................................. 13 21.8 12.5
Investments with Other-Than-Temporary Losses
During the six months ended June 30, 2003, we recorded write-downs of fixed
maturity investments totaling $34.5 million as further described in the
following paragraphs.
During the second quarter of 2003, we recognized a loss of $11.1 million to
record certain commercial loans at their estimated fair value as we intend to
sell them and use the proceeds to repay the senior financing used to acquire the
loans. The sale is expected to be completed in the third quarter of 2003.
During the six months ended June 30, 2003, we recorded writedowns of $8.4
million related to our holdings of fixed maturity investments in a major airline
that has filed bankruptcy. Although our investments are backed by collateral,
our analysis of the value of the underlying collateral indicated that the
decline in fair value of the investment is other than temporary.
During the six months ended June 30, 2003, we recorded writedowns of $3.7
million related to our holdings of fixed maturity investments in a fertilizer
company that has filed for bankruptcy. A significant portion of its production
capacity was recently idled. Accordingly, we concluded that the decline in fair
value was other than temporary.
During the six months ended June 30, 2003, we recorded writedowns totaling
$1.8 million related to holdings of a health care company that has had financial
problems due to financial misstatements and its failure to meet debt service
requirements. The adverse effect on liquidity and access to capital may force
this issuer to file for bankruptcy. Accordingly, we concluded the decline in
fair value was other than temporary.
During the six months ended June 30, 2003, we recorded writedowns of $1.5
million related to holdings of a finance company that has had significant
financial and liquidity problems. Accordingly, we concluded the decline in fair
value was other than temporary.
In addition to the specific investments discussed above, we recorded $8.0
million of writedowns related to various other fixed maturity investments. No
other writedowns of a single issuer exceeded $1.5 million.
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Recognition of Losses
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value.
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time.
Our periodic assessment of whether unrealized losses are "other than
temporary" requires significant judgment. Factors considered include: (i) the
extent to which market value is less than the cost basis; (ii) the length of
time that the market value has been less than cost; (iii) whether the unrealized
loss is event driven, credit-driven or a result of changes in market interest
rates; (iv) the near-term prospects for improvement in the issuer and/or its
industry; (v) whether the investment is investment-grade and our view of the
investment's rating and whether the investment has been downgraded since its
purchase; (vi) whether the issuer is current on all payments in accordance with
the contractual terms of the investment and is expected to meet all of its
obligations under the terms of the investment; (vii) our ability and intent to
hold the investment for a period of time sufficient to allow for any anticipated
recovery; and (viii) the underlying current and prospective asset and enterprise
values of the issuer and the extent to which our investment may be affected by
changes in such values.
If a decline in value is determined to be other than temporary and the cost
basis of the security is written down to fair value, we review the circumstances
which caused us to believe that the decline was other than temporary with
respect to other investments in our portfolio. If such circumstances exist with
respect to other investments, those investments are also written down to fair
value. Future events may occur, or additional or updated information may become
available, which may necessitate future realized losses of securities in our
portfolio. Significant losses in the carrying value of our investments could
have a material adverse effect on our earnings in future periods.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at June 30,
2003, by contractual maturity. Actual maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties. Most of the mortgage-backed
securities shown below provide for periodic payments throughout their lives.
Estimated
Amortized fair
cost value
--------- ---------
(Dollars in millions)
Due in one year or less................................................................... $ 9.4 $ 9.4
Due after one year through five years..................................................... 125.5 115.6
Due after five years through ten years.................................................... 416.3 379.1
Due after ten years....................................................................... 2,181.3 2,031.9
-------- --------
Subtotal............................................................................... 2,732.5 2,536.0
Mortgage-backed securities................................................................ 97.9 92.3
-------- --------
Total.................................................................................. $2,830.4 $2,628.3
======== ========
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The following summarizes the investments in fixed maturities rated
below-investment grade or classified as equity-type securities which have been
continuously in an unrealized loss position exceeding 20 percent of the cost
basis for the period indicated as of June 30, 2003:
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------- ---------- ----- ---- ----------
(Dollars in millions)
Less than 6 months(1) 8 $15.6 $ 4.8 $10.8
Greater than or equal to
6 months and less
than 12 months(2) 8 88.4 28.4 60.0
Greater than 12 months(3) 9 82.6 22.4 60.2
-----------------------
(1) No single issuer in this category had an unrealized loss
exceeding $2.5 million.
(2) These investments include: (i) fixed maturity investments in
a commercial airline with a cost basis of $26.4 million and
an estimated fair value of $18.1 million; (ii) fixed
maturity investments in a retail chain with a cost basis of
$26.5 million and an estimated fair value of $20.4 million;
and (iii) fixed maturity investments in an airline trust
with a cost basis of $15.8 million and an estimated fair
value of $7.4 million. See "Investments with Unrealized
Losses" for additional Information. No other single issuer
in this category had an unrealized loss exceeding $2.5
million.
(3) These investments include: (i) a fixed maturity investment
in a telecommunications company with a cost basis of $26.5
million and an estimated fair value of $18.5 million; (ii) a
fixed maturity investment in a reinsurance company with a
cost basis of $23.1 million and an estimated fair value of
$17.9 million; and (iii) fixed maturity investments in a
fertilizer company with a cost basis of $12.5 million and an
estimated fair value of $9.2 million. No other single issuer
in this category had an unrealized loss exceeding $2.5
million.
Our investment strategy is to maximize over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change. While we have both the ability and intent to hold
securities with unrealized losses until they mature or recover in value, we may
sell securities at a loss in the future because of actual or expected changes in
our view of the particular investment, its industry, its type or the general
investment environment.
Based on management's current assessment of these securities and other
investments with unrealized losses at June 30, 2003, the Company believes the
issuers of the securities will continue to meet their obligations (or with
respect to equity-type securities, the investment value will recover to its cost
basis). The Company has no current plans to sell these securities and has the
ability to hold them to maturity. The recognition of an other-than-temporary
impairment through a charge to earnings may be recognized in future periods if
management later concludes that the decline in market value below the cost basis
is other than temporary.
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CONSECO, INC. AND SUBSIDIARIES
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Investments with Unrealized Losses
The following is a brief description of our assessment of the potential
other-than-temporary losses related to investments in our below-investment grade
portfolio (or equity-type securities) with significant unrealized losses at June
30, 2003 (unrealized losses which exceed $2.5 million and 20 percent of the cost
basis of the securities by the same issuer):
At June 30, 2003, we held fixed maturity investments issued by a commercial
airline rated B1/BB+ with an amortized cost of $26.4 million and an estimated
fair value of $18.1 million. This issuer is facing operational challenges that
affect the entire industry. The securities we hold are secured by collateral,
which we believe is sufficient in value to support our carrying value. In
addition, we believe the issuer has the ability to meet its scheduled debt
obligations. Therefore, we concluded that the unrealized loss at June 30, 2003
is not an other-than-temporary decline in value.
At June 30, 2003, we held fixed maturity investments issued by a regional
retail chain rated B2/B+ with an amortized cost of $26.5 million, a par amount
of $22.2 million and an estimated fair value of $20.4 million. 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 fair value of this
security has increased significantly during the last 15 months (from 70 percent
of par at December 31, 2001 to 92 percent of par at June 30, 2003). We believe
that we will recover the full value from this investment and we intend to hold
the security to maturity. Therefore, we concluded that the unrealized loss at
June 30, 2003 is not an other-than-temporary decline in value.
At June 30, 2003, we held fixed maturity investments issued by a
telecommunications holding company rated Caa2/CCC+ with an amortized cost of
$26.5 million and an estimated fair value of $18.5 million. The sale of a
subsidiary of this issuer is expected to close in 2003 with gross proceeds of
$4.3 billion. The sale of this subsidiary is likely to provide ample liquidity
to meet this issuer's obligations in the near term. Therefore, we concluded that
the unrealized loss at June 30, 2003 is not an other-than-temporary decline in
value.
At June 30, 2003, we held a fixed maturity investment in a reinsurance
company rated Ba2/BB+ with an amortized cost of $23.1 million and an estimated
fair value of $17.9 million. The reinsurance on the books of the issuer is high
quality, with counterparties rated AA or better. The issuer is reporting
improvements in operating performance, recently received a capital infusion and
is seeing strong price increases across most product lines. The issuer appears
to have sufficient cash flow to service its existing debt obligations. We
concluded that the unrealized loss at June 30, 2003 is not an
other-than-temporary decline in value.
At June 30, 2003, we held fixed maturity investments in an airline trust
rated Ba3/CCC+ with an amortized cost of $15.8 million and an estimated fair
value of $7.4 million. We believe the collateral supporting these investments is
sufficient, and, therefore, we concluded that the unrealized loss at June 30,
2003 is not an other-than-temporary decline in value.
At June 30, 2003, we held a fixed maturity investment in a large global
fertilizer company rated B2/B- with an amortized cost of $12.5 million and an
estimated fair value of $9.2 million. We believe this issuer will continue to
service all of its debt obligations on a timely basis. The financial condition
and near term prospects of this issuer are good. Therefore, we concluded that
the unrealized loss at June 30, 2003 is not an other-than-temporary decline in
value.
Investment in General Motors Building
At June 30, 2003, Conseco holds $292.9 million of investments related to a
50 story office building in New York City known as the General Motors Building.
Such investments are primarily held in our fixed maturity investment portfolio.
In January 2002, Conseco exercised its right to purchase the interest of the
other investor in the building.
Pursuant to GAAP, Conseco's future earnings on these investments are
limited to amounts which are based on the actual earnings related to the
operation of the building (including adjustments to reflect Conseco's actual
cost basis). These earnings were not material in 2002 and are not expected to be
material in 2003; accordingly, our income from these investments will be less
than the stated return on the investment of 12.7 percent.
The Company previously announced its intention to sell its interest in the
GM Building. On June 13, 2003, the Company and the other investor in the
building reached an agreement on a long-standing dispute over control and
distribution of profits
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CONSECO, INC. AND SUBSIDIARIES
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which was hindering Conseco's ability to sell its interest. The building is
currently being marketed for sale. See the caption "Investment in General Motors
Building" in the note to the consolidated financial statements entitled
"Investments in Variable Interest Entities" for further information on this
investment.
Mortgage Backed Securities
At June 30, 2003, fixed maturity investments included $6.4 billion of
mortgage-backed securities (or 31 percent of all fixed maturity securities). The
yield characteristics of mortgage-backed securities differ from those of
traditional fixed-income securities. Interest and principal payments for
mortgage-backed securities occur more frequently, often monthly. Mortgage-backed
securities are subject to risks associated with variable prepayments. Prepayment
rates are influenced by a number of factors that cannot be predicted with
certainty, including: the relative sensitivity of the underlying mortgages
backing the assets to changes in interest rates; a variety of economic,
geographic and other factors; and the repayment priority of the securities in
the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities
backed by these loans increase when prevailing interest rates decline
significantly relative to the interest rates on such loans. The yields on
mortgage-backed securities purchased at a discount to par will increase when the
underlying mortgages prepay faster than expected. The yields on mortgage-backed
securities purchased at a premium will decrease when they prepay faster than
expected. When interest rates decline, the proceeds from the prepayment of
mortgage-backed securities are likely to be reinvested at lower rates than we
were earning on the prepaid securities. When interest rates increase,
prepayments on mortgage-backed securities decrease as fewer underlying mortgages
are refinanced. When this occurs, the average maturity and duration of the
mortgage-backed securities increase, which decreases the yield on
mortgage-backed securities purchased at a discount, because the discount is
realized as income at a slower rate, and increases the yield on those purchased
at a premium as a result of a decrease in the annual amortization of the
premium.
The following table sets forth the par value, amortized cost and estimated
fair value of mortgage-backed securities, summarized by interest rates on the
underlying collateral at June 30, 2003:
Par Amortized Estimated
value cost fair value
----- ---- ----------
(Dollars in millions)
Below 5 percent..................................................................... $ 527.2 $ 535.5 $ 551.8
5 percent - 6 percent............................................................... 771.4 780.2 806.0
6 percent - 7 percent............................................................... 3,847.3 3,813.8 4,021.2
7 percent - 8 percent............................................................... 784.6 792.4 845.2
8 percent and above................................................................. 123.3 125.8 131.1
-------- -------- --------
Total mortgage-backed securities (a)......................................... $6,053.8 $6,047.7 $6,355.3
======== ======== ========
- ----------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $5.9 million and $3.6 million,
respectively.
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CONSECO, INC. AND SUBSIDIARIES
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The amortized cost and estimated fair value of mortgage-backed securities
at June 30, 2003, 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............ $4,417.6 $4,642.4 23%
Planned amortization classes and accretion-directed bonds................. 330.9 348.4 2
Commercial mortgage-backed securities..................................... 1,004.9 1,060.3 5
Subordinated classes and mezzanine tranches............................... 286.3 298.0 1
Other..................................................................... 8.0 6.2 -
-------- -------- --
Total mortgage-backed securities (a)............................... $6,047.7 $6,355.3 31%
======== ======== ==
- ----------------
(a) Includes below-investment grade mortgage-backed securities with an
amortized cost and estimated fair value of $5.9 million and $3.6 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. Subordinated and mezzanine
tranches bear a majority of the risk of loss due to property owner defaults.
Subordinated bonds are generally rated "AA" or lower; we typically do not hold
securities rated lower than "BB".
Mortgage Loans
At June 30, 2003, the mortgage loan balance was primarily comprised of
commercial loans. Less than one percent of the mortgage loan balance was
noncurrent (loans with two or more scheduled payments past due) at June 30,
2003.
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CONSECO, INC. AND SUBSIDIARIES
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Investment Borrowings
Our investment borrowings averaged approximately $704.9 million during the
first six months of 2003, compared with approximately $1,298.0 million during
the same period of 2002 and were collateralized by investment securities with
fair values approximately equal to the loan value. The weighted average interest
rates on such borrowings were 1.8 percent and 1.6 percent during the first six
months of 2003 and 2002, respectively.
STATUTORY INFORMATION
Statutory accounting practices prescribed or permitted by regulatory
authorities for the Company's insurance subsidiaries differ from GAAP. The
statutory net loss of our life insurance subsidiaries was $1.9 million and $46.9
million in the first six months of 2003 and 2002, respectively (including
realized investment losses of $70.8 million and $122.3 million, respectively).
The Company's life insurance subsidiaries reported the following amounts to
regulatory agencies at June 30, 2003, after appropriate eliminations of
intercompany accounts among such subsidiaries (dollars in millions):
Statutory capital and surplus .................................. $1,045.1
Asset valuation reserve......................................... 51.6
Interest maintenance reserve.................................... 376.1
--------
Total........................................................ $1,472.8
========
The statutory capital and surplus shown above included investments in the
preferred stock of CIHC of $146.4 million, all of which were eliminated in the
consolidated financial statements prepared in accordance with GAAP.
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 or net income for the prior year; or
(ii) 10 percent of capital and surplus as of the end of the preceding year. Any
dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department.
On October 30, 2002, Bankers National Life Insurance Company and Conseco
Life Insurance Company of Texas (on behalf of itself and its insurance
subsidiaries), our insurance subsidiaries domiciled in Texas, each entered into
consent orders with the Commissioner of Insurance for the State of Texas whereby
they agreed: (i) not to request any dividends or other distributions before
January 1, 2003 and, thereafter, not to pay any dividends or other distributions
to parent companies outside of the insurance system without the prior approval
of the Texas Insurance Commissioner; (ii) to continue to maintain sufficient
capitalization and reserves as required by the Texas Insurance Code; (iii) to
request approval from the Texas Insurance Commissioner before making any
disbursements not in the ordinary course of business; (iv) to complete any
pending transactions previously reported to the proper insurance regulatory
officials prior to and during Conseco's restructuring, unless not approved by
the Texas Insurance Commissioner; (v) to obtain a commitment from Conseco 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. Conseco Life Insurance Company of Texas is the parent of
all of the Company's insurance subsidiaries, except for Bankers National Life
Insurance Company. 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 National Association of Insurance Commissioners' Risk-Based Capital for
Life and/or Health Insurers Model Act (the "Model Act") provides a tool for
insurance regulators to determine the levels of statutory capital and surplus an
insurer must maintain in relation to its insurance and investment risks and
whether there is a need for possible regulatory attention. The Model Act
provides four levels of regulatory attention, varying with the ratio of the
insurance company's total adjusted capital (defined as the total of its
statutory capital and surplus, asset valuation reserve and certain other
adjustments) to its ACLRBC: (i) if a company's total adjusted capital is less
than or equal to 200 percent but greater than 150 percent of its ACLRBC (the
"Company Action Level"), the company must submit a comprehensive plan to the
regulatory authority proposing corrective actions aimed at improving its capital
position; (ii) if a company's total adjusted capital is less than or equal to
150 percent but greater than 100 percent of its ACLRBC (the "Regulatory Action
Level"), the regulatory authority will perform a special examination of the
company and issue an order specifying the corrective actions that must be
followed;
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CONSECO, INC. AND SUBSIDIARIES
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(iii) if a company's total adjusted capital is less than or equal to 100 percent
but greater than 70 percent of its ACLRBC (the "Authorized Control Level"), the
regulatory authority may take any action it deems necessary, including placing
the company under regulatory control; and (iv) if a company's total adjusted
capital is less than or equal to 70 percent of its ACLRBC (the "Mandatory
Control Level"), the regulatory authority must place the company under its
control. In addition, the Model Law provides for an annual trend test if a
company's total adjusted capital is between 200 percent and 250 percent of its
ACLRBC at the end of the year. The trend test calculates the greater of the
decrease in the margin of total adjusted capital over ACLRBC: (i) between the
current year and the prior year; and (ii) for the average of the last 3 years.
It assumes that such decrease could occur again in the coming year. Any company
whose trended total adjusted capital is less than 190 percent of its ACLRBC
would trigger a requirement to submit a comprehensive plan as described above
for the Company Action Level.
The 2002 statutory annual statements filed with the state insurance
regulators of each of our insurance subsidiaries reflected total adjusted
capital in excess of the levels subjecting the subsidiary to any regulatory
action. The 2002 audited financial statements of our insurance subsidiaries were
completed in June 2003. Two of our subsidiaries' ACLRBC ratios, based on the
capital balances reflecting audit adjustments, were less than 250 percent. As a
result of the audit adjustments, a regulation of the domiciliary state of one of
the subsidiaries requires a filing of an amended 2002 annual statement, which
will subject the subsidiary to the trend test. The result of the trend test
indicates a trended total adjusted capital of less than 190 percent of its
ACLRBC, which requires the subsidiary to prepare a comprehensive plan proposing
corrective actions aimed at improving its capital position.
The combined ACLRBC ratio for our insurance subsidiaries was 328 percent at
December 31, 2002. At December 31, 2002, the ratios for our insurance
subsidiaries that are subject to the four levels of regulatory attention
described above ranged from 226 percent to 563 percent. We are taking actions
intended to improve the ACLRBC ratios of our insurance subsidiaries. Such
actions include: (i) discontinuing or reducing sales of products that create
initial reductions in statutory surplus because of the costs of selling the
products; (ii) reducing operating expenses; (iii) merging some of our insurance
subsidiaries with other insurance subsidiaries; and (iv) restructuring our
investment portfolio to better match the risk profile of the portfolio with the
insurance subsidiary's earnings and capital requirements. We have discussed
these actions with insurance regulators in each of the states in which our
insurance subsidiaries are domiciled.
NEW ACCOUNTING STANDARDS
See "Recently Issued Accounting Standards" in the notes to consolidated
financial statements for a discussion of recently issued accounting standards.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our market risks, and the ways we manage them, are summarized in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", included in the Company's Form 10-K for the year ended December 31,
2002. There have been no material changes in the first six months of 2003 to
such risks or our management of such risks.
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CONSECO, INC. AND SUBSIDIARIES
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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
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as of the
end of the period covered by this 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 over financial reporting that
have materially affected, or are reasonably likely to materially affect,
Conseco's internal controls over financial reporting. The results of this
evaluation have been discussed with Conseco's Audit Committee and with our
external auditors.
PART II - OTHER INFORMATION
ITEM 1. LITIGATION AND OTHER LEGAL PROCEEDINGS.
As described in the note to the consolidated financial statements entitled
"Proceedings under Chapter 11 of the Bankruptcy Code", CNC and several of its
subsidiaries filed voluntary petitions for reorganization under Chapter 11 of
the Bankruptcy Code in the Bankruptcy Court. The Company's insurance
subsidiaries and other subsidiaries that did not file petitions are separate
legal entities and are not included in the petitions filed by the parent. The
Debtors retain control of the insurance subsidiaries and related subsidiaries
and are authorized to operate these businesses as debtors-in-possession while
being subject to the jurisdiction of the Bankruptcy Court. As of the Petition
Date, pending litigation against the Debtors is stayed, and absent further order
of the Bankruptcy Court, substantially all prepetition liabilities of the
Debtors are subject to settlement under a plan of reorganization. Based on the
Plan of the Debtors, liabilities subject to compromise against CNC exceed the
fair value of the Debtors' assets, and unsecured claims will be satisfied at
less than 100 percent of their fair value.
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.
Securities Litigation
A total of forty-five suits filed in 2000 against CNC in the United States
District Court for the Southern District of Indiana 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. 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 CNC and Conseco
Financing Trust VII. These cases were ultimately settled for $120 million, $20
million of which was paid by Conseco and $100 million of which was paid by
certain of the Company's directors' and officers' liability insurance carriers,
subject to certain modifications approved by the Bankruptcy Court and Indiana
District Court. The Company had previously provided a liability of $40 million
related to these cases due to disputes with certain insurance carriers. During
the quarter ending June 30, 2003, these disputes were resolved without any
payment and the liability was released.
Since we announced our intention to restructure our capital on August 9,
2002, a total of eight purported securities fraud class action lawsuits have
been filed in the United States District Court for the Southern District of
Indiana. The complaints name CNC as a defendant, along with certain current and
former officers of CNC. These lawsuits were filed on behalf of persons or
entities who purchased CNC'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 CNC and alleged problems in CFC's manufactured
housing division, allegedly resulting in the artificial inflation of CNC's stock
price. On March 13, 2003, all of these cases were consolidated into one case in
the United States District Court for the Southern District of Indiana, captioned
"Franz Schleicher, et al. v. Conseco, Inc., et al.," File No. 02-CV-1332
DFH-TAB. CNC believes these lawsuits are without merit and intends to defend
them vigorously. The ultimate outcome of these lawsuits cannot be predicted with
certainty. CNC has filed an adversary proceeding to extend the automatic stay
provided for by the Bankruptcy Code to this litigation as it pertains to current
and former officers and directors of CNC.
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CONSECO, INC. AND SUBSIDIARIES
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Derivative Litigation
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 CNC (in one case), and, alleging aiding and abetting liability,
certain banks that made loans in relation to CNC's "Stock Purchase Plan" (in
three cases). CNC 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 CFC, and engaged in
corporate waste by causing CNC to guarantee loans that certain officers,
directors and key employees of CNC 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). CNC believes that these lawsuits are without merit and intends
to defend them vigorously. The cases filed in Hamilton County have been stayed
pending resolution of the derivative suits filed in the United States District
Court. CNC asserts that these lawsuits are assets of the estate pursuant to
section 541(a) of the Bankruptcy Code and does not currently intend to pursue
them postpetition because they are meritless. The ultimate outcome of these
lawsuits cannot be predicted with certainty.
Other Litigation
In October 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSave Plan filed an
action in the United States District Court for the Southern District of Indiana
against CNC, Conseco Services, LLC and certain current and former officers of
CNC (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 CNC 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 CNC's common stock
without full disclosure of the Company's true financial condition. CNC believes
the lawsuit is without merit and intends to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty. CNC has filed an
adversary proceeding to extend the automatic stay provided for by the Bankruptcy
Code to this litigation as it pertains to current and former officers and
directors of CNC.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against CNC, 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 CNC 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. CNC believes the heirs' claims are without merit and will defend the
action vigorously. The maximum exposure to the Company for this lawsuit is
estimated to be $33 million. The heirs did not file a proof of claim in the
Bankruptcy Court. Subject to dispositive motions which are yet to be filed, the
matter will continue to trial against Conseco Services, LLC and the other
co-defendants on September 13, 2004. The ultimate outcome cannot be predicted
with certainty.
On June 27, 2001, two suits against the Company's subsidiary, Philadelphia
Life Insurance Company, both purported nationwide class actions seeking
unspecified damages, were consolidated in the U.S. District Court, Middle
District of Florida (In Re PLI Sales Litigation, Cause No. 01-MDL-1404),
alleging among other things, fraudulent sales and a "vanishing premium" scheme.
Philadelphia Life filed a motion for summary judgment against both named
plaintiffs, which motion was granted in June 2002. Plaintiffs appealed to the
11th Circuit. The 11th Circuit, in July 2003, affirmed in part and reversed in
part, allowing two fraud counts with respect to one plaintiff to survive. The
plaintiffs have asked for a rehearing with respect to this decision.
Philadelphia Life believes this lawsuit is without merit and intends to defend
it vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
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On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New Mexico
(Robert Atencio and Theresa Atencio, for themselves and all other similarly
situated v. Manhattan National Life Insurance Company, an Ohio corporation,
Cause No. D-0101-CV-2000-2817), alleging among other things fraud by
non-disclosure of additional charges for those policyholders wishing to pay
premium modes other than annual. This matter was stayed until recently while a
similar suit against another insurance carrier was allowed to pursue an appeal
in the New Mexico Appellate Court system. Manhattan National Life believes this
lawsuit is without merit and intends to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
On December 19, 2001, four of the Company's subsidiaries were named in a
purported nationwide class action seeking unspecified damages in the District
Court of Adams County, Colorado (Jose Medina and others similarly situated v.
Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers
National Life Insurance Company and Bankers Life and Casualty Company, Cause No.
01-CV-2465), alleging among other things breach of contract regarding alleged
non-disclosure of additional charges for those policy holders wishing to pay
premium modes other than annual. On July 14 and 15, 2003 the plaintiff's motion
for class certification was heard and the Court took the matter under
advisement. The defendants believe this lawsuit is without merit and intends to
defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted
with certainty.
On July 31, 2001, the Company's subsidiary, Conseco Senior Health Insurance
Company was named in an action filed by the State of Texas in the District Court
of Travis County, Texas (State of Texas v. Conseco Senior Health Insurance
Company, Cause No. GV102103), alleging among other things a violation of the
Deceptive Trade Practices Act related to allegations of failure to adequately
notify policyholders that premium rates could increase. Conseco Senior is
pursuing settlement discussions with the State of Texas, however in the event a
settlement is not reached, it intends to defend this matter vigorously as it
believes the lawsuit is without merit. The ultimate outcome of this 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. 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.
On June 13, 2003, the Company and an affiliate of Donald Trump reached an
agreement on a long-standing dispute over control and distribution of profits
related to investments in the General Motors Building (the "GM Building"). See
the note to the consolidated financial statements entitled "Investment in
General Motors Building" for additional information on this investment and the
Company's plans to sell it.
Other Proceedings
The Company has been notified that the staff of the SEC has obtained a
formal order of investigation in connection with an inquiry that relates to
events in and before the spring of 2000, including CFC's accounting for its
interest-only securities and servicing rights. These issues were among those
addressed in 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 fully 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 Commission's staff in this matter.
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 3. DEFAULTS UPON SENIOR SECURITIES
As described in the note to the consolidated financial statements of the
Company entitled "Changes in Direct Corporate Obligations", 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 $127
D&O loans...................................................... 481 45
Guaranteed senior notes (a).................................... 1,293 160
Senior notes (a)............................................... 1,258 146
Trust preferred securities (b)................................. 1,930 204
-------------------------
(a) Additional detail regarding the different maturities of guaranteed
senior debt and senior debt 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,
January 1, 2003, April 1, 2003 and July 1, 2003 under its terms. If declared,
these dividends would have been payable by the issuance of an additional 115,945
shares of Series F Preferred Stock to the existing holders thereof.
ITEM 5. OTHER INFORMATION
None.
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a) Exhibits.
12.1 Computation of Ratio of Earnings to Fixed Charges, Preferred
Dividends and Distributions on Company-obligated Mandatorily
Redeemable Preferred Securities of Subsidiary Trusts.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
b) Reports on Form 8-K.
A report on Form 8-K dated June 16, 2003, was filed with the
Commission to report under Item 5, the Company's filing with the
United States Bankruptcy Court of the Third Amended Joint Plan of
Reorganization of the Debtors.
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CONSECO, INC. AND SUBSIDIARIES
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: August 14, 2003
By: /s/ William J. Shea
-----------------------------
William J. Shea, President and
Chief Executive Officer
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