================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the period ended March 31, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
----- -----
Commission File Number 001-31792
Conseco, Inc.
Delaware 75-3108137
- ---------------------- -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
- -------------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act): Yes [X] No [ ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court: Yes [X] No [ ]
Shares of common stock outstanding as of May 4, 2004: 100,115,772
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
Successor
-----------------------------
March 31, December 31,
2004 2003
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
March 31, 2004 - $20,145.4; December 31, 2003 - $19,470.7)........................... $20,963.4 $19,840.1
Equity securities at fair value (cost: March 31, 2004 - $72.3;
December 31, 2003 - $71.8)........................................................... 77.2 74.5
Mortgage loans......................................................................... 1,116.0 1,139.5
Policy loans........................................................................... 492.9 503.4
Trading securities..................................................................... 935.4 915.1
Other invested assets ................................................................. 195.8 324.1
--------- ---------
Total investments.................................................................. 23,780.7 22,796.7
Cash and cash equivalents:
Unrestricted........................................................................... 999.0 1,228.7
Restricted............................................................................. 15.5 31.9
Accrued investment income................................................................. 309.0 315.5
Value of policies in force at the Effective Date.......................................... 2,807.2 2,949.5
Cost of policies produced................................................................. 181.4 101.8
Reinsurance receivables................................................................... 924.4 930.5
Income tax assets......................................................................... 9.8 24.6
Goodwill.................................................................................. 773.9 952.2
Other intangible assets................................................................... 153.3 155.2
Assets held in separate accounts.......................................................... 34.8 37.7
Other assets.............................................................................. 475.3 395.8
--------- ---------
Total assets....................................................................... $30,464.3 $29,920.1
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
2
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
Successor
----------------------------
March 31, December 31,
2004 2003
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products............................................................ $12,443.7 $12,480.4
Traditional products................................................................... 11,435.7 11,431.8
Claims payable and other policyholder funds............................................ 903.4 892.3
Liabilities related to separate accounts............................................... 34.8 37.7
Other liabilities........................................................................ 742.1 573.0
Investment borrowings.................................................................... 461.2 387.3
Notes payable - direct corporate obligations............................................. 1,296.5 1,300.0
--------- ---------
Total liabilities.................................................................. 27,317.4 27,102.5
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Preferred stock.......................................................................... 910.4 887.5
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: March 31, 2004 - 100,115,772; December 31, 2003 - 100,115,772)........ 1.0 1.0
Additional paid-in-capital............................................................... 1,646.4 1,641.9
Accumulated other comprehensive income................................................... 470.7 218.7
Retained earnings........................................................................ 118.4 68.5
--------- ---------
Total shareholders' equity......................................................... 3,146.9 2,817.6
--------- ---------
Total liabilities and shareholders' equity......................................... $30,464.3 $29,920.1
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Revenues:
Insurance policy income............................................................. $ 748.4 $ 873.6
Net investment income:
General account assets............................................................ 312.0 347.3
Policyholder and reinsurer accounts............................................... 15.7 (23.1)
Venture capital income related to investment in
AT&T Wireless Services, Inc..................................................... - 2.5
Net realized investment gains..................................................... 27.1 23.3
Fee revenue and other income........................................................ 7.4 13.6
------- -------
Total revenues.................................................................. 1,110.6 1,237.2
------- -------
Benefits and expenses:
Insurance policy benefits........................................................... 719.7 858.7
Provision for losses................................................................ - 15.3
Interest expense (contractual interest of $97.6 for the three months
ended March 31, 2003)............................................................. 29.1 73.6
Amortization........................................................................ 98.2 158.0
Other operating costs and expenses.................................................. 151.2 161.0
Reorganization items................................................................ - 18.1
------- -------
Total benefits and expenses..................................................... 998.2 1,284.7
------- -------
Income (loss) before income taxes and discontinued operations................... 112.4 (47.5)
Income tax expense (benefit) on period income (losses)................................. 39.6 (14.6)
------- -------
Income (loss) before discontinued operations.................................... 72.8 (32.9)
Discontinued operations, net of income taxes........................................... - 13.9
------- -------
Net income (loss)............................................................... 72.8 (19.0)
Preferred stock dividends.............................................................. 22.9 -
------- -------
Net income (loss) applicable to common stock.................................... $ 49.9 $ (19.0)
======= =======
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor
------------
Three months
ended
March 31,
2004
----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 100,116,000
===========
Net income................................................. $.50
====
Diluted:
Weighted average shares outstanding........................ 100,588,000
===========
Net income................................................. $.50
====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital income (deficit)
----- ----- --------------- ---------- -------
Successor balance, January 1, 2004................... $ 2,817.6 $887.5 $1,642.9 $218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 72.8 - - - 72.8
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $140.5)............................ 252.0 - - 252.0 -
---------
Total comprehensive income.................. 324.8
Issuance of shares for stock options and
for employee benefit plans.................... 4.5 - 4.5 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 22.9 22.9 - -
Dividends on preferred stock.................... (22.9) - - - (22.9)
--------- ------ -------- ------ ---------
Successor balance, March 31, 2004.................... $ 3,146.9 $910.4 $1,647.4 $470.7 $ 118.4
========= ====== ======== ====== =========
Predecessor balance, January 1, 2003................. $(2,050.4) $501.7 $3,497.0 $580.6 $(6,629.7)
Comprehensive income, net of tax:
Net loss........................................ (19.0) - - - (19.0)
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $14.1)............................. 69.9 - - 69.9 -
---------
Total comprehensive income.................. 50.9
Change in shares for stock options and for
employee benefit plans.......................... .3 - .3 - -
---------- ------ -------- ------ ---------
Predecessor balance, March 31, 2003.................. $(1,999.2) $501.7 $3,497.3 $650.5 $(6,648.7)
========= ====== ======== ====== =========
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 649.6 $ 739.5
Net investment income................................................................. 336.2 343.6
Fee revenue and other income.......................................................... 7.4 13.7
Insurance policy benefits............................................................. (519.5) (616.9)
Interest expense...................................................................... (25.5) -
Policy acquisition costs.............................................................. (89.8) (117.6)
Reorganization items.................................................................. - (2.8)
Other operating costs................................................................. (159.1) (134.0)
Taxes................................................................................. 12.9 33.4
--------- --------
Net cash provided by operating activities........................................... 212.2 258.9
--------- --------
Cash flows from investing activities:
Sales of investments.................................................................. 2,563.1 2,380.2
Maturities and redemptions of investments............................................. 634.3 494.5
Purchases of investments.............................................................. (3,636.2) (2,571.0)
Change in restricted cash............................................................. 16.4 (11.0)
Other................................................................................. 4.3 .4
--------- ---------
Net cash provided (used) by investing activities ................................... (418.1) 293.1
--------- ---------
Cash flows from financing activities:
Amounts received for deposit products................................................. 359.6 496.6
Withdrawals from deposit products..................................................... (453.7) (849.0)
Investment borrowings................................................................. 73.9 84.5
Other................................................................................. (3.6) -
--------- ---------
Net cash used by financing activities............................................. (23.8) (267.9)
--------- ---------
Net increase (decrease) in cash and cash equivalents.............................. (229.7) 284.1
Cash and cash equivalents, beginning of period........................................... 1,228.7 1,217.6
--------- ---------
Cash and cash equivalents, end of period................................................. $ 999.0 $ 1,501.7
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2003 Form 10-K of Conseco,
Inc.
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco"), in connection with our
bankruptcy reorganization. The terms "Conseco", the "Company", "we", "us", and
"our" as used in this report refer to CNO and its subsidiaries and, unless the
context requires otherwise, Old Conseco and its subsidiaries. We focus on
serving the senior and middle-income markets, which we believe are attractive,
high growth markets. We sell our products through three distribution channels:
career agents, professional independent producers (some of whom sell one or more
of our product lines exclusively) and direct marketing.
OUR RECENT EMERGENCE FROM BANKRUPTCY
We emerged from bankruptcy protection under the Sixth Amended Joint Plan of
Reorganization (the "Plan"), which was confirmed pursuant to an order of the
United States Bankruptcy Court for the Northern District of Illinois, Eastern
Division (the "Bankruptcy Court") on September 9, 2003 (the "Confirmation
Date"), and became effective on September 10, 2003 (the "Effective Date"). Upon
the confirmation of the Plan, we implemented fresh start accounting in
accordance with Statement of Position 90-7 "Financial Reporting by Entities in
Reorganization under the Bankruptcy Code" ("SOP 90-7"). References in these
consolidated financial statements to "Predecessor" refer to Old Conseco prior to
August 31, 2003. References to "Successor" refer to the Company on and after
August 31, 2003, after giving effect to the implementation of fresh start
reporting. Our accounting and actuarial systems and procedures are designed to
produce financial information as of the end of a month. Accordingly, for
accounting convenience purposes, we applied the effects of fresh start
accounting on August 31, 2003.
BASIS OF PRESENTATION
Upon our emergence from bankruptcy, we implemented fresh start reporting in
accordance with SOP 90-7. These rules required the Company to revalue its assets
and liabilities to current estimated fair value, re-establish shareholders'
equity at the reorganization value determined in connection with the Plan, and
record any portion of the reorganization value which cannot be attributed to
specific tangible or identified intangible assets as goodwill. As a result, the
Company's financial statements for periods following August 31, 2003, will not
be comparable with those of Old Conseco prepared before that date.
Pursuant to SOP 90-7, professional fees associated with the Chapter 11
cases are expensed as incurred and reported as reorganization items. Interest
expense is reported only to the extent that it was paid during the Chapter 11
cases. The Company recognized expenses associated with the Chapter 11 cases for
fees payable to professionals to assist with the Chapter 11 cases totaling $18.1
million in the three months ended March 31, 2003.
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly our financial position and
results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2004 presentation. These reclassifications
have no effect on net income or shareholders' equity. Results for interim
periods are not necessarily indicative of the results that may be expected for a
full year.
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, the value of policies in force at the Effective
Date, certain investments, assets and liabilities related to income taxes,
goodwill, liabilities for insurance and asset accumulation products, liabilities
related to litigation, guaranty fund assessment accruals and amounts recoverable
from loans to certain former directors and employees. If our future experience
differs from these estimates and assumptions, our financial statements would be
materially affected.
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
FRESH START REPORTING
Upon the confirmation of the Plan on September 9, 2003, we implemented
fresh start reporting in accordance with SOP 90-7. However, in light of the
proximity of this date to the August month end, for accounting convenience
purposes, we have reported the effects of fresh start accounting as if they
occurred on August 31, 2003. We engaged an independent financial advisor to
assist in the determination of our reorganization value as defined in SOP 90-7.
We determined a reorganization value, together with our financial advisor, using
various valuation methods, including: (i) selected comparable companies
analysis; and (ii) actuarial valuation analysis. These analyses are necessarily
based on a variety of estimates and assumptions which, though considered
reasonable by management, may not be realized, and are inherently subject to
significant business, economic and competitive uncertainties and contingencies,
many of which are beyond our control. Changes in these estimates and assumptions
may have had a significant effect on the determination of our reorganization
value. The estimated reorganization value of the Company was calculated to be
approximately $3.7 billion to $3.9 billion. We selected the midpoint of the
range, $3.8 billion, as the reorganization value. Such value was confirmed by
the Bankruptcy Court on the Confirmation Date.
Under fresh start reporting, a new reporting entity is considered to be
created and the Company was required to revalue its assets and liabilities to
current estimated fair value, re-establish shareholders' equity at the
reorganization value determined in connection with the Plan, and record any
portion of the reorganization value which could not be attributed to specific
tangible or identified intangible assets as goodwill. In addition, all
accounting standards that were required to be adopted in the financial
statements within twelve months following the adoption of fresh start accounting
were adopted as of August 31, 2003.
GOODWILL
Upon our emergence from bankruptcy, we revalued our assets and liabilities
to current estimated fair value and established our capital accounts at the
reorganization value determined in connection with the Plan. We recorded the
$1,141.6 million of the reorganization value which could not be attributed to
specific tangible or identified intangible assets as goodwill. Under current
accounting rules (which became effective January 1, 2002) goodwill is not
amortized but is subject to an annual impairment test (or more frequent under
certain circumstances). We obtained an independent appraisal of our business in
connection with the preparation of the Plan and our implementation of fresh
start accounting.
Although the goodwill balance will not be subject to amortization, it will
be reduced by future use of the Company's net deferred income tax assets
(including the tax operating loss carryforwards) existing at August 31, 2003
(such balance was reduced by $178.3 million and $189.4 million in the three
months ended March 31, 2004 and the four months ended December 31, 2003,
respectively). A valuation allowance has been provided for the remaining balance
of such net deferred income tax assets due to the uncertainties regarding their
realization. See the note entitled "Income Taxes" for further discussion.
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Changes in the carrying amount of goodwill are as follows (dollars in
millions):
Successor
------------
Three months
ended
March 31,
2004
----
Goodwill balance, beginning of period.................................. $ 952.2
Recognition of tax valuation reserve established at the
Effective Date.................................................... (178.3)
-------
Goodwill balance, end of period........................................ $ 773.9
=======
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); and (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
At August 31, 2003, we established trading security accounts which are
designed to act as a hedge for embedded derivatives related to: (i) our
equity-indexed annuity products; and (ii) certain modified coinsurance
agreements. See the note entitled "Accounting for Derivatives" for further
discussion regarding the embedded derivatives and the trading accounts. In
addition, the trading account includes the investments backing the market
strategies of our multibucket annuity products. The change in market value of
these securities is substantially offset by the change in insurance policy
benefits for these products. All of our trading securities totaled $935.4
million at March 31, 2004. The change in the market value of these securities is
recognized currently in investment income (classified as income from
policyholder and reinsurer accounts).
Accumulated other comprehensive income is primarily comprised of unrealized
gains on actively managed fixed maturity investments. These amounts, included in
shareholders' equity as of March 31, 2004, and December 31, 2003, were as
follows (dollars in millions):
March 31, December 31,
2004 2003
---- ----
Net unrealized gains on investments................................................... $ 823.9 $ 375.2
Adjustments to value of policies inforce at the Effective Date........................ (89.7) (33.5)
Deferred income tax liability......................................................... (263.5) (123.0)
------- -------
Accumulated other comprehensive income........................................... $ 470.7 $ 218.7
======= =======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
Prior to its sale in December 2003, our venture capital investment in AT&T
Wireless Services, Inc. ("AWE") was carried at fair value, with changes in such
value recognized as investment income (loss). In the first three months of 2003,
we recognized venture capital investment income of $2.5 million.
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
AMORTIZATION OF THE VALUE OF POLICIES INFORCE AT THE EFFECTIVE DATE
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of Old Conseco's cost of policies purchased
and cost of policies produced as of the Effective Date and replaced them with
the value of policies inforce as of the Effective Date.
The cost assigned to the right to receive future cash flows from contracts
existing at August 31, 2003 is referred to as the value of policies inforce as
of the Effective Date. We also defer renewal commissions paid in excess of
ultimate commission levels related to the existing policies in this account. We
amortize these costs (using the interest rate credited to the underlying policy
for universal life or investment-type products and the projected investment
earnings rate for other products): (i) in relation to the estimated gross
profits for universal life-type and investment-type products; or (ii) in
relation to future anticipated premium revenue for other products.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the value of
policies inforce at the Effective Date for the change in amortization that would
have been recorded if actively managed fixed maturity securities had been sold
at their stated aggregate fair value and the proceeds reinvested at current
yields. We include the impact of this adjustment in accumulated other
comprehensive income (loss) within shareholders' equity.
The Company expects to amortize approximately 10 percent of the December
31, 2003 balance of the value of policies inforce at the Effective Date in 2004,
10 percent in 2005, 9 percent in 2006, 8 percent in 2007 and 8 percent in 2008.
EARNINGS PER SHARE
A reconciliation of net income and shares used to calculate basic and
diluted earnings per share is as follows:
Three months
ended
March 31, 2004
--------------
(Dollars in millions and
shares in thousands)
Net income.................................................................... $ 72.8
Preferred stock dividends..................................................... (22.9)
------
Net income applicable to common stock
for basic and diluted earnings per share............................... $ 49.9
=======
Shares:
Weighted average shares outstanding
for basic earnings per share............................................. 100,116
Effect of dilutive securities on weighted average shares:
Stock options and employee benefit plans................................. 472
-------
Weighted average shares outstanding for diluted earnings per share......... 100,588
=======
For the three months ended March 31, 2004, equivalent common shares of 44.2
million related to the assumed conversion of convertible exchangeable preferred
stock were not included in the computation of diluted earnings per share because
doing so would have been antidilutive.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Basic earnings per common share is computed by dividing income applicable
to common stock by the weighted average number of common shares outstanding for
the period. Restricted shares are not included in basic earnings per share until
vested. Diluted earnings per share reflects the potential dilution that could
occur if outstanding stock options were exercised and restricted stock was
vested. The dilution from stock options and restricted shares are calculated
using the treasury stock method. Under this method we assume the proceeds from
the exercise of the options (or the unrecognized compensation expense with
respect to restricted stock) will be used to purchase shares of our common stock
at the average market price during the period, reducing the dilutive effect of
the exercise of the options (or the vesting of the restricted stock).
ACCOUNTING FOR STOCK OPTIONS
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure", an Amendment of FASB Statement No. 123 ("SFAS 148"), which provides
three alternative methods of transition to the fair value method of accounting
for stock options. SFAS 148 also amends the disclosure requirements of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123").
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" and related interpretations in accounting for our stock
option plans. Had compensation cost been determined based on the fair value at
the grant dates for awards granted after January 1, 1995, consistent with the
method of SFAS 123, the Company's pro forma net income (loss) and pro forma
earnings per share would have been as follows (dollars in millions, except per
share amounts):
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Net income (loss), as reported ......................................... $72.8 $(19.0)
Less stock-based employee compensation expense determined
under the fair value based method for all awards, net of
income taxes....................................................... .3 2.7
----- ------
Pro forma net income (loss)............................................. $72.5 $(21.7)
===== ======
Earnings per share:
Basic, as reported................................................. $.50
Basic, pro forma................................................... .50
Diluted, as reported............................................... $.50
Diluted, pro forma................................................. .49
BUSINESS SEGMENTS
After our emergence from bankruptcy, we began to manage our business
operations through two primary operating segments, based on method of product
distribution, and a third segment comprised of business in run-off. We refer to
these segments as: (i) Bankers Life; (ii) Conseco Insurance Group; and (iii)
Other Business in Run-Off. We also have a corporate segment, which consists of
holding company activities and certain noninsurance company businesses that are
not related to our other operating segments. Prior period segment data has been
reclassified to conform to the current period presentation.
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Operating information regarding our segments was as follows (dollars in
millions):
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.................................................................... $ 12.2 $ 11.8
Supplemental health.......................................................... 292.4 285.0
Life......................................................................... 37.7 31.9
Other........................................................................ 2.8 3.0
Net investment income (a)......................................................... 99.1 89.9
Fee revenue and other income (a).................................................. .3 .4
Net realized investment gains (a)................................................. 11.0 11.3
-------- --------
Total Bankers Life segment revenues...................................... 455.5 433.3
-------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities.................................................................... 5.4 26.9
Supplemental health.......................................................... 186.3 188.1
Life......................................................................... 103.8 121.8
Other........................................................................ 4.5 17.2
Net investment income (a)......................................................... 188.1 189.9
Fee revenue and other income (a).................................................. 1.8 6.4
Net realized investment gains (a)................................................. 16.2 7.8
-------- --------
Total Conseco Insurance Group
segment revenues..................................................... 506.1 558.1
-------- --------
Other Business in Run-Off:
Insurance policy income - supplemental health..................................... 103.3 187.9
Net investment income (a)......................................................... 40.3 37.5
Fee revenue and other income (a).................................................. .3 .2
Net realized investment gains (a)................................................. 2.7 4.2
-------- --------
Total Other Business in Run-Off
segment revenues..................................................... 146.6 229.8
-------- --------
Corporate:
Net investment income (a)......................................................... .2 6.9
Venture capital income related to investment in AWE............................... - 2.5
Fee and other income (a).......................................................... 5.0 6.6
Net realized investment losses (a)................................................ (2.8) -
-------- --------
Total corporate segment revenues......................................... 2.4 16.0
-------- --------
Total revenues........................................................... 1,110.6 1,237.2
-------- --------
(continued on next page)
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Expenses:
Bankers Life:
Insurance policy benefits........................................................ $ 306.5 $ 288.4
Amortization..................................................................... 45.7 43.6
Interest expense on investment borrowings........................................ .4 1.2
Other operating costs and expenses............................................... 35.5 33.9
-------- --------
Total Bankers Life segment expenses......................................... 388.1 367.1
-------- --------
Conseco Insurance Group:
Insurance policy benefits........................................................ 311.9 356.9
Amortization..................................................................... 47.7 97.2
Interest expense on investment borrowings........................................ .9 1.5
Other operating costs and expenses............................................... 76.3 78.1
-------- --------
Total Conseco Insurance Group segment expenses.............................. 436.8 533.7
-------- --------
Other Business in Run-Off:
Insurance policy benefits........................................................ 101.3 213.4
Amortization..................................................................... 4.8 17.2
Other operating costs and expenses............................................... 22.9 27.4
-------- --------
Total Other Business in Run-Off segment expenses............................ 129.0 258.0
-------- --------
Corporate:
Interest expense on corporate debt............................................... 27.8 70.9
Provision for losses and interest expense related to
stock purchase plan......................................................... - 15.3
Other operating costs and expenses............................................... 16.5 21.6
Reorganization items............................................................. - 18.1
-------- --------
Total corporate segment expenses............................................ 44.3 125.9
-------- --------
Total expenses.............................................................. 998.2 1,284.7
-------- --------
Income (loss) before income taxes and discontinued operations:
Bankers Life................................................................ 67.4 66.2
Conseco Insurance Group..................................................... 69.3 24.4
Other Business in Run-Off................................................... 17.6 (28.2)
Corporate operations........................................................ (41.9) (109.9)
-------- --------
Income (loss) before income taxes and discontinued operations........... $ 112.4 $ (47.5)
======== ========
- -------------------
(a) It is not practicable to provide additional components of revenue by product
or services.
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return linked to the performance of the Standard &
Poor's 500 Index ("S&P 500 Index") based on a percentage (the "participation
rate") over an annual period. At the beginning of each policy year, a new index
period begins. We are able to change the participation rate at the beginning of
each index period, subject to contractual minimums. We buy S&P 500 Call Options
in an effort to hedge potential increases to policyholder benefits resulting
from increases in the S&P 500 Index to which the product's return is linked. We
include the cost of the S&P 500 Call Options in the pricing of these products.
Policyholder account balances for these annuities fluctuate in relation to
changes in the values of these options. We reflect changes in the estimated
market value of these options in net investment income (classified as investment
income from policyholder accounts). Option costs that are attributable to
benefits provided were $17.1 million and $21.0 million in the three months ended
March 31, 2004 and 2003, 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 $22.6 million and $(2.1) million in the three months ended March 31, 2004
and 2003, respectively. These amounts were substantially offset by the
corresponding charge to insurance policy benefits. The estimated fair value of
the S&P 500 Call Options was $87.2 million and $97.2 million at March 31, 2004
and December 31, 2003, respectively. We classify these instruments as other
invested assets. The Company accounts for the options attributed to the
policyholder for the estimated life of the annuity contract as embedded
derivatives as defined by Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities", as amended by
Statement of Financial Accounting Standards No. 137, "Deferral of the Effective
Date of FASB Statement No. 133" and Statement of Financial Accounting Standards
No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities" (collectively referred to as "SFAS 138"). We record the changes in
the fair values of the embedded derivatives in current earnings as a component
of policyholder benefits. The fair value of these derivatives, which are
classified as "liabilities for interest-sensitive products", was $224.3 million
and $214.7 million at March 31, 2004 and December 31, 2003, respectively. We
have transferred a specified block of investments which are equal to the balance
of these liabilities to our trading securities account, which we carry at
estimated fair value with changes in such value recognized as investment income
(classified as investment income from policyholder accounts). The change in
value of these trading securities should largely offset the portion of the
change in the value of the embedded derivative which is caused by interest rate
fluctuations.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At March 31, 2004, all of the counterparties were rated "A" or
higher by Standard & Poor's Corporation ("S&P").
The FASB's Derivative Implementation Group issued SFAS No. 133
Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance
Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that
are Unrelated or Only Partially Related to the Creditworthiness of the Obligor
of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific
circumstances under which bifurcation of an instrument into a host contract and
an embedded derivative is required. DIG B36 requires the bifurcation of a
derivative from the receivable or payable related to a modified coinsurance
agreement, where the yield on the receivable and payable is based on a return of
a specified block of assets rather than the creditworthiness of the ceding
company. We implemented this guidance on August 31, 2003, in conjunction with
our adoption of fresh start accounting. We have determined that certain of our
reinsurance payable balances contain embedded derivatives. Such derivatives had
an estimated fair value of $35.8 million and $27.2 million at March 31, 2004 and
December 31, 2003, respectively. We record the change in the fair value of these
derivatives as a component of investment income (classified as investment income
from reinsurer accounts). We have transferred the specific block of investments
related to these agreements to our trading securities account, which we carry at
estimated fair value with changes in such value recognized as investment income
(also classified as investment income from reinsurer accounts). The change in
value of these trading securities should largely offset the change in value of
the embedded derivatives.
GUARANTEES
In conjunction with the Plan, $481.3 million principal amount of bank loans
made to certain former directors and employees to enable them to purchase common
stock of Old Conseco were transferred to the Company. These loans had been
guaranteed by Old Conseco. We received all rights to collect the balances due
pursuant to the original terms of these loans.
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
In addition, we hold loans to participants for interest on the bank loans which
total approximately $233 million. The former bank loans and the interest loans
are collectively referred to as the "D&O loans." We regularly evaluate the
collectibility of these loans in light of the collateral we hold and the credit
worthiness of the participants. At March 31, 2004, we have estimated that
approximately $51.0 million of the D&O balance (which is included in other
assets) is collectible (net of the cost of collection). An allowance has been
established to reduce the recorded balance of the D&O loans to this balance.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by Old Conseco's subsidiary trusts and eliminated in our reorganization)
who did not opt out of the bankruptcy settlement, will be entitled to receive 45
percent of any proceeds from the collection of certain D&O loans in an aggregate
amount not to exceed $30 million. We have established a liability of $23.1
million (which is included in other liabilities), representing our estimate of
the amount which will be paid to the former holders of TOPrS pursuant to the
settlement.
In accordance with the terms of the 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 March 31, 2004 and December 31, 2003 was $15.8 million and $15.6
million, respectively, and is included in the caption "Other liabilities" in the
liability section of the consolidated balance sheet.
REINSURANCE
The cost of reinsurance ceded totaled $64.7 million and $74.0 million in
the three months ended March 31, 2004 and 2003, 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
$82.9 million and $73.8 million in the three months ended March 31, 2004 and
2003, respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced. Reinsurance premiums
assumed totaled $18.2 million and $23.0 million in the three months ended March
31, 2004 and 2003, respectively.
See the note entitled "Accounting for Derivatives" for a discussion of the
derivative embedded in the payable related to certain modified coinsurance
agreements.
INCOME TAXES
The components of income tax expense (benefit) are as follows (dollars in
millions):
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Current tax provision (benefit).......................................................... $ 1.8 $(14.6)
Deferred tax provision................................................................... 37.8 -
----- ------
Income tax expense (benefit) on period income................................... $39.6 $(14.6)
===== ======
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
U.S. statutory corporate rate........................................................ 35.0% (35.0)%
Net deferred benefits not recognized in the current period........................... - 5.0
Other nondeductible expenses......................................................... .3 (.6)
State taxes.......................................................................... .4 (.1)
Provision for tax issues and other................................................... (.5) -
---- -----
Effective tax rate.......................................................... 35.2% (30.7)%
==== =====
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
Successor
------------------------------
March 31, December 31,
2004 2003
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to CFC worthless investment............................... $1,183.0 $1,183.0
Other.......................................................................... 67.9 84.2
Capital loss carryforwards........................................................ 418.6 411.2
Deductible temporary differences:
Insurance liabilities.......................................................... 1,705.6 1,688.0
Reserve for loss on loan guarantees............................................ 217.2 217.2
-------- --------
Gross deferred tax assets.................................................... 3,592.3 3,583.6
-------- --------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (91.2) (80.9)
Cost of policies purchased and cost of policies produced....................... (715.2) (716.3)
Unrealized appreciation........................................................ (263.5) (123.0)
Other.......................................................................... (338.8) (301.3)
-------- --------
Gross deferred tax liabilities............................................... (1,408.7) (1,221.5)
-------- --------
Valuation allowance............................................................ (2,183.6) (2,362.1)
-------- --------
Net deferred tax assets...................................................... - -
Current income taxes prepaid.......................................................... 9.8 24.6
-------- --------
Net income tax assets................................................................. $ 9.8 $ 24.6
======== ========
Conseco and its affiliates are currently under examination by the Internal
Revenue Service (the "IRS") for tax years ending December 31, 1999 through
December 31, 2001. The outcome of these examinations is not expected to result
in material adverse deficiencies, but may result in utilization or adjustment to
the income tax loss carryforwards reported below.
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss
carryforwards. The net
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
deferred tax assets totaled $2.2 billion at March 31, 2004. In assessing the
realization of deferred income tax assets, we consider whether it is more likely
than not that the deferred income tax assets will be realized. The ultimate
realization of our deferred income tax assets depends upon generating future
taxable income during the periods in which our temporary differences become
deductible and before our capital loss carryforwards and net operating loss
carryforwards expire. In addition, the use of the Company's net ordinary loss
carryforwards is dependent, in part, on whether the IRS ultimately agrees with
the tax position we plan to take in our current and future tax returns. We
evaluate the realizability of our deferred income tax assets by assessing the
need for a valuation allowance on a quarterly basis. Based upon information
existing at the time of our emergence from bankruptcy, we established a
valuation allowance against our entire balance of net deferred income tax assets
as we believed that the realization of such net deferred income tax assets in
future periods was uncertain. As of March 31, 2004, we continue to believe that
the realization of our net deferred income tax asset is uncertain and that a
valuation allowance is required for our entire balance of net deferred income
tax assets. We reached this conclusion after considering the losses realized by
the Company in recent years, the uncertainties related to the tax treatment for
the worthlessness of our investment in Conseco Finance Corp. ("CFC"), (which is
more fully discussed below), and the likelihood of future taxable income and
capital gains exclusive of reversing temporary differences and carryforwards.
The reduction of any portion of our deferred income tax valuation allowance
(including the capital loss carryforwards and net operating loss carryforwards)
existing as of August 31, 2003, will be accounted for as a reduction of goodwill
when utilized pursuant to SOP 90-7. If goodwill is eliminated, any additional
reduction of the valuation allowance existing at August 31, 2003 will be
accounted for as a reduction of other intangible assets until exhausted and
thereafter as an addition to paid-in-capital. During the three months ended
March 31, 2004, we reduced our tax valuation reserve (with corresponding
reductions to goodwill) by $37.8 million related to income taxes on current
period income and $140.5 million related to income taxes on unrealized gains.
Future decreases in the market value of our investment portfolio could result in
a reversal of all or a portion of the $140.5 million reduction in the valuation
reserve and goodwill described above.
As of March 31, 2004, we had $3.6 billion of net operating loss
carryforwards (after taking into account the reduction in tax attributes
described in the paragraph which follows and the loss resulting from the
worthlessness of CFC discussed below), which expire as follows: $9.6 million in
2004; $4.6 million in 2005; $.2 million in 2006; $5.8 million in 2007; $5.4
million in 2008; $10.1 million in 2009; $4.2 million in 2010; $2.5 million in
2011; $13.2 million in 2012; $8.7 million in 2013; $6.9 million in 2014; $60.5
million in 2016; $35.7 million in 2017; $3,399.5 million in 2018; $.7 million in
2019; $5.5 million in 2020; and $1.0 million in 2022. At March 31, 2004, Conseco
had $1.2 billion of capital loss carryforwards. These carryforwards will expire
as follows: $2.7 million in 2005; $5.5 million in 2006; $484.4 million in 2007;
$682.2 million in 2008; and $21.2 million in 2009. The timing and manner in
which we will utilize the net operating loss carryforwards and capital loss
carryforwards in any year or in total may be limited by various provisions of
the Internal Revenue Code (the "Code") (and interpretation thereof) and our
ability to generate sufficient future taxable income in the relevant
carryforward period.
The Code provides that any income realized as a result of the cancellation
of indebtedness (cancellation of debt income or "CODI") in bankruptcy, will
reduce certain tax attributes including net operating loss carryforwards. We
realized an estimated $2.5 billion of CODI when we emerged from bankruptcy.
Accordingly, our net operating loss carryforwards were reduced by $2.5 billion
as of December 31, 2003.
The following paragraphs summarize some of the limitations and
contingencies which exist with respect to the future utilization of the net
operating loss carryforwards.
The Company realized an estimated $5.4 billion tax loss in 2003 as a result
of the worthlessness of our investment in CFC. In consultation with our tax
advisors and based on relevant provisions of the Code, the Company intends to
treat this loss as an ordinary loss, thereby increasing the Company's net
operating loss carryforward. The Company has requested a pre-filing examination
by the IRS to confirm that this loss should be treated as an ordinary loss. If
the IRS were to disagree with our conclusion and such determination ultimately
prevailed, the loss would be treated as a capital loss, which would only be
available to reduce future capital gains for the next 5 years. The pre-filing
examination is currently in process, but is not expected to be completed before
August 2004.
The Code limits the extent to which losses realized by a non-life entity
(or entities) may offset income from a life insurance company (or companies) to
the lesser of: (i) 35 percent of the income of the life insurance company; or
(ii) 35 percent of the total loss. There is no limitation with respect to the
ability to utilize net operating losses generated by a life
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
insurance company. Subsequent to our emergence from bankruptcy, we reorganized
certain of our subsidiaries to improve their capital position. As a result of
the reorganization, the loss related to CFC was realized by a life insurance
company. Accordingly, we believe the loss should be treated as a life insurance
loss and would not be subject to the limitations described above. However, if
the IRS were to disagree with our conclusion and such determination ultimately
prevailed, the loss related to CFC would be subject to the limitation described
in the first sentence of this paragraph. The IRS has informed the Company that
it will not address this matter during the pre-filing examination.
The timing and manner in which the Company will be able to utilize some or
all of its net operating loss carryforward may be limited by Section 382 of the
Code. Section 382 imposes limitations on a corporation's ability to use its net
operating losses if the company undergoes an ownership change. Because the
Company underwent an ownership change pursuant to its reorganization, we have
determined that this limitation applies to the Company. In order to determine
the amount of this limitation we must determine how much of our net operating
loss carryforward relates to the period prior to our emergence from bankruptcy
(such amount will be subject to the 382 limitation) and how much relates to the
period after emergence (such amount will not be subject to the 382 limitation).
Pursuant to the Code, we may: (i) allocate the current year tax loss on a pro
rata basis to determine earnings (loss) post- and pre-emergence; or (ii)
specifically identify transactions in each period and record it in the period it
actually occurred. We intend to elect the latter, which we believe will result
in a substantial portion of the loss related to CFC being treated as post
emergence and therefore not subject to the Section 382 limitation. Any losses
that are subject to the Section 382 limitation will only be utilized by the
Company up to approximately $140 million per year with any unused amounts
carried forward to the following year.
CHANGES IN DIRECT CORPORATE OBLIGATIONS
Notes payable representing direct corporate obligations of the Company at
March 31, 2004 and December 31, 2003, were as follows (dollars in millions):
March 31, December 31,
2004 2003
---- ----
$1.3 billion credit agreement ("Senior Credit Facility")................................ $1,300.0 $1,300.0
Unamortized amendment fees.............................................................. (3.5) -
-------- --------
Direct corporate obligations....................................................... $1,296.5 $1,300.0
======== ========
In January 2004, our Senior Credit Facility was amended to remove
requirements that our insurance subsidiaries maintain minimum A.M. Best Company
("A.M. Best") financial strength ratings. In March 2004, the Senior Credit
Facility was further amended to change the definition of a financial ratio we
are required to maintain. The change was made to clarify how the ratio is
calculated. The definition in the amended facility is consistent with
calculations used to determine the original covenant levels. The fees incurred
to obtain these amendments totaled $3.6 million which are being amortized as
interest expense over the remaining term of the Senior Credit Facility.
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The Senior Credit Facility consists of two tranches: Tranche A - $1.0
billion; and Tranche B - $.3 billion. Principal repayments are due as follows
(dollars in millions):
Tranche A Tranche B
--------- ---------
June 30, 2004......................................................... $ 50.0 $ 3.0
June 30, 2005......................................................... 50.0 3.0
June 30, 2006......................................................... 50.0 1.5
December 31, 2006..................................................... 50.0 1.5
June 30, 2007......................................................... 75.0 1.5
December 31, 2007..................................................... 75.0 1.5
June 30, 2008......................................................... 75.0 1.5
December 31, 2008..................................................... 75.0 1.5
June 30, 2009......................................................... - 1.5
September 10, 2009.................................................... 500.0 -
December 31, 2009..................................................... - 1.5
September 10, 2010.................................................... - 282.0
-------- ------
$1,000.0 $300.0
======== ======
On March 31, 2004, the interest rates on our Tranche A and Tranche B
borrowings were 7.25 percent and 9.50 percent, respectively.
Pursuant to the Senior Credit Facility, the Company is required to make
mandatory prepayments with all or a portion of the proceeds from the following
transactions or events including: (i) the issuance of certain indebtedness; (ii)
equity issuances; (iii) certain asset sales or casualty events; (iv) a certain
percentage of amounts received or recovered with respect to the D&O loans; and
(v) excess cash flow as defined in the Senior Credit Facility. Proceeds not used
to prepay indebtedness must generally be: (i) used to redeem our Preferred
Stock; or (ii) contributed to the capital of our insurance subsidiaries.
The Senior Credit Facility requires the Company to maintain various
financial ratios and balances, as defined in the agreement including: (i) a
debt-to-total capitalization ratio of .351:1.0 or less at March 31, 2004,
..339:1.0 or less at June 30, 2004 and decreasing over time to .200:1.0 at June
30, 2008 (such ratio was .328:1.0 at March 31, 2004); (ii) an interest coverage
ratio greater than or equal to 1.00:1.0 for the two quarters ending March 31,
2004, 1.05:1.0 for the year ending December 31, 2004, and increasing over time
to 4.50:1.0 for the year ending December 31, 2009 (such ratio was greater than
1.25:1.0 for the quarter ending March 31, 2004); (iii) EBITDA, as defined in the
Senior Credit Facility, greater than or equal to $490.0 million for the two
quarters ended March 31, 2004, $767.0 million for the three quarters ended June
30, 2004, and increasing over time to $1,296.0 million for the four quarters
ending March 31, 2010 (such amount was greater than $590.0 million at March 31,
2004); (iv) an aggregate risk-based capital ratio, as defined in the Senior
Credit Facility, greater than or equal to 167 percent at March 31, 2004, 176
percent at June 30, 2004, and increasing over time to 225 percent at March 31,
2006 (such ratio was 297 percent at March 31, 2004); (v) minimum individual
risk-based capital ratios for certain insurance companies as of the end of each
fiscal year (such minimum ratios were exceeded at December 31, 2003); (vi)
minimum levels of statutory capital and surplus, as defined in the Senior Credit
Facility (statutory capital and surplus at March 31, 2004 exceeded such
requirements); and (vii) minimum investment portfolio requirements (such minimum
investment portfolio requirements were met at March 31, 2004).
The Senior Credit Facility prohibits or restricts, among other things: (i)
the payment of cash dividends on the Company's common or preferred stock; (ii)
the repurchase of our common stock; (iii) the issuance of additional debt or
capital stock; (iv) liens; (v) asset dispositions; (vi) affiliate transactions;
(vii) certain investment activities; (viii) change in business; and (ix)
prepayment of indebtedness (other than the Senior Credit Facility). The
obligations under our Senior Credit Facility are guaranteed by Conseco's current
and future domestic subsidiaries, other than: (i) its insurance companies; (ii)
subsidiaries of the insurance companies; or (iii) certain immaterial
subsidiaries as defined in the Senior Credit Facility. This guarantee was
secured by granting liens on substantially all the assets of the guarantors
including the capital stock of our top tier insurance company, Conseco Life
Insurance Company of Texas.
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Pursuant to the Senior Credit Facility, the Company is required to pay a
fee of $6.5 million on June 30, 2004, unless all borrowings under the Senior
Credit Facility have been repaid.
RECENTLY ISSUED ACCOUNTING STANDARDS
Pursuant to SOP 90-7, we have implemented the provisions of accounting
principles required to be adopted within twelve months of the adoption of fresh
start accounting. The following summarizes the new accounting pronouncements we
have recently adopted:
The FASB's Derivative Implementation Group issued DIG B36 in April 2003.
DIG B36 addresses specific circumstances under which bifurcation of an
instrument into a host contract and an embedded derivative is required. DIG B36
requires the bifurcation of a derivative from the receivable or payable related
to a modified coinsurance agreement, where the yield on the receivable and
payable is based on a return of a specified block of assets rather than the
creditworthiness of the ceding company. We implemented this guidance on August
31, 2003, in conjunction with our adoption of fresh start accounting. See the
note entitled "Accounting for Derivatives" for a discussion of the impact of
implementing this guidance.
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 a
liability 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. Effective July
1, 2003, Old Conseco's Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts, or TOPrS, with an aggregate carrying value of
$1,921.5 million, were reclassified to liabilities pursuant to the provisions of
SFAS 150. The adoption of SFAS 150 does not impact the financial statements of
Conseco subsequent to the Effective Date since the Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts are no longer outstanding.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants issued Statement of Position 03-01 "Accounting and
Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration
Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01
provides guidance on several insurance company disclosure and accounting matters
including the appropriate accounting for: (i) separate accounts; (ii) additional
interest (for example, persistency bonus) accruing to the investment contract
holder; (iii) the liability for contracts where the amounts assessed against the
contract holder each period are assessed in a manner that is expected to result
in profits in earlier years and losses in subsequent years; (iv) potential
benefits to annuity holders in addition to their account balance; (v) sales
inducements to contract holders; and (vi) other provisions. The Company recently
sold most of its separate account business. Accordingly, the new guidance
related to separate accounts will have no impact on the Company's consolidated
financial position, results of operations or cash flows. As a result of our
adoption of fresh start accounting, we were required to revalue our insurance
product liabilities and record them at their estimated fair market value. In
calculating the value of the liabilities for insurance and asset accumulation
products, we followed the guidance of SOP 03-01. We have changed the way we
classify the costs related to sales inducements in accordance with the new
guidance. However, such change was not material. Our reserve for persistency
bonus benefits was $288.8 million at March 31, 2004 and $282.8 million at
December 31, 2003.
In January 2003, the FASB issued 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
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
The Company has investments in various types of VIEs, some of which require
additional disclosure under FIN 46, and several of which require consolidation
under FIN 46. As further discussed in the note to the consolidated financial
statements entitled "Investments in Variable Interest Entities", we have
consolidated all of our investments in VIEs. The adoption of the consolidation
requirements of FIN 46 did not 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 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 an
impact on the Company's 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.
DISCONTINUED OPERATIONS
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited this line of business.
Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, CFC. We accounted for our finance business as a
discontinued operation in 2002 once we formalized our plans to sell it. On April
1, 2003, CFC and 22 of its direct and indirect subsidiaries, which collectively
comprised substantially all of the finance business, filed liquidating plans of
reorganization with the Bankruptcy Court in order to facilitate the sale of this
business. The sale of the finance business was completed in the second quarter
of 2003. We did not receive any proceeds from this sale in respect of our
interest in CFC, nor did any creditors of our Predecessor. As of March 31, 2003,
we ceased to include the assets and liabilities of CFC on our Predecessor's
consolidated balance sheet.
During the third quarter of 2002, Old Conseco entered into an agreement to
sell Conseco Variable Insurance Company ("CVIC"), its wholly owned subsidiary
and the primary writer of its variable annuity products. The sale was completed
in October 2002 and was accounted for as a discontinued operation.
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 three months ended March 31, 2003, we reduced the accrual for such
estimated costs by $13.9 million (after income taxes of $2.8 million). We
recorded the reduction of such accrual as income from discontinued operations.
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
LITIGATION AND OTHER LEGAL PROCEEDINGS
We 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 former directors are defendants in
pending class action lawsuits asserting claims under the securities laws. The
ultimate outcome of these lawsuits cannot be predicted with certainty and we
have estimated the potential exposure for each of the matters and have recorded
a liability if a loss is deemed probable.
Securities Litigation
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 us as a defendant, along with certain of our
current and former officers. These lawsuits were filed on behalf of persons or
entities who purchased our Predecessor's common stock on various dates between
October 24, 2001 and August 9, 2002. In each case the plaintiffs allege claims
under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") and allege material omissions and dissemination of
materially misleading statements regarding, among other things, the liquidity of
Conseco and alleged problems in CFC's manufactured housing division, allegedly
resulting in the artificial inflation of our Predecessor's stock price. On March
13, 2003, all of these cases were consolidated into one case in the United
States District Court for the Southern District of Indiana, captioned Franz
Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel
and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The lawsuits were stayed
as to all defendants by order of the United States Bankruptcy Court for the
Northern District of Illinois. The stay was lifted on October 15, 2003. The
plaintiffs have filed a consolidated class action complaint with respect to the
individual defendants. Our liability with respect to these lawsuits was
discharged in the Plan and our obligation to indemnify individual defendants who
were not serving as one of our officers or directors on the Effective Date of
the Plan is limited to $3 million in the aggregate under the Plan. Our liability
to indemnify individual defendants who were serving as an officer or director on
the Effective Date, of which there is one such defendant, is not limited by the
Plan. A motion to dismiss was filed on behalf of defendants Shea, Wendt and
Chokel on March 30, 2004. We believe these lawsuits are without merit and intend
to defend them vigorously. The ultimate outcome of these lawsuits cannot be
predicted with certainty.
Other Litigation
Collection efforts by the Company and its wholly owned subsidiary, Conseco
Services, LLC, related to the 1996-1999 director and officer loan programs have
been commenced against various past board members and executives with
outstanding loan balances. In addition, certain former officers and directors
have sued the companies for declaratory relief concerning their liability for
the loans. Currently, we are involved in litigation with Stephen C. Hilbert,
James D. Massey, Dennis E. Murray, Sr., Rollin M. Dick, James S. Adams, Maxwell
E. Bublitz, Ngaire E. Cuneo, David R. Decatur, Donald F. Gongaware and Bruce A.
Crittenden. The specific lawsuits include: Hilbert v. Conseco, Case No. 03A
04283 (Bankr. Northern District, Illinois); Conseco Services v. Hilbert, Case
No. 29C01-0310 MF 1296 (Circuit Court, Hamilton County, Indiana); Murray and
Massey v. Conseco, Case No. 1:03-CV-1482 LJM-WTL (Southern District, Indiana);
Conseco Services v. Adams, et al, Case No. 29DO2- 0312-CC-1035(Circuit Court,
Hamilton County, Indiana); Conseco v. Adams, et al, Case No. 03A 04545, (Bankr.
Northern District, Illinois) Dick v. Conseco Services, Case No. 29
D01-0207-PL-549 (Superior Court, Hamilton County, Indiana); Conseco Services v.
Dick, et al., Case No. 06C01-0311-CC-356 (Circuit Court, Boone County, Indiana);
Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026
(Superior Court, Hamilton County, Indiana); Crittenden v. Conseco, Case No.
IP02-1823-C B/S (Southern District, Indiana); and Conseco v. Dick, Case No. 04L
002811 (Circuit Court, Cook County, Illinois). The Company and Conseco Services,
LLC believe that all amounts due under the director and officer loan programs,
including all applicable interest, are valid obligations owed to the companies.
As part of the Plan, we have agreed to pay 45 percent of any net proceeds
recovered in connection with these lawsuits, in an aggregate amount not to
exceed $30 million, to former holders of our Predecessor's trust preferred
securities that did not opt out of a settlement reached with the committee
representing holders of these securities. We are required to use the balance of
any net proceeds recovered in connection with these lawsuits to pay down our
Senior Credit Facility. Any remaining proceeds will be used to contribute
capital to our insurance subsidiaries. We intend to prosecute these claims to
obtain the maximum recovery possible. Further, with regard to the various claims
brought against the Company and Conseco Services, LLC by certain former
directors and officers, we believe that these claims are without merit and
intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be
predicted with certainty.
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 our Predecessor, Conseco Services, LLC and certain of our current and
former officers (Roderick Russell, et al. v. Conseco, Inc., et al., Case No.
1:02-CV-1639 LJM). The purported class action consists of all individuals whose
401(k) accounts held common stock of our Predecessor at any time since April 28,
1999. The complaint alleges, among other things, breaches of fiduciary duties
under ERISA by continuing to permit employees to invest in our Predecessor's
common stock without full disclosure of the Company's true financial condition.
We filed a motion to dismiss the complaint in December 2002. This lawsuit was
stayed as to all defendants by order of the Bankruptcy Court. The stay was
lifted on October 15, 2003. On March 22, 2004, plaintiffs filed an amended
complaint (which made our motion to dismiss moot) and added additional former
officers as named defendants and dismissed Conseco, Inc. as a party. On February
13, 2004, the Company's fiduciary insurance carrier, RLI Insurance Company,
filed a declaratory judgment action asking the court to find no liability under
its policy for the claims made in the Russell matter (RLI Insurance Company v.
Conseco, Inc., Stephen Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern
District, Indiana.)) On March 15, 2004, RLI filed an amended complaint adding
Conseco Services, LLC as an additional defendant. We believe the lawsuits are
without merit and intend to defend them vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against our Predecessor, Conseco Services, LLC and two former officers
in the Circuit Court of Boone County, Indiana (Inlow et al. v. Conseco, Inc., et
al., Cause No. 06C01-0206-CT-244). The heirs assert that unvested options to
purchase 756,248 shares of our Predecessor's common stock should have been
vested at Mr. Inlow's death. The heirs further claim that if such options had
been vested, they would have been exercised, and that the resulting shares of
common stock would have been sold for a gain of approximately $30 million based
upon a stock price of $58.125 per share, the highest stock price during the
alleged exercise period of the options. We believe the heirs' claims are without
merit and will defend the action vigorously. The maximum exposure to the Company
for this lawsuit is estimated to be $33 million. The heirs did not file a proof
of claim with 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 (now known as Conseco 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' request for a
rehearing with respect to this decision has been denied. Philadelphia Life has
filed a summary judgment motion with respect to the remaining claims. This
summary judgment was denied in February 2004. In March 2004, the remaining
plaintiff filed a motion to substitute plaintiff, to which Philadelphia Life has
objected. We expect the court to set a trial date during the June 2005 trial
term. 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 paying via premium
modes other than annual. We retained liability for this litigation in connection
with the sale of Manhattan National Life in June 2002. We believe this lawsuit
is without merit and intend to defend it vigorously. 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 paying via 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. On
November 10,
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
2003, the court denied the motion for class certification. On January 26, 2004,
the plaintiff appealed the trial court's ruling denying class certification. All
further proceedings have been stayed pending the outcome of the appeal. The
defendants believe this lawsuit is without merit and intend to defend it
vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
The Company's subsidiaries, Conseco Life Insurance Company and Bankers Life
and Casualty Company, have recently been named in multiple purported class
actions and individual lawsuits alleging, among other things, breach of contract
with regard to a change made in the way monthly deductions are calculated for
insurance coverage. This change was the adjustment of a non-guaranteed element,
which was not in the applicable policy form. The specific lawsuits include:
David Barton v. Conseco Life Insurance Company, Case No. 04-20048-CIV-MORENO
(Southern District, Florida); Stephen Hook, an individual, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Bankers
Life and Casualty Company and Does 1 through 10, Case No. CGC-04-428872
(Superior Court, San Francisco County, California); Donald King, as Trustee of
the Irrevocable Trust of Arnold L. King v. Conseco Life Insurance Company, Case
No. 1: 04CV0163 (Northern District, Ohio); Michael S. Kuhn, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Does 1
through 100, Case No. 03-416786 (Superior Court, San Francisco County,
California); Sidney H. Levine and Judith A. Levine v. Conseco Life Insurance
Company, Mark F. Peters Insurance Services, Inc. Hon. John Garamendi (in his
capacity as Insurance Commissioner for the State of California) and Does 1
through 10, Case No. 04 CV 125 LAB (BLM) (Southern District, California); Edwin
Jacob "Jake" Garn et al. v. Conseco Life Insurance Company, Case No.
29D02-0312-PL-1034 (Superior Court, Hamilton County, Indiana); Edward M.
Medvene, an Individual, and Sherwin Samuels and Miles Rubin, as Trustees of the
Edward Medvene 2984 Insurance Trust v. Conseco Life Insurance Company, Case No.
CV04-846-AHM (MCX) (Central District, California); Edwin Jacob "Jake" Garn, on
Behalf of Himself and All Others Similarly Situated v. Conseco Life Insurance
Company, Case No. 1:04-CV-0514SEB-VSS (Southern District, Indiana); Steven Rose,
on Behalf of Himself and All Others Similarly Situated, and on Behalf of the
General Public for the State of California vs. Conseco Life Insurance Company,
Case No. GIC 827178 (Superior Court, San Diego County, California); Murray
Gomer, Murray Gomer Irrevocable Trust, individually, and on behalf of the class
of all others similarly situated, and on behalf of the General Public v. Conseco
Life Insurance Company, successor to Philadelphia Life Insurance Company and
formerly known as Massachusetts General Life Insurance Company, Case No.
CV04-1409-SJO (RNDX) (Central District, California); James S. Farley and Judy B.
Farley, individually and on behalf of all others similarly situated, and on
behalf of the general public vs. Conseco Life Insurance Company, Case No.
C-041563 ED (Northern District, California); H. Lee Druckman, Druckman, Trust,
individually and on behalf of class of all others similarly situated, and on
behalf of general public v. Conseco Life Insurance Company, Case No.
CV04-3031-DT-VBKX (Central District of California); and Myron L. Glucksman and
Dr. Ronald Einhorn as trustee of the Jonathan Alexander Irrevocable Trust, on
behalf of themselves and all others similarly situated v. Conseco Life Insurance
Company, Case No. 04C-3039 (Northern District of Illinois). In those cases
pending in Federal court, motions to stay and to consolidate have been or will
be filed pursuant to Federal multidistrict litigation rules. We believe these
lawsuits are without merit and intend to defend them vigorously. The ultimate
outcome of the lawsuits cannot be predicted with certainty.
On February 7, 2003, the Company's subsidiary, Conseco Life Insurance
Company, was named in a purported Texas statewide class action seeking
unspecified damages in the County Court of Cameron County, Texas (Lawrence
Onderdonk and Yolanda Carrizales v. Conseco Life Insurance Company, and Pete
Ramirez, III Cause No. 2003-CCL-102-C). On February 12, 2004, the complaint was
amended to allege a purported nationwide class and to name Conseco Services, LLC
as an additional defendant. On March 5, 2004, the complaint was amended a second
time naming additional plaintiffs. The purported class consists of all former
Massachusetts General Flexible Premium Adjustable Life Insurance Policy
policyholders who were converted to Conseco Life Flexible Premium Adjustable
Life Insurance Policies and whose accumulated values in the Massachusetts
General policies were applied to first year premiums on the Conseco Life
policies. The complaint alleges, among other things, civil conspiracy to convert
the accumulated cash values of the plaintiffs and the class, and the violation
of insurance laws nationwide. We believe this lawsuit is without merit and
intend to defend it vigorously. The ultimate outcome of the lawsuit cannot be
predicted with certainty.
On December 30, 2002 and December 31, 2002, five suits were filed in
various Mississippi counties against Conseco Life Insurance Company (Kathie
Allen, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Jones
County, Mississippi, Cause No. 2002-448-CV12; Malcolm Bailey, et al. v. Conseco
Life Insurance Company, et al., Circuit Court of Claiborne County, Mississippi,
Cause No. CV-2002-371; Anthony Cascio, et al. v. Conseco Life Insurance Company,
et al, Circuit Court of LeFlore County, Mississippi, Cause No.
CV-2002-0242-CICI; William Garrard, et al. v. Conseco Life Insurance Company, et
al., Circuit Court of Sunflower County, Mississippi, Cause No. CV-2002-0753-CRL;
and William
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Weaver, et al. v. Conseco Life Insurance Company, et al., Circuit Court of
LeFlore County, Mississippi, Cause No. CV-2002-0238-CICI) alleging, among other
things, a "vanishing premium" scheme. Conseco Life removed all of the cases to
the U.S. District Courts in Mississippi. In September 2003, plaintiffs' motion
to remand was denied in the Garrard and Weaver matters, but granted in the
Cascio matter. In November 2003, Conseco Life filed motions for summary judgment
in the Garrard and Weaver matters. No ruling has been made on these motions. In
November 2003, Conseco Life again removed the Cascio matter to U.S. District
Court. In April 2004, the Cascio matter was remanded to state court. Conseco
Life awaits the court's ruling on plaintiff's motion to remand in the Allen
matter. In Bailey the parties have agreed to a settlement. Conseco Life believes
the lawsuits are without merit and intends to defend them vigorously. The
ultimate outcome of the lawsuits cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other arbitrations and lawsuits, including purported class actions,
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
Other Proceedings
On September 18, 2003, the Company received a grand jury subpoena from the
U.S. District Court for the Southern District of Indiana in connection with a
Department of Justice investigation requiring production of documents relating
to the valuation of interest-only securities held by CFC, our Predecessor's
former finance subsidiary, contemporaneous earnings estimates for the
Predecessor, certain personnel records and other accounting and financial
disclosure records for the period June 1, 1998 to June 30, 2000. The Company has
subsequently received follow-up grand jury document subpoenas concerning other
matters. All of these follow-up requests have been limited to the time period
prior to the December 17, 2002 bankruptcy filing. The Company has been advised
by the Department of Justice that neither it nor any of its current directors or
employees are subjects or targets of this investigation. The Company is
cooperating fully with the Department of Justice investigation.
On March 10, 2004, we entered into a settlement with the SEC in connection
with the SEC's investigation of 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 our Predecessor's writedown
and restatement in the spring of 2000, and were the subject of shareholder class
action litigation, which we settled in the second quarter of 2003. Without
admitting or denying the SEC's findings, we consented to the entry of a
cease-and-desist order requiring future compliance with periodic reporting,
record keeping, internal control and other provisions of the securities laws.
The settlement did not impose any fine or monetary penalty, or require us to
restate any of our historical financial statements.
On October 29, 2003, the New York Attorney General served Conseco Life
Insurance Company of Texas ("Conseco Life") with a document subpoena concerning
customer transfers between mutual fund subaccounts offered by CVIC, a former
wholly-owned subsidiary of Conseco Life, that occurred prior to the sale of CVIC
to an unrelated third party in October 2002. The SEC served the Company with a
similar subpoena shortly after we received the Attorney General's subpoena.
Certain of our employees have also received subpoenas regarding duties they
previously performed in respect of annuity sales by CVIC. The purchase agreement
pursuant to which CVIC was sold contains indemnification provisions with respect
to certain liabilities relating to Conseco Life's period of ownership, including
provisions concerning certain business activities, including marketing
activities, of CVIC. Conseco Life and the Company have cooperated with the
Attorney General and the SEC in producing documents responsive to their
subpoenas. In January 2004, the Company received telephonic notification of a
potential enforcement action by the Attorney General and a Wells notification
from the SEC regarding alleged market timing on the part of holders of variable
annuity policies issued by CVIC. The Company and its affiliates have not issued
any variable annuity policies since the sale of CVIC. The Company and Conseco
Life believe, based on the information obtained and supplied to the
investigators to date, that CVIC violated no federal or state law prior to the
October 2002 sale. The investigations are continuing and their outcome cannot be
predicted with certainty. In other cases involving the investigation of market
timing allegedly permitted by mutual fund managers, the SEC and state regulators
have sought to impose penalties far in excess of the alleged losses to the
investing public, and we cannot assure you that they would not seek to do so
with us. The Company and Conseco Life are cooperating fully with the Attorney
General and the SEC in these investigations.
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The deadline to file administrative claims in the bankruptcy proceeding was
October 9, 2003. The Plan provides that all such claims must be paid in full, in
cash. We are reviewing all timely filed administrative claims and may resolve
disputes regarding allowance of such claims in the Bankruptcy Court. The amount
of known disputed administrative claims as of April 27, 2004 was approximately
$.1 million.
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Cash flows from operating activities:
Net income (loss).................................................................... $ 72.8 $ (19.0)
Adjustments to reconcile net income (loss) to net cash provided
by operating activities:
Provision for losses............................................................. - 15.3
Amortization and depreciation.................................................... 106.9 167.7
Income taxes..................................................................... 52.5 21.6
Insurance liabilities............................................................ 78.8 109.8
Accrual and amortization of investment income.................................... 31.1 15.7
Deferral of policy acquisition costs............................................. (89.8) (117.6)
Special charges.................................................................. - 15.3
Net realized investment gains.................................................... (27.1) (23.3)
Discontinued operations.......................................................... - (16.7)
Other............................................................................ (13.0) 90.1
------ -------
Net cash provided by operating activities...................................... $212.2 $ 258.9
====== =======
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.................................................................... $ 4.5 $.3
Issuance of convertible preferred shares........................................... 22.9 -
At March 31, 2004, restricted cash consisted of $15.5 million held in trust
for the payment of bankruptcy-related professional fees.
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 as described in the note
entitled "Recently Issued Accounting Standards".
In December 1998, Old Conseco formed three investment trusts which invest
in various fixed maturity, limited partnership and other types of investments.
The initial capital structure of each of the trusts consisted of: (i)
principal-protected senior notes; (ii) subordinated junior notes; and (iii)
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 owned 100 percent of the senior principal-protected notes. Certain
of Conseco's non-life insurance subsidiaries owned all of the subordinated
junior notes, which had 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 was owned by unrelated third parties.
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 were consolidated in our financial statements at
December 31, 2003. The carrying value of the total invested assets in the three
trusts was approximately $228 million at December 31, 2003, which also
represented Conseco's maximum exposure to loss as a result of our ownership
interests in the trusts. The trusts had no obligations or debt to outside
parties. During the fourth quarter of 2003, the trusts began liquidating their
portfolios, a process that was completed in the first quarter of 2004. The
investments held by the trusts were reflected in our investments in the
consolidated balance sheet at December 31, 2003.
SUBSEQUENT EVENT
On May 6, 2004, we announced the pricing of the public offerings of 44.0
million shares of our common stock at an offering price of $18.25 per share and
24.0 million shares of our 5.5 percent Class B mandatorily convertible preferred
stock at an offering price of $25 per share. We have granted the underwriters an
option to purchase an additional 6.6 million shares of common stock and 3.6
million shares of Class B preferred stock to cover over-allotments, if any.
Proceeds from the offering are expected to be used: (i) to redeem all
outstanding shares of our Class A preferred stock; (ii) to repay approximately
$400 million of our Senior Credit Facility; (iii) to contribute capital to our
insurance subsidiaries; and (iv) for general corporate purposes. We also
announced that we expect to grant approximately three million stock options
under our long-term equity incentive plan to our officers at an exercise price
equal to the greater of: (i) the fair market value on the date of grant; or (ii)
$21.00 per share.
28
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 March 31, 2004, and the consolidated results of operations for the three
months ended March 31, 2004 and 2003, 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
Our 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 Conseco's
operations or financial results, as well as other statements, contain
forward-looking statements, within the meaning of the federal securities law and
the Private Securities Litigation Reform Act of 1995. Forward-looking statements
typically are identified by the use of terms such as "anticipate," "believe,"
"plan," "estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" section of this Item 2
provides examples of risks, uncertainties and events that could cause our actual
results to differ materially from the expectations expressed in our
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:
o the potential adverse impact of our Predecessor's Chapter 11 petition
on our business operations, and relationships with our customers,
employees, regulators, distributors and agents;
o our ability to operate our business under the restrictions imposed by
our senior bank credit facility or future credit facilities;
o our ability to improve the financial strength ratings of our insurance
company subsidiaries and the impact of rating downgrades on our
business;
o our ability to obtain adequate and timely rate increases on our
supplemental health products including our long-term care business;
o 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) our ability to
sell products and access capital on acceptable terms, the market value
of our investments, and the lapse rate and profitability of policies;
o our ability to achieve anticipated synergies and levels of operational
efficiencies;
o customer response to new products, distribution channels and marketing
initiatives;
o mortality, morbidity, usage of health care services, persistency and
other factors which may affect the profitability of our insurance
products;
o performance of our investments;
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products;
o increasing competition in the sale of insurance and annuities;
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CONSECO, INC. AND SUBSIDIARIES
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o regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, including the
payment of dividends to us, regulation of financial services affecting
(among other things) bank sales and underwriting of insurance
products, regulation of the sale, underwriting and pricing of
products, and health care regulation affecting health insurance
products;
o the ultimate outcome of lawsuits filed against us and other legal and
regulatory proceedings to which we are subject; and
o the risk factors or uncertainties listed from time to time in our
filings with the Securities and Exchange Commission.
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.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
We conduct our business operations through two primary operating segments,
based primarily on method of product distribution, and a third segment comprised
of businesses in run-off. Prior to September 30, 2003, we conducted our
insurance operations through one segment. In the fourth quarter of 2003, we
implemented changes contemplated in our restructuring plan to conduct our
business through the following segments:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty and Colonial Penn. Bankers Life and Casualty markets and
distributes Medicare supplement insurance, life insurance, long-term
care insurance and fixed annuities to the senior market through
exclusive career agents and sales managers. Colonial Penn markets
graded benefit and simplified issue life insurance directly to
consumers through television advertising, direct mail, the internet
and telemarketing. Both Bankers Life and Casualty and Colonial Penn
market their products under their own brand names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through
professional independent producers. This segment markets its products
under the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold through independent agents and major medical insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments.
We have restated all historical periods presented in "Management's
Discussion and Analysis of Financial Condition and Results of Operations" to
reflect our new segments.
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CONSECO, INC. AND SUBSIDIARIES
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CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2003 Annual Report on
Form 10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements.
Under fresh start reporting the Company was required to revalue its assets
and liabilities to current estimated fair value, re-establish shareholders'
equity at the reorganization value determined in connection with the Plan, and
record any portion of the reorganization value which can not be attributed to
specific tangible or identified intangible assets as goodwill. As a result, the
Company's financial statements for periods following August 31, 2003, will not
be comparable with those of Old Conseco prepared before that date. Consistent
with SOP 90-7 we implemented accounting standards that were required to be
adopted in our consolidated financial statements within twelve months of our
Effective Date.
RISK FACTORS
We are subject to a number of risks. These risks could have a material
adverse effect on our business, financial condition or results of operations.
Our recent bankruptcy may continue to disrupt our operations and hamper our
efforts to restore confidence in the "Conseco" brand, which may contribute
to lower sales, increased agent attrition and policyholder lapses and
redemptions.
The announcement of our intention to seek a restructuring of our capital in
August 2002 and our subsequent filing of bankruptcy petitions in December 2002
caused significant disruptions in our operations. We believe that adverse
publicity in national and local media concerning our distressed financial
condition and disputes with former members of our management caused sales of our
insurance products to decline and policyholder lapses and redemptions to
increase. For example, our total premium collections decreased by 8.4 percent to
$4,180.9 million for the year ended December 31, 2003, compared to 2002. In
addition, withdrawals from annuities and other investment-type products exceeded
deposits received by $615.4 million during the year ended December 31, 2003.
We also experienced increased agent attrition, which in some cases led us
to increase agents' commissions or sales incentives in order to retain agents.
For example, the number of producing agents selling products through the Conseco
Insurance Group segment decreased by approximately 45 percent to 9,100 at
December 31, 2003 compared to a year earlier. The number of career agents
selling products through the Bankers Life segment remained at approximately
4,000 throughout 2003. We implemented agent sales incentive programs to retain
the career agency force during periods of negative media coverage, decreased
ratings and increased competitive activity from agents selling competitors'
products. The total cost for the agent incentive programs during 2003 was $17
million.
While we cannot quantify with specificity the portion of these adverse
changes that were caused by our distressed financial condition and the
associated negative publicity, we believe that these events contributed
significantly to these trends. Although we believe that the successful
completion of the bankruptcy and our continuing restructuring efforts will
reverse these trends and will enable us to restore confidence in the "Conseco"
brand among customers, agents, regulators and our other constituencies, we only
recently emerged from bankruptcy and although the level of surrenders of our in
force insurance have decreased in recent periods, the level of our sales have
not improved. It may take several quarters of operating results following our
emergence to determine the extent of our operational and reputational recovery
from these events.
Legal proceedings that arose in the context of our bankruptcy and current
regulatory investigations may continue to disrupt our operations, subject
us to material liability and hamper our efforts to restore confidence in
the "Conseco" brand, which may negatively impact our financial results and
liquidity.
We continue to be involved in various legal proceedings that arose in the
context of our restructuring. For example, since our August 2002 announcement
that we would seek to restructure our capital, we and/or our Predecessor and
several of our former, and in some instances current, officers and directors
have been named as defendants in lawsuits, including class action lawsuits,
alleging, among other things, securities fraud and breaches of fiduciary duty
under ERISA. While we were discharged from pre-petition obligations of our
Predecessor in connection with the bankruptcy, we still owe indemnity
obligations to some of our current and former officers and directors for
expenses and losses they may incur in connection with
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CONSECO, INC. AND SUBSIDIARIES
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these lawsuits. Our ultimate financial exposure with respect to this indemnity
may be limited by the availability of insurance, but not all of the cases
relating to periods prior to our bankruptcy are so limited and we cannot predict
with certainty what our ultimate liability in these cases may be.
We are also involved in, and have been subject to subpoena with respect to,
federal investigations relating to the accounting for certain interest-only
securities by our Predecessor's finance subsidiary, which was sold in connection
with our reorganization. We have also commenced litigation against certain of
our former officers and directors in connection with our efforts to collect
amounts outstanding under our Predecessor's director and officer loan programs.
Finally, the New York Attorney General and the SEC are conducting
investigations concerning alleged market timing on the part of holders of
variable annuity policies issued by CVIC, a former wholly-owned subsidiary of
Conseco Life Insurance Company of Texas, that occurred prior to the sale of CVIC
to an unrelated third party in October 2002, and could make a claim against us
at any time. In addition, we may be subject to potential indemnity claims by the
buyer in respect of our prior ownership. Other investigations by the SEC and
state regulators concerning market timing allegedly permitted by mutual fund
managers have resulted in highly publicized settlements involving substantial
penalties. While we believe the facts in those other cases are distinguishable,
it is not possible to predict the ultimate resolution of these investigations at
this time.
We believe that adverse publicity in national and local media concerning
the above proceedings may hamper our efforts to restore confidence in the
"Conseco" brand, and impose impediments to our customers' willingness to
continue to buy our products and our ability to attract new customers.
Similarly, the adverse publicity concerning these proceedings may make it more
difficult for us to attract and retain agents and independent marketing
organizations to market our products. While we believe that these events have
affected, and may continue to affect, our customers' and agents' willingness to
do business with us, we cannot quantify the extent of these effects with
specificity.
A failure to improve and maintain the financial strength ratings of our
insurance subsidiaries could cause us to experience lower sales, increased
agent attrition and increased policyholder lapses and redemptions.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. Agents,
insurance brokers and marketing companies who market our products and
prospective purchasers of our products view ratings as an important factor in
determining which insurer's products to market or purchase. This is especially
true for annuity, interest-sensitive life insurance and long-term care products.
Our insurance companies' financial strength ratings were downgraded by all of
the major rating agencies beginning in July 2002 in connection with the
financial distress that ultimately led to our Predecessor's bankruptcy. The
current financial strength ratings of our insurance subsidiaries from A.M. Best,
S&P and Moody's Investors Services, Inc. ("Moody's") are "B (Fair)," "BB-" and
"Ba3," respectively, except that the current financial strength ratings of
Conseco Senior Health Insurance Company from A.M. Best, S&P and Moody's are "B
(Fair)," "CCC" and "Caa1," respectively. A "B" rating from A.M. Best is the
seventh highest of sixteen possible ratings. A "BB-" rating from S&P is the
thirteenth highest of twenty-one possible ratings, and a "CCC" rating from S&P
is the eighteenth highest of twenty-one possible ratings. A "Ba3" rating from
Moody's is the thirteenth highest of twenty-one possible ratings, and a "Caa1"
rating from Moody's is the seventeenth highest of twenty-one possible ratings.
Most of our competitors have higher financial strength ratings and we believe it
is critical for us to improve our ratings to be competitive. The lowered ratings
assigned to our insurance subsidiaries were one of the primary factors causing
sales of our insurance products to decline and policyholder redemptions and
lapses to increase during 2002 and 2003. We also experienced increased agent
attrition, which in some cases led us to increase commissions or sales
incentives in an effort to retain them. These events have had a negative effect
on our ability to market our products and attract and retain agents, which in
turn negatively affected our financial results.
Our Plan contemplated that our insurance subsidiaries would achieve an "A"
category rating from A.M. Best approximately by the end of 2004. In order to
achieve this rating, we believe that we will have to demonstrate to the rating
agencies a sustained improvement in our financial results, a lower debt to total
capital ratio, and improved risk-based capital ratios of our insurance
subsidiaries. While we believe that the improved capital position of our
insurance subsidiaries, the lower debt to capital ratio that we expect to have
upon completion of the offerings referred to in the notes to our consolidated
financial statements included in this Form 10-Q entitled "Subsequent Event" and
our plan for continued improvements in our financial results will warrant an
upgrade to an "A" category rating from A.M. Best, the decision to upgrade is a
subjective one that will be made if and when A.M. Best believes it is warranted.
If we fail to achieve and maintain an "A" category rating from A.M. Best, sales
of our insurance products could fall further, we may face further defections
among our
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CONSECO, INC. AND SUBSIDIARIES
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independent and career sales force, and existing policyholders may redeem or
allow their policies to lapse, adversely affecting our financial results, which
in turn could lead to further downgrades.
If our financial performance or business prospects deteriorate, and we
experience a downgrade in our current ratings, our product sales would likely
decline significantly, we would likely experience substantial defections among
our independent and career sales force, and our existing policyholders would
likely redeem or allow their policies to lapse at higher rates. In addition,
events that may cause the ratings agencies to downgrade our financial strength
ratings may also cause us to be in breach of covenants under our Senior Credit
Facility, which would entitle our lenders to accelerate these borrowings. We
presently do not have sufficient liquidity to repay these borrowings if they
were to be accelerated, and we may not have such liquidity in the future or we
may not be able to borrow money from other lenders to enable us to refinance
these loans. If we are unable to repay or refinance these loans, we may be
forced to seek bankruptcy protection again.
Our ability to meet our obligations may be constrained by our subsidiaries'
ability to distribute cash to us.
Conseco, Inc. and CDOC, Inc., our wholly owned subsidiary and a guarantor
under the Senior Credit Facility, are holding companies with no business
operations of their own. As a result, 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 they receive from
insurance subsidiaries consists of dividends and distributions, principal and
interest payments on surplus debentures, fees for services, tax-sharing
payments, and from our non-insurance subsidiaries, loans and advances. A
deterioration in the financial condition, earnings or cash flow of the
significant subsidiaries of Conseco or CDOC for any reason could limit their
ability to pay cash dividends or other disbursements to Conseco and CDOC, which,
in turn, would limit the ability of Conseco and CDOC 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 and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
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:
o statutory net gain from operations or statutory net income for the
prior year; or
o 10 percent of statutory 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. Prior to
their release on November 19, 2003, we were subject to consent orders with the
Commissioner of Insurance for the State of Texas that, among other things,
limited the ability of our insurance subsidiaries to pay dividends. The
following table sets forth the aggregate amount of dividends and other
distributions that our insurance subsidiaries would have been able to pay to us
in each of the last two fiscal years without obtaining specific approval from
state insurance regulators, assuming that the Texas consent order released in
November 2003 had not been in effect (dollars in millions):
2003 2002
---- ----
Dividends............................................................... $340.6 $230.8
Surplus debenture interest.............................................. 52.1 56.0
------ ------
Total that was available to be paid ................................ $392.7 $286.8
====== ======
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Our business may be adversely impacted as a result of our substantial
indebtedness, which requires the use of a substantial portion of our excess
cash flow and may limit our access to additional capital.
We continue to have significant indebtedness after our emergence from
bankruptcy. As of December 31, 2003, we had approximately $1.3 billion of
indebtedness under our Senior Credit Facility. The following table sets forth
the aggregate amount of our debt payment obligations, including estimated
interest, for each of the next five years (dollars in millions):
5 Year
2004 2005 2006 2007 2008 Total
---- ---- ---- ---- ---- -----
Scheduled principal payments...........................$ 53.0 $ 53.0 $103.0 $153.0 $153.0 $515.0
Projected interest payments ........................... 107.2 101.3 97.1 88.1 76.2 469.9
------ ----- ------ ------ ------ ------
Total debt service.................................$160.2 $154.3 $200.1 $241.1 $229.2 $984.9
====== ====== ====== ====== ====== ======
As of March 31, 2004, our debt to total capital ratio was 29 percent. This
ratio is higher than the ratio of most of our competitors. In order to raise our
financial strength ratings, we will need to improve this ratio by either
lowering our indebtedness or increasing our equity capital or through a
combination of both.
Consequences resulting from our substantial indebtedness could include:
o increasing our vulnerability to adverse economic and industry
conditions by limiting our flexibility in planning for and reacting to
changes in our business and industry;
o requiring us to dedicate a substantial portion of our cash flow from
operations to payments on our indebtedness, therefore diverting funds
from other beneficial uses;
o limiting our ability to make strategic acquisitions or take other
significant corporate actions;
o placing us at a competitive disadvantage compared to our competitors
that have proportionately less debt; and
o limiting our ability to borrow funds and increase the cost of funds
that we can borrow.
Moreover, if are unable to meet our repayment obligations, our lenders are
entitled to accelerate their loans, and we may be forced to seek bankruptcy
protection again.
S&P and Moody's have assigned ratings on our senior secured debt of "B-
(Weak)" and "Caa1 (Very Poor)", respectively. In S&P's view, an obligation rated
"B-" is vulnerable to nonpayment, but the obligor currently has the capacity to
meet its commitment on the obligation. S&P has a total of twenty-two separate
categories in which to rate senior debt, ranging from "AAA (Extremely Strong)"
to "D (Payment Default)". A "B-" rating is the seventeenth highest rating. In
Moody's view, an obligation rated "Caa" is of poor standing and may be in
default, or there may be present elements of danger with respect to the payment
of principal or interest. Moody's has a total of twenty-one separate categories
in which to rate senior debt, ranging from "Aaa (Exceptional)" to "C (Lowest
Rated)". A "Caa" rating is the seventeenth highest rating. Our current senior
debt ratings may restrict our access to capital, and therefore our ability to
refinance our Senior Credit Facility.
If we fail to meet or maintain various covenants and financial ratios under
our Senior Credit Facility, our lenders are entitled to accelerate the
repayment of these loans; if the loans are accelerated and we do not have
sufficient liquidity to repay them, we may be forced to seek bankruptcy
protection again.
Our Senior Credit Facility imposes a number of covenants and financial
ratios that we must meet or maintain. For example, we must:
o have earnings before interest, taxes, depreciation and amortization,
as defined in the Senior Credit Facility, of greater than or equal to
$490 million for the two quarters ended March 31, 2004, $767.0 million
for the three
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CONSECO, INC. AND SUBSIDIARIES
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quarters ended June 30, 2004, and increasing over time to $1,296.0
million for the four quarters ending March 31, 2010. This amount was
greater than $590.0 million for the two quarters ended March 31, 2004;
o have a debt to total capitalization (excluding unrealized gains
(losses)) ratio of .351 to 1.0 or less at March 31, 2004, .339:1.0 or
less at June 30, 2004, with such ratio decreasing over time to .20 to
1.0 at June 30, 2008 and remaining level thereafter. At March 31,
2004, our debt to total capitalization ratio was .328 to 1.0;
o have an interest coverage ratio of greater than or equal to 1.0 to 1.0
for the two quarters ending March 31, 2004, 1.05:1.0 for the year
ending December 31, 2004, and increasing over time to 4.50 to 1.0 for
the four quarters ending December 31, 2009 and remaining level
thereafter. Our interest coverage ratio was greater than 1.25 to 1.0
for the two quarters ending March 31, 2004.
Although we believe we are on track to meet and/or maintain these covenants
and financial ratios, our ability to do so may be affected by events outside of
our control. If we default under these requirements, the lenders could declare
all outstanding borrowings immediately due and payable, the aggregate amount of
which was approximately $1.3 billion as of March 31, 2004. We presently do not
have sufficient liquidity to repay these borrowings if they were to be
accelerated, and we may not have sufficient liquidity in the future and may not
be able to borrow money from other lenders to enable us to refinance these
loans. Accordingly, if we default under these requirements and the loans are
accelerated, we may be forced to seek bankruptcy protection again.
Our operating flexibility is limited in significant respects by the
restrictive covenants in our Senior Credit Facility.
Our Senior Credit Facility imposes restrictions on us that could increase
our vulnerability to adverse economic and industry conditions by limiting our
flexibility in planning for and reacting to changes in our business and
industry. Specifically, these restrictions limit our ability to:
o incur additional indebtedness;
o issue stock of subsidiaries;
o create liens;
o transfer or sell assets;
o enter into transactions with affiliates;
o fundamentally change the type of business in which we engage;
o enter into mergers or other types of business combination
transactions;
o pay cash dividends and make cash distributions on certain classes of
equity securities;
o repurchase stock;
o make investments; and
o make capital expenditures.
Our ability to engage in these types of transactions is generally limited
by the terms of our Senior Credit Facility, even if we believe that a specific
transaction would contribute to our future growth, operating results or
profitability. If we are able to enter into these types of transactions under
the terms of our Senior Credit Facility, or if we obtain a waiver from our
lenders with respect to any specific transaction, that transaction may cause our
indebtedness to increase, may not result in the benefits we anticipate or may
cause us to incur greater costs or suffer greater disruptions in our business
than we anticipate, and could therefore negatively impact our business and
operating results.
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The results of operations of our insurance business will decline if our
premium rates are not adequate or if we are unable to obtain regulatory
approval to increase rates.
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, maintenance costs to
administer the policies 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, but we
cannot predict with certainty what the actual claims on our products will be. 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.
Most of our supplemental health policies allow us to increase premium rates
when warranted by our actual claims experience. These rate increases must be
approved by the applicable state insurance departments, and we are required to
submit actuarial claims data to support the need for the rate increases. The
re-rate application and approval process on supplemental health products is a
normal recurring part of our business operations and reasonable rate increases
are typically approved by the state departments as long as they are supported by
actual claims experience and are not unusually large in either dollar amount or
percentage increase. For policy types on which rate increases are a normal
recurring event, our estimates of insurance liabilities assume we will be able
to raise rates if the blocks warrant such increases in the future.
The loss ratio for our long-term care products included in the other
business in run-off segment has increased in recent periods and was 110 percent
during the three months ended March 31, 2004. We will have to raise rates or
take other actions with respect to some of these policies or this business will
continue to be unprofitable and our financial results will be adversely
affected. During 2002 and 2003, we filed for and received approval on rate
increases totaling $44 million and $37 million, respectively, relating to this
long-term care business that had approximately $400 million of collected
premiums.
We review the adequacy of our premium rates regularly and file proposed
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. Moreover, in
some instances our ability to exit unprofitable lines of business is limited by
the guaranteed renewal feature of the policy. In that situation we cannot exit
the business without regulatory approval, which may require that we continue to
service products at a loss for an extended period of time. For example, most of
our long-term care business is guaranteed renewable, meaning we cannot terminate
these policies without regulatory approval. Therefore, without approval of
necessary rate increases, we may have no other option but to operate this
business at a loss for an extended period of time.
If we are successful in obtaining regulatory approval to raise premium
rates, 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 significantly higher claim costs as a percentage of premiums if healthier
policyholders who can get coverage elsewhere allow their policies to lapse,
while policies related to less healthy policyholders continue in force. This
would reduce our premium income and profitability in future periods.
On home health care policies issued in some areas of Florida and other
states, payments for the benefit of policyholders have exceeded the premiums we
receive by a significant amount. On April 20, 2004, the Florida Office of
Insurance Regulation issued an order to our subsidiary, Conseco Senior Health
Insurance Company, that affects approximately 18,000 home health care policies
issued in Florida by Conseco Senior Health and its predecessor companies. The
order provides for Conseco Senior Health to offer the following three
alternatives to holders of these policies:
o retention of their current policy with a maximum rate increase of 50
percent in the first year and actuarially justified increases in
subsequent years;
o receipt of a replacement policy with reduced benefits and a maximum
rate increase in the first year of 25 percent and no more than 15
percent in subsequent years;
o receipt of a paid up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy.
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CONSECO, INC. AND SUBSIDIARIES
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The order also requires Conseco Senior Health to pursue a similar course of
action with respect to approximately 21,000 home health care policies issued by
Conseco Senior Health and its predecessor companies in other states, subject to
consideration and approval by other state insurance departments. If we are
unsuccessful in obtaining rate increases or other forms of relief in other
states, or if the policy changes approved by the Florida Office of Insurance
Regulation prove inadequate, our future results of operations could be adversely
affected.
We are also aggressively seeking rate increase on other long-term care
policies in our other business in run-off segment.
The limited historical claims experience on our long-term care products
could negatively impact our operations if our estimates prove wrong and we
have not adequately set premium rates.
In setting premium rates, we consider historical claims information and
other factors, but we cannot predict with certainty what the actual claims on
our products will be. This is particularly true in the context of setting
premium rates on our long-term care insurance products, for which we have
relatively limited historical claims experience. Long-term care products tend to
have lower frequency of claims than other health products such as Medicare
supplement or specified disease, but when claims are incurred on long-term care
policies they tend to be much higher in dollar amount. Also, long-term care
products have a much longer tail, meaning that claims are incurred much later in
the life of the policy than other supplemental health products. As a result of
these product traits, longer historical experience is necessary in order to
price products appropriately.
Our Bankers Life segment has offered long-term care insurance since 1985.
Bankers Life's experience on its long-term care blocks has generally been within
its pricing expectations. Our acquired blocks of long-term care insurance
included in the other business in run-off segment were acquired through
acquisitions completed in 1996 and 1997. The majority of the business was
written between 1990 and 1997. The experience on these acquired blocks has
generally been worse than the acquired companies' original pricing expectations.
We have requested and received approval for numerous premium rate increases in
recent years on these blocks. Even with the various rate increases, these blocks
experienced loss ratios of 110 percent in the three months ended March 31, 2004,
103 percent in the four months ended December 31, 2003, 170 percent in the eight
months ended August 31, 2003, 139 percent in 2002 and 96 percent in 2001. If
future claims experience proves to be worse than anticipated as our long-term
care blocks continue to age, our financial results could be adversely affected.
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
life insurance business, our limit of risk retention for each policy is
generally $.8 million or less because amounts above $.8 million are ceded to
reinsurers. 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 on claims not yet due. For our long-term care insurance
business, we establish reserves based on the same assumptions and estimates of
factors that we consider when we set premium rates. Many factors can affect
these reserves and liabilities, such as economic and social conditions,
inflation, hospital and pharmaceutical costs, regulatory actions, changes in
doctrines of legal liability and extra-contractual damage awards. Therefore, the
reserves and liabilities we establish are necessarily based on 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. We have recently incurred significant losses which have
exceeded our expectations as a result of actual claim costs and persistency of
our long-term care business included in the other business in run-off segment.
For example, we increased claim reserves by $130 million during 2002 and $85
million during the eight months ended August 31, 2003 as a result of adverse
developments and changes in our estimates of ultimate claims for these products.
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. 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, and it could result in a default
under our Senior Credit Facility.
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CONSECO, INC. AND SUBSIDIARIES
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Our net income and revenues will suffer if policyholder surrender levels
differ significantly from our assumptions.
Surrenders of our annuities and life insurance products can result in
losses and decreased revenues if surrender levels differ significantly from
assumed levels. At December 31, 2003, approximately 18 percent of our total
insurance liabilities, or approximately $4.5 billion, could be surrendered by
the policyholder without penalty. The surrender charges that are imposed on our
fixed rate annuities typically decline during a penalty period which ranges from
five to twelve years after the date the policy is issued. Surrenders and
redemptions could require us to dispose of assets earlier than we had planned,
possibly at a loss. Moreover, surrenders and redemptions require faster
amortization of the acquisition costs or commissions associated with the
original sale of a product, thus reducing our net income. We believe
policyholders are generally more likely to surrender their policies if they
believe the issuer is having financial difficulties, or if they are able to
reinvest the policy's value at a higher rate of return in an alternative
insurance or investment product.
For example, policyholder redemptions of annuity and, to a lesser extent,
life products increased 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
insurance intangibles to write off the balance associated with the redeemed
policies. We recorded additional amortization related to higher redemptions and
changes to our lapse assumptions of $203.2 million in 2002. Such additional
amortization was not significant in 2003.
Recently enacted and pending or future legislation could adversely 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 could
affect our ability to price or sell our products or profitably maintain our
blocks in force. For example, recent reforms provide some additional incentives
under the Medical Advantage program for health plans to offer managed care plans
to seniors. Any resulting growth of managed care plans over time could decrease
sales of the traditional Medicare supplement products we sell.
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 proposal that
would limit the amount we can charge for our products, such as guaranteed
premium rates, or increase in benefits we must pay, such as limitations on
waiting periods, or otherwise increase the costs associated with our business,
could adversely affect our financial results.
Tax law changes could adversely affect our insurance product sales and
profitability.
We sell deferred annuities and some forms of life insurance products which
we believe 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 be made to individual
retirement accounts and 401(k) accounts. While these tax law changes will expire
at the beginning of 2011 absent future congressional action, they could in the
interim diminish the appeal of our annuity and life insurance products since the
benefit of tax deferral is not as great if tax rates are lower and because fewer
people may purchase these products if they are able to contribute more money to
individual retirement accounts and 401(k) accounts. 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, which would make these products
less attractive to prospective purchasers and therefore would be likely to
reduce our sales of these products.
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CONSECO, INC. AND SUBSIDIARIES
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Our results of operations may be negatively impacted if we are unable to
achieve the goals of the initiatives we have undertaken with respect to the
restructuring of our principal insurance businesses.
Our Conseco Insurance Group segment has experienced declining sales and
expense levels that exceed product pricing. We have adopted several initiatives
designed to improve these operations, including focusing sales efforts on higher
margin products, such as our specified disease products; reducing operating
expenses by eliminating or reducing the costs of marketing some of our products;
personnel reductions and streamlined administrative procedures; increasing
retention rates on our more profitable blocks of inforce business; stabilizing
the profitability of the long-term care block of business in run-off sold
through independent agents through premium rate increases, improved claim
adjudication procedures and other actions as necessary; and combining legal
insurance entities to improve the efficient use of capital and eliminate the
costs of separate financial reporting requirements. Conseco Insurance Group has
29 separate policy administration systems for its three main lines of business:
life, health and annuities. Many of our initiatives are intended to address
issues resulting from the substantial number of acquisitions undertaken by our
Predecessor. Between 1982 and 1997, our Predecessor completed 19 transactions
involving the acquisition of 44 separate insurance companies. Our future
performance depends, in part, on our ability to successfully integrate these
prior acquisitions. This process of integration may involve unforeseen expenses,
complications and delays, including, among other things, further difficulties in
integrating the systems and operations of the acquired companies, and our
current initiatives may be inadequate to address such issues. In addition, some
of our initiatives have only recently been adopted, and may not be successfully
implemented. Our initiatives include the elimination of duplicate processing
systems by converting all similar business currently accounted for on multiple
systems to a single system. We expect to spend over $35 million on capital
expenditures in 2004 (including amounts related to these initiatives). Even if
we are able to successfully implement these measures, these measures alone may
not be sufficient to improve our results of operations.
Our investment portfolio is subject to several risks which may diminish the
value of our invested assets and negatively impact our profitability.
The values of the assets in our investment portfolio are subject to
numerous factors, which are difficult to predict, and are in many instances
beyond our control. These factors include, but are not limited to, the
following:
o Changes in interest rates can reduce the value of our investments.
Actively managed fixed maturity investments comprised 87 percent of
our total investments as of December 31, 2003. The value of these
investments can be affected by changing levels of market interest
rates. For example, an increase in interest rates of 10 percent could
reduce the value of our actively managed fixed maturity investments
and short-term investments, net of corresponding changes in the value
of insurance intangibles, by approximately $625 million, in the
absence of other factors.
o Our actively managed fixed maturity investments are subject to a
deterioration in the ability of the issuer to make timely repayment of
the securities. This risk is significantly greater with respect to
below-investment grade securities, which comprised 3.5 percent of our
actively managed fixed maturity investments as of March 31, 2004. We
have sustained substantial credit-related investment losses in recent
periods when a number of large, highly leveraged issuers experienced
significant financial difficulties resulting in our recognition of
other-than-temporary impairments. For example, we have recognized
other-than-temporary declines in value of several of our investments,
including K-Mart Corp., Amerco, Inc., Global Crossing, MCI
Communications, Mississippi Chemical, United Airlines and Worldcom,
Inc. We have recorded writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which
caused us to conclude a decline in the fair value of the investment
was other than temporary as follows: $11.9 million in the three months
ended March 31, 2004; $9.6 million in the four months ended December
31, 2003; $51.3 million in the eight months ended August 31, 2003;
$556.8 million in 2002; and $361.7 million in 2001.
In order to reduce our exposure to similar credit losses, we have taken a
number of specific steps, including:
o reducing the percentage of below-investment grade fixed maturity
investments from 5.9 percent at December 31, 2001 to 3.5 percent at
March 31, 2004;
o implementing conservative portfolio compliance guidelines which
generally limit our exposure to single issuer risks; and
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CONSECO, INC. AND SUBSIDIARIES
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o expanding our portfolio reporting procedures to proactively identify
changes in value related to credit risk in a more timely manner.
Our structured security investments, which comprised 29 percent of our
actively managed fixed maturity investments at March 31, 2004, are subject to
risks relating to variable prepayment and default on the assets underlying such
securities, such as mortgage loans. To the extent that structured security
investments prepay faster than the expected rate of repayment, refinancing or
default on the assets underlying the securities, such investments, which have a
cost basis in excess of par, may be redeemed at par, thus resulting in a loss.
Our need for liquidity to fund substantial product surrenders or policy
claims may require that we maintain highly liquid, and therefore lower-yielding,
assets, or that we sell assets at a loss, thereby further eroding the
performance of our portfolio.
We have sustained substantial investment losses in the past and may again
in the future. Because a substantial portion of our net income is derived from
returns on our investment portfolio, significant losses in the portfolio may
have a direct and materially adverse impact on our results of operations. In
addition, losses on our investment portfolio could reduce the investment returns
which we are able to credit to our customers on certain of our products, thereby
impacting our sales and further eroding our financial performance.
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. Our ability to adjust for such a compression is
limited by virtue of the guaranteed minimum rates that we must credit to
policyholders on certain of our products, as well as by the fact that we are
able to reduce the crediting rates on most of our products only at limited,
pre-established intervals. As of December 31, 2003, approximately 40 percent of
our insurance liabilities were subject to interest rates that may be reset
annually; 45 percent have a fixed explicit interest rate for the duration of the
contract; 10 percent have credited rates which approximate the income we earn;
and the remainder have no explicit interest rates. 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. The profits from many non-spread-based insurance products, such
as long-term care policies, are adversely affected when interest rates decline
because we may be unable to reinvest the cash flows generated from premiums
received and our investment portfolio at the interest rates anticipated when we
sold the policies. Finally, changes in interest rates can have significant
effects on the performance of our structured 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 but do not currently employ derivative instruments for this
purpose. We may not be successful in implementing these strategies and achieving
adequate investment spreads.
We use computer models to simulate the cash flows expected from our
existing insurance business under various interest rate scenarios. These
simulations help us measure the potential gain or loss in fair value of our
interest-sensitive financial instruments. With such estimates, we seek to manage
the relationship between the duration of our assets and the expected duration of
our liabilities. When the estimated durations of assets and liabilities are
similar, exposure to interest rate risk is minimized because a change in the
value of assets should be largely offset by a change in the value of
liabilities. At December 31, 2003, the duration of our fixed maturity securities
and short-term investments was approximately 6.7 years, and the duration of our
insurance liabilities was approximately 7.2 years. We estimate that our fixed
maturity securities and short-term investments, net of corresponding changes in
the value of insurance intangibles, would decline in fair value by approximately
$625 million if interest rates were to increase by 10 percent from their
December 31, 2003 levels. This compares to a decline in fair value of $595
million based on amounts and rates at December 31, 2002. The calculations
involved in our computer simulations incorporate numerous assumptions, require
significant estimates and assume an immediate change in interest rates without
any management of the investment portfolio in reaction to such change.
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Consequently, potential changes in value of our financial instruments indicated
by the simulations will likely be different from the actual changes experienced
under given interest rate scenarios, and the differences may be material.
Because we actively manage our investments and liabilities, our net exposure to
interest rates can vary over time.
A decline or increased volatility in the securities markets, and other
economic factors, may adversely affect our business, particularly our sales
of certain of our life insurance products and annuities.
Fluctuations in the securities markets and other economic factors may
adversely affect sales and/or policy surrenders of our annuities and life
insurance policies. For example, volatility in the equity markets may cause
potential new purchasers of equity-indexed annuities to refrain from purchasing
these products and may cause current policyholders to surrender their policies
for the cash value or reduce their investments. For example, our sales of these
products decreased significantly in 2001 and 2002 during periods of significant
declines in the equity markets. Sales of equity-indexed annuities totaled $220.1
million in 2002 and $380.9 million in 2001, as compared to $643.5 million in
2000. In addition, significant or unusual volatility in the general level of
interest rates could negatively impact sales and/or lapse rates on certain types
of insurance products.
We are subject to further risk of loss notwithstanding our reinsurance
agreements.
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. As
of December 31, 2003, our reinsurance receivables totaled $930.5 million. Our
ceded life insurance in force totaled $23.4 billion. Our seven largest
reinsurers accounted for 80 percent of our ceded life insurance in force. 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 may require us to increase liabilities, thereby reducing our net
income and shareholders' equity.
Our goodwill and other intangible assets are subject to impairment tests,
which may require us to reduce shareholders' equity.
Upon our emergence from bankruptcy, we revalued our assets and liabilities
to estimated fair value as of August 31, 2003 and established our capital
accounts at the reorganization value determined in conjunction with our
bankruptcy plan. We recorded the $1,141.6 million of reorganization value which
could not be attributed to specific tangible or identified intangible assets as
goodwill.
Under GAAP, we are required to evaluate our goodwill and other intangible
assets for impairment on an annual basis, or more frequently if there is an
indication that an impairment may exist. If certain criteria are met, we are
required to record an impairment charge. We obtained independent appraisals to
determine the value of the Company in conjunction with the preparation of our
bankruptcy plan which indicated no impairments of our goodwill or other
intangible assets existed. However, we cannot assure you that we will not have
to recognize an impairment charge in future periods.
The appraisals prepared to determine the value of our subsidiaries are
based on numerous estimates and assumptions which, though considered reasonable
by management, may not be realized, and are inherently subject to significant
business, economic and competitive uncertainties and contingencies, many of
which are beyond our control. These estimates and assumptions had a significant
effect on the determination of our reorganization value and the amount of
goodwill we recognized. Accordingly, if our actual experience differs from our
estimates and assumptions, it is possible we will have to recognize an
impairment charge in future periods.
Our business is subject to extensive regulation, which limits our operating
flexibility and could result in our insurance subsidiaries being placed
under regulatory control or otherwise negatively impact our financial
results.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate. 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, approving premium rate
increases, licensing agents, approving policy forms, setting reserve and
solvency requirements, determining the form and
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CONSECO, INC. AND SUBSIDIARIES
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content of required statutory financial statements, limiting dividends and
prescribing the type and amount of investments we can make.
We have been operating under heightened scrutiny from state insurance
regulators. For example, 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, which were
formally released on November 19, 2003. These consent orders applied to all of
our insurance subsidiaries and, among other things, restricted the ability of
our insurance subsidiaries to pay dividends and other amounts to the parent
company without regulatory consent. Notwithstanding the release of these consent
orders, we have agreed with the Texas Department of Insurance to provide prior
notice of certain transactions, including up to 30 days prior notice for the
payment of dividends by an insurance subsidiary to any non-insurance company
parent, and to provide information periodically concerning our financial
performance and condition. As noted above, state laws generally provide state
insurance regulatory agencies with broad authority to protect policyholders in
their jurisdictions. Accordingly, we cannot assure you that regulators will not
seek to assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs.
Our insurance subsidiaries are also 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 potentially weakly-capitalized companies for the
purpose of initiating regulatory action. Generally, if an insurer's risk-based
capital falls below specified levels, the insurer would be subject to different
degrees of regulatory action depending upon the magnitude of the deficiency. The
2003 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 subsidiaries to any regulatory action. However, as a
result of losses on the long-term care business within our other business in
run-off segment, the risk-based capital ratio of Conseco Senior Health Insurance
Company, which issued most of the long-term care business in our other business
in run-off segment, is near the level which would require it to submit a
comprehensive plan aimed at improving its capital position. Furthermore, we may
not be able to maintain the risk-based capital ratios of our subsidiaries above
levels that could give rise to regulatory action.
Our insurance subsidiaries may be required to pay assessments to fund
policyholder losses or liabilities and this may negatively impact our
financial results.
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 other 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. Although past assessments have not been material, if there were a
number of large insolvencies, future assessments could be material and could
have a material adverse effect on our financial results and financial position.
Litigation and regulatory investigations are inherent in our business and
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
typically face policyholder suits and class action suits. 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 focus 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. We are, in the ordinary course
of our business, a plaintiff or defendant in actions arising out of our
insurance business, including class actions and reinsurance disputes, and, from
time to time, are also involved in various governmental and administrative
proceedings and investigations. Our subsidiary, Philadelphia Life Insurance
Company, which is now known as Conseco Life Insurance Company, is a defendant in
two purported nationwide class action lawsuits alleging fraudulent sales
practices and seeking unspecified damages in Florida federal court. Four
lawsuits are pending in Mississippi against Conseco Life Insurance Company
alleging similar claims. Our former subsidiary, Manhattan National Life
Insurance Company, is a defendant in a purported nationwide class action lawsuit
alleging fraud by non-disclosure of additional charges
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CONSECO, INC. AND SUBSIDIARIES
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for policyholders wishing to pay premiums on other than an annual basis and
seeking unspecified damages in New Mexico state court. Four of our subsidiaries
have also been named in purported nationwide class action lawsuits seeking
unspecified damages in Colorado state court alleging claims similar to those
alleged in the New Mexico suit naming Manhattan National Life Insurance Company.
Conseco Life Insurance Company has been named as a defendant in thirteen
recently filed purported class actions and individual cases alleging, among
other things, breach of contract with regard to a change made in the way monthly
deductions are calculated for insurance coverage. The ultimate outcome of these
lawsuits, however, cannot be predicted with certainty, and although we do not
presently believe that any of these lawsuits, individually, are material, they
could, in the aggregate, have a material adverse effect on our financial
condition. Because our insurance subsidiaries were not part of our bankruptcy
proceedings, the bankruptcy proceedings did not result in the discharge of any
claims, including claims asserted in litigation, against our insurance
subsidiaries. The New York Attorney General and the SEC are also conducting
investigations concerning alleged market timing on the part of holders of
variable annuity policies issued by CVIC, a former wholly-owned subsidiary of
Conseco Life of Texas, that occurred prior to the sale of CVIC to an unrelated
third party in October 2002, and could make a claim against us at any time. In
addition, we may be subject to potential indemnity claims by the buyer in
respect of our prior ownership. In other cases involving the investigation of
market timing allegedly permitted by mutual fund managers, the SEC and state
regulators have sought to impose penalties far in excess of the alleged losses
to the investing public, and we cannot assure you that they would not seek to do
so with us. While we would vigorously defend against efforts to impose
substantial penalties against us, any such penalties, if imposed, could have a
material adverse effect on our financial condition.
Competition from companies that have greater market share, higher ratings
and greater financial resources may impair our ability to retain existing
customers and sales representatives, attract new customers and sales
representatives and maintain or improve our financial results.
The supplemental health insurance, annuity and individual life insurance
markets are highly competitive. Competitors include other life and accident and
health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
Our principal competitors vary by product line. Our main competitors for
agent sold long-term care insurance products include GE Financial Assurance,
John Hancock Financial Services, Aegon USA, Lincoln Benefit Life, MetLife and
Unum Provident. Our main competitors for agent sold Medicare supplement
insurance products include Mutual of Omaha, Blue Cross and Blue Shield of
Florida, Physicians Mutual and Standard Life and Accident.
In some of our product lines, such as life insurance and fixed annuities,
we have a relatively small market share. Even in some of the lines in which we
are one of the top five writers, our market share is relatively small. For
example, while our Bankers Life segment ranked third in agent sold long-term
care insurance products in 2003 with a market share of approximately seven
percent, the top two writers of agent sold long-term care insurance products had
a combined market share of approximately 45 percent during the period. In
addition, while our Bankers Life segment was ranked third and our Conseco
Insurance Group segment was ranked fourth in agent sold Medicare supplement
insurance products in 2003 with a combined market share of approximately 17
percent, the top two writers of agent sold Medicare supplement insurance
products had a combined market share of approximately 63 percent during the
period.
Virtually all of our major competitors have higher financial strength
ratings than we do. Many of our competitors are larger companies that have
greater capital, technological and marketing resources, and access to capital at
a lower cost. Recent industry consolidation, including business combinations
among insurance and other financial services companies, has resulted in larger
competitors with even greater financial resources. Furthermore, recent changes
in federal law have narrowed the historical separation between banks and
insurance companies, enabling traditional banking institutions to enter the
insurance and annuity markets and further increase competition. This increasing
competition may harm our ability to maintain or increase our profitability.
In addition, 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. Accordingly, if we do not also lower our prices for
similar products, we may lose market share to these competitors. If we lower our
prices to maintain market share, our profitability will decline.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among insurance and financial
services companies for sales representatives. We compete with other insurance
and financial services companies for sales representatives primarily on the
basis of our financial position, financial strength ratings, support
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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.
If we are unable to attract and retain independent agents for the
distribution of products sold through the Conseco Insurance Group segment,
sales of our products will decline.
Our Conseco Insurance Group segment markets and distributes its products,
including specified disease insurance, Medicare supplement insurance,
equity-indexed life insurance and equity-indexed annuities, exclusively through
independent agents. Premiums collected by our Conseco Insurance Group segment
through independent distributors totaled: $1,301.6 million, or 31 percent, of
our collected premiums in 2003; $1,680.2 million, or 37 percent, of collected
premiums in 2002; and $2,048.0 million, or 40 percent, of collected premiums in
2001. Given the significance of this distribution channel to our business, our
ability to maintain our relationships with these independent agents is critical
to our financial performance. This ability is dependent upon, among other
things, the compensation we offer independent distributors and the overall
attractiveness of our products to their customers. In addition, the distribution
of our life insurance and annuity products through this channel is particularly
sensitive to the financial strength ratings of our insurance subsidiaries. The
downgrades of our ratings in 2002, as well as our bankruptcy, caused significant
defections among our independent agents and increased our costs of retaining
them, which had a material adverse effect on our results of operations.
Following the downgrade of our A.M. Best rating to "B" in August 2002, the
premiums we collected from business distributed by independent agents decreased
to $762.6 million in the last six months of 2002 and $668.7 million in the first
six months of 2003, compared to $917.6 million in the first six months of 2002,
the period immediately preceding the downgrade. In the event that we are unable
to attract and retain qualified independent distributors of our products, our
operations and financial results may be materially adversely affected.
We may require additional capital in the future, which may not be available
or may only be available on unfavorable terms.
Our future capital requirements depend on many factors, including our
ability to write new business successfully and to establish premium rates and
reserves at levels sufficient to cover losses. While we currently expect to fund
our capital needs for the next several years from our operations, if those prove
to be insufficient we may need to raise additional funds through future
financings and, if we are unable to raise additional funds, we may need to
curtail our growth and reduce our assets. Any equity or debt financing, if
available at all, may be on terms that are not favorable to us. In the case of
equity financings, dilution to our shareholders could result, and in any case
such securities may have rights, preferences and privileges that are senior to
those of the shares offered hereby. If we cannot obtain adequate capital on
favorable terms or at all, our business, operating results and financial
condition could be adversely affected.
Our financial results would be negatively impacted if we are required to
indemnify the purchasers of businesses that we have recently sold.
We are subject to retained liabilities and indemnification obligations
related to businesses we have sold. For example, we retained liabilities for
certain purported class action litigation in connection with our sale of
Manhattan National Life Insurance Company in June 2002. In addition, the
agreement entered into in connection with our sale of CVIC imposes continuing
indemnification obligations with respect to liabilities relating to our period
of ownership of CVIC, and the agreement entered into in connection with our sale
of CFC imposes continuing tax sharing obligations with respect to tax
liabilities relating to our period of ownership of CFC. We cannot assure you
that we will not be subject to claims with respect to these continuing or
residual obligations, or that any such claims would not be material.
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
Due to the application of fresh start accounting, the reported historical
financial statements of our Predecessor for periods prior to August 31, 2003
generally are not comparable to our financial statements for periods after that
date. Please read this discussion in conjunction with the consolidated financial
statements and notes included in this Form 10-Q.
After our emergence from bankruptcy, we began to manage our business
operations through two primary operating segments, based on method of product
distribution, and a third segment comprised of business in run-off. We refer to
these segments as: (i) Bankers Life; (ii) Conseco Insurance Group; and (iii)
Other Business in Run-Off. Prior to its disposition effective March 31, 2003, we
also had a finance segment. We also have a corporate segment, which consists of
holding company activities and certain noninsurance company businesses that are
not related to our other operating segments. The following tables and narratives
summarize the operating results of our segments for the periods presented as we
currently manage them (dollars in millions):
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Earnings (losses) before taxes:
Bankers Life (a).................................................................... $ 67.4 $ 66.2
Conseco Insurance Group (b)......................................................... 69.3 24.4
Other Business in Run-off (c)....................................................... 17.6 (28.2)
Corporate operations (d)............................................................ (41.9) (109.9)
------ -------
Income (loss) before income taxes and
discontinued operations.......................................................... $112.4 $ (47.5)
====== =======
- ----------------
(a) The earnings before taxes of the Bankers Life segment included realized
gains, net of related amortization, of $11.0 million and $10.3 million for
the three months ended March 31, 2004 and 2003, respectively.
(b) The earnings before taxes of the Conseco Insurance Group segment included
realized gains, net of related amortization, of $8.8 million and $8.1
million for the three months ended March 31, 2004 and 2003, respectively.
(c) The earnings before taxes of the Other Business in Run-off segment included
realized gains, net of related amortization, of $2.7 million and $4.2
million for the three months ended March 31, 2004 and 2003, respectively.
(d) The earnings before taxes in our Corporate operations segment included
realized losses of $2.8 million in the first three months of 2004 and
venture capital income of $2.5 million in the first three months of 2003.
General: Conseco is the top tier holding company for a group of insurance
companies operating throughout the United States that develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. We distribute these products through a career agency
force and direct response marketing (which, together, represent our Bankers Life
segment) and through professional independent producers (which represent our
Conseco Insurance Group segment). Our Other Business in Run-off segment consists
of: (i) long-term care products written in prior years through independent
agents; (ii) small group and individual major medical business which we began to
nonrenew in 2001; and (iii) other group major medical business which we no
longer actively market. Most of the long-term care business in run-off relates
to business written by certain of our subsidiaries prior to their acquisitions
by Conseco in 1996 and 1997.
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Premiums and asset accumulation product collections:
Annuities............................................................................ $ 177.3 $ 260.0
Supplemental health.................................................................. 303.2 278.5
Life................................................................................. 37.8 34.1
-------- --------
Total premium collections.......................................................... $ 518.3 $ 572.6
======== ========
Average liabilities for insurance products:
Annuities:
Mortality based.................................................................. $ 355.0 $ 282.2
Equity-linked.................................................................... 266.8 268.2
Deposit based.................................................................... 3,287.8 2,644.5
Health............................................................................. 2,712.0 1,865.4
Life:
Interest sensitive............................................................... 331.0 319.7
Non-interest sensitive........................................................... 755.6 651.2
-------- --------
Total average liabilities for insurance
products, net of reinsurance ceded............................................. $7,708.2 $6,031.2
======== ========
Revenues:
Insurance policy income.............................................................. $ 345.1 $ 331.7
Net investment income:
General account invested assets.................................................... 97.9 93.2
Equity-indexed products based on the change in value of the
S&P 500 Call Options............................................................. 1.2 (3.3)
Trading account income related to policyholder and reinsurer
accounts......................................................................... 5.9 -
Change in value of embedded derivatives related to modified
coinsurance agreements........................................................... (5.9) -
Net realized investment gains........................................................ 11.0 11.3
Fee revenue and other income......................................................... .3 .4
-------- --------
Total revenues................................................................... 455.5 433.3
-------- --------
Expenses:
Insurance policy benefits............................................................ 265.0 252.5
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.................................................... 36.2 31.6
Equity-indexed products based on S&P 500 Index..................................... 5.3 4.3
Amortization expense................................................................. 45.7 43.6
Interest expense on investment borrowings............................................ .4 1.2
Other operating costs and expenses................................................... 35.5 33.9
-------- --------
Total benefits and expenses...................................................... 388.1 367.1
-------- --------
Income before income taxes and discontinued operations.................................... $ 67.4 $ 66.2
======== ========
(continued)
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Health loss ratios:
All health lines:
Insurance policy benefits........................................................ $224.9 $220.1
Loss ratio (a)................................................................... 76.18% 76.42%
Medicare Supplement:
Insurance policy benefits........................................................ $106.0 $114.9
Loss ratio (a)................................................................... 65.56% 71.08%
Long-Term Care:
Insurance policy benefits........................................................ $116.6 $102.8
Loss ratio (a)................................................................... 89.26% 83.31%
Interest-adjusted loss ratio (b)................................................. 62.86% 66.90%
Other:
Insurance policy benefits........................................................ $2.3 $2.4
Loss ratio (a)................................................................... 79.70% 81.06%
- ----------------
(a) We calculate loss ratios by taking the related product's: (i) insurance
policy benefits; divided by (ii) insurance policy income.
(b) We calculate the interest-adjusted loss ratio for Bankers Life's long-term
care products by taking the product's: (i) insurance policy benefits less
interest income on the accumulated assets which back the insurance
liabilities; divided by (ii) insurance policy income. Interest income is an
important factor in measuring losses on this product. The net cash flows
from 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 reflects the effects of the
investment income offset.
Total premium collections were $518.3 million in the first quarter of 2004,
down 9.5 percent from 2003. Bankers Life's annuity premium collections in 2003
were positively impacted by sales inducements provided to purchasers of our
annuities and sales incentives to our career agents. These programs ended at
various times during the second quarter of 2003. See "-- Premium and Asset
Accumulation Product Collections" for further analysis of Bankers Life's premium
collections.
Average liabilities for insurance products, net of reinsurance ceded were
$7.7 billion in the first quarter of 2004, up 28 percent from 2003. The increase
in such liabilities is primarily due to: (i) the adoption of fresh start
accounting and its effects on the reserves for our health insurance; and (ii)
increases in annuity reserves resulting from increased sales of these products
in the Bankers Life segment. As discussed above under "-- Total premium
collections", annuity premium collections in our Bankers Life segment were
positively impacted during the first half of 2003 by sales inducements and
incentives.
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 policyholder and reinsurer accounts) was $97.9 million in the first
quarter of 2004, up 5.0 percent from 2003. The average balance of general
account invested assets was $7.2 billion and $6.4 billion in the first quarters
of 2004 and 2003, respectively. The yield on these assets
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
was 5.4 percent and 5.8 percent in the first quarters of 2004 and 2003,
respectively. Net investment income on general account invested assets in the
2004 period is not comparable to the 2003 period due to the application of fresh
start accounting which reset the cost basis and yield of our investments to
market as of August 31, 2003. Net investment income on general account invested
assets in the fourth quarter of 2003 was $96.5 million and the yield on these
investments was 5.5 percent. The decrease in yield from the fourth quarter of
2003 to the first quarter of 2004 reflects: (i) the lower interest rate
environment prevailing in periods subsequent to August 31, 2003; and (ii) the
high level of prepayments experienced on fixed maturity investments (primarily
mortgage-backed securities) which have a new cost basis in excess of par value.
To the extent investments with a cost basis in excess of par value prepay faster
than expected, a reduction in yield will occur due to the acceleration of
premium amortization. In addition, the proceeds from investment maturities and
prepayments were reinvested at the lower prevailing interest rates, further
reducing the overall portfolio yield.
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 Bankers Life's 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 $6.9 million and $3.0 million in the first quarters of 2004 and
2003, 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 $8.1 million and $(.3) million in the first quarters of 2004 and 2003,
respectively. Such amounts are generally offset by the corresponding charge
(credit) to amounts added to policyholder account balances for equity-indexed
products based on S&P 500 Index. Such income and related charge fluctuate based
on the value of options embedded in the segment'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.
Change in value of embedded derivatives related to modified coinsurance
agreements are described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We have transferred the specific block of
investments related to these agreements to our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
trading account income. We expect the change in the value of the embedded
derivatives largely to be offset by the change in value of the trading
securities.
Net realized investment gains (losses) fluctuate from period to period.
During the three months ended March 31, 2004, net realized investment gains in
our Bankers Life segment included: (i) $14.3 million of net gains from the sales
of investments (primarily fixed maturities), net of (ii) $3.3 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. During the first three months
of 2003, the net realized investment gains included: (i) $18.1 million of net
gains from the sales of investments (primarily fixed maturities), net of (ii)
$6.8 million of writedowns of fixed maturity investments, equity securities and
other invested assets as a result of conditions which caused us to conclude a
decline in fair value of the investment was other than temporary.
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)
insurance policy benefits; divided by (ii) insurance policy income.
The loss ratio on Bankers Life's Medicare supplement products for the first
quarter of 2004 was in line with our expectations. Governmental regulations
generally require us to attain and maintain a ratio of total benefits incurred
to total premiums earned (as calculated based on amounts reported for statutory
accounting purposes), after three years, of not less than 65 percent on these
products. The loss ratio for the first quarter of 2003 was higher than we
expected. We experience quarterly fluctuations in this ratio from time to time.
(Such ratio for the entire year of 2003 was approximately equal to our
expectation of a loss ratio over time of approximately 65 percent).
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
loss ratio on this business has increased over the last year, consistent with
the aging of this block. In addition, the older policies which have
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
higher loss ratios have not lapsed at the rate we expected. The
interest-adjusted loss ratio for long-term care products is calculated by taking
the insurance product's: (i) insurance policy benefits less interest income on
the accumulated assets which back the insurance liabilities divided by (ii)
policy income. The decrease in the interest-adjusted loss ratio for the first
quarter of 2004, is primarily due to the adoption of fresh start accounting
which increased the assets assigned to back the insurance liabilities on this
block of business. The interest-adjusted loss ratio on this business increased
from 59.27 percent in the fourth quarter of 2003 to 62.86 percent in the first
quarter of 2004.
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
in line with our expectations.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $36.2 million in the first quarter of
2004, up 15 percent from 2003. The increases are primarily due to increases in
annuity reserves partially offset by the decrease in average crediting rates.
The weighted average crediting rates for these products were 4.0 percent and 4.3
percent in the first quarters of 2004 and 2003, respectively.
Amounts added to equity-indexed products based on S&P 500 Index correspond
to the related investment income accounts described above.
Amortization expense includes amortization of the value of policies inforce
at the Effective Date, cost of policies produced and the cost of policies
purchased (such amortization is collectively referred to as "amortization of
insurance intangibles"). Insurance intangibles are amortized: (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. Bankers Life's amortization expense in the 2004 period is not
comparable to the 2003 period due to the application of fresh start accounting
effective August 31, 2003. Amortization expense was $46.8 million in the fourth
quarter of 2003 compared to $45.7 million in the first quarter of 2004. Such
amounts are in line with our expectations given the related premium revenue and
gross profits for the periods.
Interest expense on investment borrowings fluctuates along with our
investment borrowing activities and the interest rates thereon. Average
investment borrowings in our Bankers Life segment were $141.5 million and $313.3
million during the first quarters of 2004 and 2003, respectively. The weighted
average interest rates on such borrowings were 1.1 percent and 1.5 percent
during the first quarters of 2004 and 2003, respectively.
Other operating costs and expenses in our Bankers Life segment were $1.6
million higher in the first quarter of 2004 compared to the same period in 2003.
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Premiums and asset accumulation product collections:
Annuities.......................................................................... $ 13.4 $ 37.8
Supplemental health................................................................ 190.9 196.5
Life............................................................................... 101.8 105.9
--------- ---------
Collections on insurance products................................................ $ 306.1 $ 340.2
========= =========
Average liabilities for insurance and asset accumulation:
Annuities:
Mortality based.................................................................. $ 240.8 $ 174.1
Equity-linked.................................................................... 1,538.4 1,583.2
Deposit based.................................................................... 3,911.4 4,462.2
Separate accounts and investment trust liabilities............................... 36.3 477.1
Health............................................................................. 2,317.1 2,052.9
Life:
Interest sensitive............................................................... 3,318.2 3,457.3
Non-interest sensitive........................................................... 1,453.6 1,496.7
--------- ---------
Total average liabilities for insurance and asset
accumulation products, net of reinsurance ceded.............................. $12,815.8 $13,703.5
========= =========
Revenues:
Insurance policy income.............................................................. $ 300.0 $ 354.0
Net investment income:
General account invested assets.................................................... 173.5 209.7
Equity-indexed products based on the change in value of the
S&P 500 Call Options............................................................. 4.3 (19.8)
Trading account income related to policyholder and
reinsurer accounts............................................................... 12.9 -
Change in value of embedded derivatives related to modified
coinsurance agreements........................................................... (2.6) -
Net realized investment gains........................................................ 16.2 7.8
Fee revenue and other income......................................................... 1.8 6.4
--------- ---------
Total revenues................................................................... 506.1 558.1
--------- ---------
Expenses:
Insurance policy benefits............................................................ 233.8 271.9
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.................................................... 67.9 85.8
Equity-indexed products based on S&P 500 Index..................................... 10.2 (.8)
Amortization expense................................................................. 47.7 97.2
Interest expense on investment borrowings............................................ .9 1.5
Other operating costs and expenses................................................... 76.3 78.1
--------- ---------
Total benefits and expenses...................................................... 436.8 533.7
--------- ---------
Income before income taxes and discontinued operations.................................. $ 69.3 $ 24.4
========= ========
(continued)
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Health loss ratios:
All health lines:
Insurance policy benefits....................................................... $125.3 $136.9
Loss ratio (a).................................................................. 65.72% 66.70%
Medicare Supplement:
Insurance policy benefits....................................................... $58.8 $65.2
Loss ratio (a).................................................................. 61.10% 67.73%
Specified Disease:
Insurance policy benefits....................................................... $63.1 $63.7
Loss ratio (a).................................................................. 70.15% 69.37%
Interest-adjusted loss ratio (b)................................................ 38.37% 40.38%
- -------------
(a) We calculate loss ratios by taking the related product's: (i) insurance
policy benefits; divided by (ii) insurance policy income.
(b) We calculate the interest-adjusted loss ratio for Conseco Insurance Group's
specified disease products by taking the product's: (i) insurance policy
benefits less interest income on the accumulated assets which back the
insurance liabilities; divided by (ii) insurance policy income. Interest
income is an important factor in measuring losses on this product. The net
cash flows from specified disease 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 reflects the
effects of the investment income offset.
Collections on insurance products were $306.1 million in the first quarter
of 2004, down 10 percent from 2003. Premium collections through the independent
agents in our Conseco Insurance Group segment have been negatively impacted by
the A.M. Best ratings downgrade to "B (Fair)"in August 2002 and our decision to
de-emphasize the sale of certain products. See "-- Premium and Asset
Accumulation Product Collections" for further analysis.
Average liabilities for insurance and asset accumulation products, net of
reinsurance ceded were $12.8 billion in the first quarter of 2004, down 6.5
percent from 2003. 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)"in August 2002. The liabilities
for insurance and asset accumulation products in this segment were not
significantly affected by the adoption of fresh start accounting. See "--
Liquidity for insurance 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 policyholder and reinsurer accounts) was $173.5 million in the first
quarter of 2004, down 17 percent from 2003. The average balance of general
account invested assets was $12.6 billion and $13.7 billion in the first
quarters of 2004 and 2003, respectively. The yield on these assets was 5.5
percent and 6.1 percent in the first quarters of 2004 and 2003, respectively.
Net investment income on general account invested assets in the 2004 period is
not comparable to the 2003 period due to the application of fresh start
accounting which reset the cost basis and yield of our investments to market as
of August 31, 2003. Net investment income
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
on general account invested assets in the fourth quarter of 2003 was $180.9
million and the yield on these investments was 5.7 percent. The decrease in
income and yield from the fourth quarter of 2003 to the first quarter of 2004
reflects: (i) the lower interest rate environment prevailing in periods
subsequent to August 31, 2003; and (ii) the high level of prepayments
experienced on fixed maturity investments (primarily mortgage-backed securities)
which have a new cost basis in excess of par value. To the extent investments
with a cost basis in excess of par value prepay faster than expected, a
reduction in yield will occur due to the acceleration of premium amortization.
In addition, the proceeds from investment maturities and prepayments were
reinvested at the lower prevailing interest rates, further reducing the overall
portfolio yield.
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 Conseco Insurance Group's 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 $10.2 million and $18.0 million in the
first quarters of 2004 and 2003, 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 $14.5 million and $(1.8) million in the first quarters
of 2004 and 2003, respectively. Such amounts were partially offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products based on S&P 500 Index. Such income and related
charge fluctuate based on the value of options embedded in the segment'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.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading security accounts established on August 31,
2003, which are designed to act as a hedge for embedded derivatives related to:
(i) Conseco Insurance Group's equity-indexed products; and (ii) certain modified
coinsurance agreements. In addition, such income includes the income on
investments backing the market strategies of certain annuity products which
provide for different rates of cash value growth based on the experience of a
particular market strategy. The income on our trading account securities is
designed to substantially offset: (i) the change in value of embedded
derivatives related to modified coinsurance agreements described below; and (ii)
certain amounts included in insurance policy benefits.
Change in value of embedded derivatives related to modified coinsurance
agreements are described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We have transferred the specific block of
investments related to these agreements to our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
trading account income. The change in the value of the embedded derivatives has
largely been offset by the change in value of the trading securities.
Net realized investment gains (losses) fluctuate from period to period.
During the three months ended March 31, 2004, we recognized net realized
investment gains in our Conseco Insurance Group segment which included: (i)
$21.8 million of net gains from the sales of investments (primarily fixed
maturities), net of (ii) $5.6 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. During the first three months of 2003, the net
realized investment gains included: (i) $21.2 million of net gains from the
sales of investments (primarily fixed maturities) net of; (ii) $13.4 million of
writedowns of fixed maturity investments, equity securities and other invested
assets as a result of conditions which caused us to conclude a decline in fair
value of the investment was other than temporary.
Fee revenue and other income in the first quarter of 2003 primarily
represents income earned by a subsidiary (which was sold in September 2003)
which earned fees for marketing insurance products of other companies.
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)
insurance policy benefits; divided by (ii) insurance policy income.
The loss ratio on Conseco Insurance Group's Medicare Supplement products in
the first quarter of 2004 was impacted by rate increases. Such rate increases
were implemented earlier in 2004 than in prior years, resulting in a lower loss
ratio in the 2004 period. In addition, the higher rates caused some
policyholders to lapse their policies. The release of the active life reserve
related to the lapsed business also contributed to the lower loss ratio in the
2004 period.
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
Governmental regulations generally require us to attain and maintain a ratio of
total benefits incurred to total premiums earned (as calculated based on amounts
reported for statutory accounting purposes), after three years, of not less than
65 percent on these products. Although the ratio in the first quarter of 2004 is
less than the required ratio, it exceeds 65 percent when measured over a longer
period.
Conseco Insurance Group's specified disease products 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. Approximately
three-fourths of our specified disease policies inforce (based on policy count)
are sold with return of premium or cash value riders. The return of premium
rider generally provides that after a policy has been inforce for a specified
number of years or upon the policyholder reaching a specified age, we will pay
to the policyholder, or a beneficiary under the policy, the aggregate amount of
all premiums paid under the policy, without interest, less the aggregate amount
of all claims incurred under the policy. Accordingly, the net cash flows from
these 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 specified disease products is calculated by taking the insurance
product's: (i) insurance policy benefits less interest income on the accumulated
assets which back the insurance liabilities; divided by (ii) policy income. The
loss ratio in this block of business is affected by the number of policies which
surrender in a period. When policies surrender before reaching the specified age
when the return of premium is payable, the reserve established for such benefit
through the surrender date is released, resulting in lower insurance policy
benefits for the period. The loss ratio for this block was 61.92 percent in the
fourth quarter of 2003. The fluctuations in this loss ratio generally correspond
to the lapse experience in each period: lapses were higher in the fourth quarter
of 2003 and lower in the first quarters of 2003 and 2004. The effect of
variances in lapse rates from our expectations are partially offset by the
amortization of insurance intangibles.
In the first quarter of 2004, the Conseco Insurance Group segment
experienced higher than expected death claims. Such unfavorable experience
resulted in increases in insurance policy benefits of approximately $8.1 million
over what we expected. We are continuing to review this adverse experience.
Based on paid claims in April 2004, we believe our death claim experience is
returning to the levels we generally expect.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $67.9 million in the first quarter of
2004, down 21 percent from 2003. The decrease is primarily due to a smaller
block of annuity business inforce and changes in the weighted average crediting
rates. The weighted average crediting rates for these products were 3.9 percent
and 4.5 percent in the first quarter of 2004 and 2003, respectively.
Amounts added to equity-indexed products based on S&P 500 Index correspond
to the related investment income accounts described above.
Amortization expense includes amortization of insurance intangibles.
Conseco Insurance Group's amortization expense in the 2004 period is not
comparable to the 2003 period due to the application of fresh start accounting
effective August 31, 2003. Amortization expense was $54.5 million in the fourth
quarter of 2003 compared to $47.7 million in the first quarter of 2004.
The amount of insurance intangibles on our universal life type and
investment type products that we amortize is dependent on the profits realized
during the period. Since our profits on these products were less than what was
experienced in the fourth quarter of 2003, amortization was reduced.
Amortization expense decreased by approximately $3.7 million in the first
quarter of 2004 as a result of the higher than expected death claims described
above. In addition, amortization expense is affected by the lapse experience on
our insurance business. Amortization expense will generally increase when lapses
exceed our assumptions and will decrease when lapses are lower than our
assumptions.
The amount that we amortize is also dependent on investment gains and
losses realized. When we sell securities at a gain (loss) and reinvest the
proceeds at a different yield, we increase (reduce) the amortization of
insurance intangibles in order to reflect the change in future expected yields.
Sales of fixed maturity investments resulted in an increase in the amortization
of insurance intangibles of $7.4 million in the first quarter of 2004.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
Interest expense on investment borrowings fluctuates along with Conseco
Insurance Group's investment borrowing activities and the interest rates
thereon. Average investment borrowings were $322.7 million and $411.0 million
during the first quarters of 2004 and 2003, respectively. The weighted average
interest rates on such borrowings were 1.2 percent and 1.4 percent during the
first quarters of 2004 and 2003, respectively.
Other operating costs and expenses were $76.3 million in the first quarter
of 2004, $1.8 million lower than the same period of 2003.
Other Business in Run-Off (dollars in millions)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Premiums and asset accumulation product collections:
Long-term care..................................................................... $ 98.6 $ 96.9
Major medical..................................................................... 6.0 61.6
-------- --------
Total premium collections..................................................... $ 104.6 $ 158.5
======== ========
Average liabilities for other business in run-off:
Long-term care..................................................................... $3,293.8 $1,923.3
Major medical...................................................................... 85.2 128.8
-------- --------
Total average liabilities for other business in run-off,
net of reinsurance ceded...................................................... $3,379.0 $2,052.1
======== ========
Revenues:
Insurance policy income............................................................ $ 103.3 $ 187.9
Net investment income on general account invested assets........................... 40.3 37.5
Net realized investment gains...................................................... 2.7 4.2
Fee revenue and other income....................................................... .3 .2
-------- --------
Total revenues................................................................. 146.6 229.8
-------- --------
Expenses:
Insurance policy benefits.......................................................... 101.3 213.4
Amortization expense............................................................... 4.8 17.2
Other operating costs and expenses................................................. 22.9 27.4
-------- --------
Total benefits and expenses.................................................... 129.0 258.0
-------- --------
Income (loss) before income taxes and discontinued operations.................. $ 17.6 $ (28.2)
======== ========
Health loss ratios:
Insurance policy benefits........................................................ $101.3 $213.4
Loss ratio (a)................................................................... 98.06% 113.57%
Interest-adjusted loss ratio (b)................................................. 59.99% 95.02%
- -----------
(a) We calculate loss ratios by taking the related product's: (i) insurance
policy benefits; divided by (ii) insurance policy income.
(b) We calculate the interest-adjusted loss ratio for long-term care products
included in this segment by taking the product's: (i) insurance policy
benefits less interest income on the accumulated assets which back the
insurance
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
liabilities; divided by (ii) policy income. Interest income is an important
factor in measuring losses on this product. The net cash flows from
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 reflects the effects of the investment
income offset.
Total premium collections in this segment were $104.6 million in the first
quarter of 2004, down 34 percent from 2003. We have ceased marketing the
long-term care business included in this segment. Accordingly, collected
premiums will decrease over time. Increases in long-term care premium
collections are the result of premium rate increases, partially offset by policy
lapses. We have ceased marketing and have not renewed our major medical
business, which has resulted in the significant reduction in major medical
collected premiums. See "-- Premium and Asset Accumulation Product Collections"
for further analysis.
Average liabilities for other business in run-off, net of reinsurance ceded
were $3.4 billion in the first quarter of 2004, up 65 percent from 2003.
Liabilities for this block of long-term care business were significantly
affected by the adoption of fresh start accounting. Refer to note 6,
"Liabilities for Insurance and Asset Accumulation Products" to our consolidated
financial statements included in Form 10-K for the year ended December 31, 2003
for additional information on the effect of fresh start accounting on our
insurance liabilities.
Insurance policy income is comprised of premiums earned on the segment's
long-term care and major medical policies. See "-- Premium and Asset
Accumulation Product Collections" for further analysis.
Net investment income on general account invested assets was $40.3 million
in the first quarter of 2004, up 7.5 percent from 2003. The average balance of
general account invested assets was $3.0 billion and $2.4 billion in the first
quarters of 2004 and 2003, respectively. The yield on these assets was 5.4
percent and 6.2 percent in the first quarters of 2004 and 2003, respectively.
Net investment income on general account invested assets in the 2004 period is
not comparable to the 2003 period due to the application of fresh start
accounting which reset the cost basis and yield of our investments to market as
of August 31, 2003. Net investment income on general account invested assets in
the fourth quarter of 2003 was $41.8 million and the yield on these investments
was 5.8 percent. The decrease in income and yield from the fourth quarter of
2003 to the first quarter of 2004 reflects: (i) the lower interest rate
environment prevailing in periods subsequent to August 31, 2003; and (ii) the
high level of prepayments experienced on fixed maturity investments (primarily
mortgage-backed securities) which have a new cost basis in excess of par value.
To the extent investments with a cost basis in excess of par value prepay faster
than expected, a reduction in yield will occur due to the acceleration of
premium amortization. In addition, the proceeds from investment maturities and
prepayments were reinvested at the lower prevailing interest rates, further
reducing the overall portfolio yield.
Net realized investment gains fluctuate from period to period. During the
three months ended March 31, 2004, net realized investment gains in our Other
Business in Run-off segment included: (i) $2.8 million of net gains from the
sales of investments (primarily fixed maturities); net of (ii) $.1 million of
write-downs of fixed maturity investments as a result of conditions which caused
us to conclude a decline in the fair value of the investment was other than
temporary. During the first three months of 2003, the net realized investment
gains included: (i) $5.0 million of net gains from the sales of investments
(primarily fixed maturities); net of (ii) $.8 million of writedowns of fixed
maturity investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below related to loss ratios in the blocks of long-term care business
in this segment. Loss ratios are calculated by taking the product's: (i)
insurance policy benefits; divided by (ii) insurance policy income.
This segment includes long-term care insurance inforce, substantially all
of which was issued through independent agents by certain of our subsidiaries
prior to their acquisitions by Conseco in 1996 and 1997. The loss experience on
these products has been worse than we originally 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 have experienced
adverse developments on home health care policies issued in certain areas of
Florida and other states. This adverse experience is reflected in the higher
loss ratios. We have been aggressively seeking rate increases and pursuing other
actions on certain of these long-term
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
care policies. On April 20, 2004, the Florida Office of Insurance Regulation
issued an order to our subsidiary, Conseco Senior Health Insurance Company
("Conseco Senior"), that affects approximately 18,000 home health care policies
issued in Florida by Conseco Senior and its Predecessor companies. The order
provides for Conseco Senior to offer the following three alternatives to holders
of these policies:
o retention of their current policy with a maximum rate increase of 50
percent in the first year and actuarially justified increases in
subsequent years;
o receipt of a replacement policy with reduced benefits and a maximum
rate increase in the first year of 25 percent and no more than 15
percent in subsequent years;
o receipt of a paid up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy.
The order also requires Conseco Senior to pursue a similar course of action with
respect to approximately 21,000 home health care policies issued by Conseco
Senior and its Predecessor companies in other states, subject to consideration
and approval by other state insurance departments. If we are unsuccessful in
obtaining rate increases or other forms of relief in other states, or if the
policy changes approved by the Florida Office of Insurance Regulation prove
inadequate, our future results of operations could be adversely affected.
The loss ratio for the first quarter of 2004 reflects: (i) unfavorable
claims experience on our long-term care products; partially offset by (ii) the
elimination of $7.0 million of reserve redundancies related to our major medical
policies. The decrease in the loss ratio as compared to the first quarter of
2003 also reflects the adoption of fresh start accounting.
The net cash flows from 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) insurance policy benefits less interest income on
the accumulated assets which back the insurance liabilities; divided by (ii)
policy income.
Amortization related to operations includes amortization of insurance
intangibles. The decrease in amortization expense in the first three months of
2004 reflects the adoption of fresh start accounting, and also reflects the
relatively small amount of value of policies inforce associated with the
business comprising this segment.
Other operating costs and expenses were $22.9 million in the first quarter
of 2004, down 16 percent from 2003. The decreases in expenses were due primarily
to expense reductions in the major medical operations.
Corporate (dollars in millions)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Corporate operations:
Interest expense on corporate debt.................................................. $(27.8) $ (70.9)
Net investment income .............................................................. .2 6.9
Provision for losses and expense related to stock purchase plan..................... - (15.3)
Venture capital income related to investment in AWE, net of related expenses........ - 2.5
Fee revenue and other income........................................................ 5.0 6.6
Net realized investment losses...................................................... (2.8) -
Other items......................................................................... (16.5) (21.6)
Reorganization items................................................................ - (18.1)
------ -------
Loss before income taxes.......................................................... $(41.9) $(109.9)
====== =======
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
Interest expense on corporate debt in the three months ended March 31, 2004
includes interest expense on the Senior Credit Facility, including a credit
agreement charge of $2.0 million. Interest expense in the three months ended
March 31, 2003 reflected interest on notes payable of the Predecessor.
Investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income. The
Corporate segment held less invested assets in the first quarter of 2004 as
compared to the same period in 2003.
Provision for losses and expense related to stock purchase plan represents
the non-cash provision we established in connection with our guarantees of bank
loans to approximately 155 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 our
Predecessor's common stock. In the first three months of 2003, we established a
provision of $15.3 million in connection with these guarantees and loans. We
determined the reserve based upon the value of the collateral held by the banks.
The outstanding principal balance on the bank loans was $481.3 million.
In conjunction with the Plan, the $481.3 million principal amount of bank
loans was transferred to the Company. We received all rights to collect the
balances due pursuant to the original terms of these loans. In addition, we hold
loans to participants for interest on the bank loans which total approximately
$233 million. The former bank loans and the interest loans are collectively
referred to as the "D&O loans." We regularly evaluate the collectibility of
these loans in light of the collateral we hold and the creditworthiness of the
participants. At March 31, 2004, we have estimated that approximately $51.0
million of the D&O balance (which is included in other assets) is collectible
(net of the cost of collection). An allowance has been established to reduce the
recorded balance of the D&O loans to this balance.
Venture capital income (loss) relates to our investment in AWE, a company
in the wireless communication business. Our investment in AWE was carried at
estimated fair value, with changes in fair value recognized as investment income
(loss). We sold all of our holdings in AWE during the fourth quarter of 2003.
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. Fee revenue and other income decreased primarily as
a result of a decrease in the market value of investments managed for others,
upon which these fees are based.
Net realized investment losses often fluctuates from period to period. In
the first three months of 2004, we recognized a writedown of $2.9 million due to
an other-than-temporary decline in value.
Other items include general corporate expenses, net of amounts charged to
subsidiaries for services provided by the corporate operations. General
corporate expenses in the three months ended March 31, 2004 included severance
expense of $4.4 million.
Reorganization items in the three months ended March 31, 2003 included
$18.1 million related to professional fees associated with our bankruptcy
proceedings which are expensed as incurred in accordance with SOP 90-7.
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. Our insurance companies' financial
strength ratings were downgraded by all of the major rating agencies beginning
in July, 2002, in connection with the financial distress that ultimately led to
our Predecessor's bankruptcy. The current financial strength ratings of our
insurance subsidiaries (with the exception of Conseco Senior Health Insurance
Company) from A.M. Best, S&P and Moody's are B (Fair), BB- and Ba3,
respectively. The current financial strength ratings of Conseco Senior Health
Insurance Company from A.M. Best, S&P and Moody's are B (Fair), CCC and Caa1,
respectively. For a description of the
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
ratings issued by these firms and additional information on our ratings, see "
- -- Liquidity for Insurance Operations." Many of our competitors have higher
financial strength ratings and we believe it is critical for us to improve our
ratings to be competitive. The lowered ratings assigned to our insurance
subsidiaries were one of the primary factors causing sales of our insurance
products to decline and policyholder redemptions and lapses to increase during
2003. We also experienced increased agent attrition, which in some cases led us
to increase commissions or sales incentives in an effort to retain them.
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 our insurance intangibles relating to
lapsed policies in the period in which those policies lapse, adversely affecting
our financial results in that period.
Our insurance segments sell insurance products through three primary
distribution channels -- career agents and direct marketing (our Bankers Life
segment) and independent producers (our Conseco Insurance Group segment). Our
career agency force in the Bankers Life segment 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. Bankers Life's direct marketing distribution
channel is engaged primarily in the sale of "graded benefit life" insurance
policies which are sold directly to the policyholder. Our independent producer
distribution channel in the Conseco Insurance Group segment 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.
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premiums and accumulation product collections were as follows:
Bankers Life (dollars in millions):
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)........................................................ $ 6.5 $ 3.8
------ ------
Other fixed (first-year)........................................................... 169.8 255.2
Other fixed (renewal).............................................................. 1.0 1.0
------ ------
Subtotal - other fixed annuities................................................. 170.8 256.2
------ ------
Total annuities.................................................................. 177.3 260.0
------ ------
Supplemental health:
Medicare supplement (first-year)................................................... 16.8 13.7
Medicare supplement (renewal)...................................................... 150.6 142.3
------ ------
Subtotal - Medicare supplement................................................... 167.4 156.0
------ ------
Long-term care (first-year)........................................................ 16.8 17.8
Long-term care (renewal)........................................................... 115.7 101.4
------ ------
Subtotal - long-term care........................................................ 132.5 119.2
------ ------
Other health (first-year).......................................................... .3 .2
Other health (renewal)............................................................. 3.0 3.1
------ ------
Subtotal - other health.......................................................... 3.3 3.3
------ ------
Total supplemental health........................................................ 303.2 278.5
------ ------
Life insurance:
First-year......................................................................... 10.9 8.0
Renewal............................................................................ 26.9 26.1
------ ------
Total life insurance............................................................. 37.8 34.1
------ ------
Collections on insurance products:
Total first-year premium collections on insurance products......................... 221.1 298.7
Total renewal premium collections on insurance products............................ 297.2 273.9
------ ------
Total collections on insurance products.......................................... $518.3 $572.6
====== ======
Annuities in the Bankers Life segment include equity-indexed and other
fixed annuities sold to the senior market through our career agents. In order to
maintain our career agency distribution force during the parent company's
Chapter 11 reorganization process, we provided certain sales inducements to
purchasers of annuities and sales incentives to our career agents. These
programs ended at various times during the second quarter of 2003. Annuity
collections from career agents decreased 32 percent, to $177.3 million, in the
first quarter of 2004 as compared to the same period in 2003. Annuity premium
collections in 2003 were favorably impacted by the sales inducements and
incentives discussed above. In addition, in the first half of 2003, the minimum
guaranteed crediting rates on certain of our annuity products were very
attractive. We subsequently introduced new annuity products which have lower
minimum guaranteed crediting rates. As a result of the
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
elimination of the sales inducements and incentives and the lower minimum
guaranteed crediting rates, sales of fixed rate annuity products have declined.
Supplemental health products in the Bankers Life segment include Medicare
supplement, long-term care and other insurance products distributed through our
career agency force. 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 in the Bankers Life
segment increased 7.3 percent, to $167.4 million, in the first quarter of 2004
as compared to the same period in 2003.
Premiums collected on Bankers Life's long-term care policies increased 11
percent, to $132.5 million, in the first quarter of 2004 as compared to the same
period in 2003. Sales of first-year long-term care policies through our career
agents were comparable to the same period in 2003.
Other health products include various other health insurance products which
we have not been actively marketing. Premiums collected in the first quarter of
2004 were comparable to the same period in 2003.
Life products in our Bankers Life segment are sold primarily to the senior
market through our career agents and our direct response distribution channel.
Life premiums collected in this segment increased 11 percent, to $37.8 million,
in the first quarter of 2004 as compared to the same period in 2003. Collected
premiums have been impacted by increases in new sales.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)........................................................ $ 5.8 $ 19.4
Equity-indexed (renewal)........................................................... 2.1 2.6
------ ------
Subtotal - equity-indexed annuities.............................................. 7.9 22.0
------ ------
Other fixed (first-year)........................................................... .6 10.1
Other fixed (renewal).............................................................. 4.9 5.7
------ ------
Subtotal - other fixed annuities................................................. 5.5 15.8
------ ------
Total annuities.................................................................. 13.4 37.8
------ ------
Supplemental health:
Medicare supplement (first-year)................................................... 7.6 13.6
Medicare supplement (renewal)...................................................... 86.5 77.1
------ ------
Subtotal - Medicare supplement................................................... 94.1 90.7
------ ------
Specified disease (first-year)..................................................... 8.2 8.5
Specified disease (renewal)........................................................ 83.6 82.5
------ ------
Subtotal - specified disease..................................................... 91.8 91.0
------ ------
Other health (first-year).......................................................... - 1.8
Other health (renewal)............................................................. 5.0 13.0
------ ------
Subtotal - other health.......................................................... 5.0 14.8
------ ------
Total supplemental health........................................................ 190.9 196.5
------ ------
Life insurance:
First-year......................................................................... 5.7 8.8
Renewal............................................................................ 96.1 97.1
------ ------
Total life insurance............................................................. 101.8 105.9
------ ------
Collections on insurance products:
Total first-year premium collections on insurance products........................ 27.9 62.2
Total renewal premium collections on insurance products............................ 278.2 278.0
------ ------
Total collections on insurance products.......................................... $306.1 $340.2
====== ======
Annuities in our Conseco Insurance Group segment include equity-indexed
annuities and other fixed annuities sold through professional independent
producers. Many professional independent producers discontinued marketing our
annuity products after A.M. Best lowered our financial strength ratings.
Accordingly, we took actions to reduce our expenses related to marketing these
products through this distribution channel, and began to focus instead on the
sale of products that were less ratings sensitive. Total annuity collected
premiums in this segment decreased 65 percent, to $13.4 million, in the first
quarter of 2004 as compared to the same period in 2003.
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
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 decreased 64 percent, to $7.9 million, in
the first quarter of 2004 as compared to the same period in 2003. The decrease
can be attributed to the general stock market performance in recent periods
which has made other investment products more attractive to certain customers.
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. 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 decreased 65 percent, to $5.5
million, in the first quarter of 2004 as compared to the same period in 2003.
The decrease can be attributed to our emphasis on the sales of other products
that are less ratings sensitive.
Supplemental health products in our Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through 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 in the Conseco Insurance
Group segment increased 3.7 percent, to $94.1 million, in the first quarter of
2004 as compared to the same period in 2003. New Medicare supplement sales have
been affected by increases in premium rates.
Premiums collected on specified disease products in the first quarter of
2004 were comparable to the same period in 2003.
Other health products include disability income, dental and various other
health insurance products. We no longer actively market many of these products.
Premiums collected decreased 66 percent, to $5.0 million, in the first quarter
of 2004 as compared to the same period in 2003.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected decreased 3.9
percent, to $101.8 million, in the first quarter of 2004 as compared to the same
period in 2003. Our A.M. Best rating has negatively affected our sales of life
products. We stopped actively marketing many of our life insurance products sold
through the professional independent producer channel in the second quarter of
2003.
62
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-Off (dollars in millions)
Successor Predecessor
------------ ------------
Three months Three months
ended ended
March 31, March 31,
2004 2003
---- ----
Premiums collected:
Long-term care:
First-year.......................................................................... $ .2 $ 1.4
Renewal............................................................................. 98.4 95.5
------ ------
Subtotal - long-term care......................................................... 98.6 96.9
------ ------
Major medical:
Group (first-year).................................................................. - .2
Group (renewal)..................................................................... 5.0 60.9
------ ------
Subtotal - group major medical.................................................... 5.0 61.1
------ ------
Individual (first-year)............................................................. - -
Individual (renewal)................................................................ 1.0 .5
------ ------
Subtotal - individual major medical............................................... 1.0 .5
------ ------
Total major medical............................................................... 6.0 61.6
------ ------
Collections on insurance products:
Total first-year premium collections on insurance products.......................... .2 1.6
Total renewal premium collections on insurance products............................. 104.4 156.9
------ ------
Total collections on insurance products........................................... $104.6 $158.5
====== ======
As described elsewhere, the Other Business in Run-off segment includes: (i)
long-term care products written in prior years through independent agents; and
(ii) group and individual major medical business in run-off.
Long-term care premiums collected in this segment increased 1.8 percent, to
$98.6 million, in the first quarter of 2004 as compared to the same period in
2003. The increase was due to premium rate increases. Most of the long-term care
premiums in this segment relate to business written by certain of our
subsidiaries prior to their acquisitions by Conseco in 1996 and 1997. We ceased
selling new long-term care policies through professional independent producers
in the second quarter of 2003. We expect this segment's long-term care premiums
to reflect additional policy lapses in the future, partially offset by premium
rate increases. See "-- Other Business in Run-Off" for additional discussion
related to an order issued by the Florida Office of Insurance Regulation
regarding certain blocks of our long-term care business.
Group major medical premiums decreased 92 percent, to $5.0 million, in the
first quarter of 2004 as compared to the same period in 2003. We no longer
actively market new sales of group products. In early 2002, we decided to stop
renewing all inforce small group business and discontinued new sales.
Individual major medical premiums collected in the first quarter of 2004
were comparable to the same period in 2003. 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 major medical
business and discontinued new sales.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between March 31, 2004 and
December 31, 2003, primarily reflect: (i) our net income for the three months
ended March 31, 2004; and (ii) changes in the fair value of actively managed
fixed maturity securities.
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CONSECO, INC. AND SUBSIDIARIES
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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' equity. At March 31, 2004, we increased the
carrying value of such investments by $823.9 million as a result of this fair
value adjustment.
Our capital structure as of March 31, 2004, and December 31, 2003, was as
follows (dollars in millions):
Successor
---------------------------
March 31, December 31,
2004 2003
---- ----
Total capital:
Corporate notes payable................................................ $1,296.5 $1,300.0
Shareholders' equity:
Class A preferred stock............................................. 910.4 887.5
Common stock........................................................ 1.0 1.0
Additional paid-in-capital.......................................... 1,646.4 1,641.9
Accumulated other comprehensive income.............................. 470.7 218.7
Retained earnings................................................... 118.4 68.5
-------- --------
Total shareholders' equity....................................... 3,146.9 2,817.6
-------- --------
Total capital.................................................... $4,443.4 $4,117.6
======== ========
The following table summarizes certain financial ratios as of and for the
three months ended March 31, 2004 and as of and for the four months ended
December 31, 2003:
Successor
--------------------------
March 31, December 31,
2004 2003
---- ----
Book value per common share................................................................... $22.34 $19.28
Ratio of earnings to fixed charges............................................................ 1.82x 1.79x
Ratio of earnings to fixed charges and preferred dividends.................................... 1.45x 1.46x
Debt to total capital ratios:
Corporate debt to total capital............................................................ 29% 32%
Corporate debt and preferred stock to total capital........................................ 50% 53%
Liquidity for insurance 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.
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." On August 14,
2002, A.M. Best again 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++" rating indicates superior overall
performance and a superior ability to meet ongoing
64
CONSECO, INC. AND SUBSIDIARIES
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obligations to policyholders. 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 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 reflected A.M. Best's view of the
uncertainty surrounding our restructuring initiatives and the potential adverse
financial impact on our subsidiaries. On September 11, 2003, A.M. Best affirmed
its financial strength ratings of our primary insurance companies ("B (Fair)")
and removed the ratings from under review, indicating that the ratings outlook
is positive. On October 3, 2003, A.M. Best assigned a positive outlook to all of
our ratings. According to a press release issued by A.M. Best, the assignment of
a positive outlook to Conseco's ratings reflects their favorable view of our
bankruptcy reorganization and a number of management initiatives including the
sale of the GM building, sale of CFC, restructuring of our investment
portfolios, expense reductions, merging of certain subsidiaries, stabilization
of surrenders and a commitment in the near-to-medium term to focus on selling
higher margin products with lower capital requirements.
On August 2, 2002, S&P downgraded the financial strength rating of our
primary insurance companies from BB+ to B+. On November 19, 2003, S&P assigned a
"BB-" counterparty credit and financial strength rating to our primary insurance
companies, with the exception of Conseco Senior Health Insurance Company, which
was assigned a "CCC" rating. S&P financial strength ratings range from "AAA" to
"R" and some companies are not rated. 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 "BB" has marginal financial
security characteristics and although positive attributes exist, adverse
business conditions could lead to an insufficient ability to meet financial
commitments. In S&P's view, an insurer rated "CCC" has very weak financial
security characteristics and is dependent on favorable business conditions to
meet financial commitments. On July 1, 2003, Moody's downgraded the financial
strength rating of our primary insurance companies from "Ba3" to "B3". On
December 4, 2003, Moody's assigned a "Ba3" rating to our primary insurance
companies with the exception of Conseco Senior Health Insurance Company, which
was assigned a "Caa1" rating. Moody's financial strength ratings range from
"Aaa" to "C". Rating categories from "Ba" to "C" are classified as "vulnerable"
by Moody's, and may be supplemented with numbers "1", "2", or "3" to show
relative standing within a category. In Moody's view, an insurer rated "Ba"
offers questionable financial security and the ability of the insurer to meet
policyholder obligations may be very moderate and thereby not well safeguarded
in the future. In Moody's view, an insurer rated "Caa" offers very poor
financial security and may default on its policyholder obligations or there may
be elements of danger with respect to punctual payment of policyholder
obligations and claims.
The lowered ratings assigned to our insurance subsidiaries caused sales of
our insurance products to decline and policyholder redemptions and lapses to
increase during 2002 and 2003. We also experienced increased agent attrition,
which in some cases led us to increase commissions or sales incentives we must
pay in order to retain them. These events have had a material adverse effect on
our financial results.
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, which were formally
released on November 19, 2003. The consent orders applied to all of our
insurance subsidiaries and, among other things, restricted the ability of our
insurance subsidiaries to pay any dividends or other distributions to any
non-insurance company parent without prior approval. State laws generally
provide state insurance regulatory agencies with broad authority to protect
policyholders in their jurisdictions. Accordingly, we cannot assure you that the
regulators will not seek to assert greater supervision and control over our
insurance subsidiaries' businesses and financial affairs. We have agreed with
the Texas Department of Insurance to provide prior notice of certain
transactions, including up to 30 days prior notice for the payment of dividends
by an insurance subsidiary to any non-insurance company parent, and periodic
reporting of information concerning our financial performance and condition.
65
CONSECO, INC. AND SUBSIDIARIES
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Liquidity of the Holding Companies
Pursuant to the Plan, we entered into the Senior Credit Facility. The
Senior Credit Facility consists of two tranches: Tranche A -- $1.0 billion; and
Tranche B -- $0.3 billion. See the note to the consolidated financial statements
entitled "Changes in Direct Corporate Obligations" for further discussion
related to the Senior Credit Facility. Principal repayments are due as follows
(dollars in millions):
Tranche A Tranche B
--------- ---------
June 30, 2004..................................................... $ 50.0 $ 3.0
June 30, 2005..................................................... 50.0 3.0
June 30, 2006..................................................... 50.0 1.5
December 31, 2006................................................. 50.0 1.5
June 30, 2007..................................................... 75.0 1.5
December 31, 2007................................................. 75.0 1.5
June 30, 2008..................................................... 75.0 1.5
December 31, 2008................................................. 75.0 1.5
June 30, 2009..................................................... - 1.5
September 10, 2009................................................ 500.0 -
December 31, 2009................................................. - 1.5
September 10, 2010................................................ - 282.0
-------- ------
$1,000.0 $300.0
======== ======
At March 31, 2004, Conseco Inc. and CDOC held unrestricted cash of $22.0
million and additional restricted cash of $15.5 million held in trust for the
payment of bankruptcy-related professional fees. In addition, our other non-life
insurance companies held unrestricted cash of approximately $50.1 million which
could be upstreamed to the parent companies if needed. As further discussed in
the note to the consolidated financial statements entitled "Subsequent Event",
we expect to repay approximately $400 million of the Senior Credit Facility
using a portion of the net proceeds received from the offering of the Company's
common stock and Class B preferred stock.
Conseco and CDOC 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 Conseco and CDOC receive from insurance subsidiaries consists of
dividends and distributions, principal and interest payments on surplus
debentures, fees for services, tax-sharing payments, 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 Conseco or CDOC
for any reason could further limit such subsidiaries' ability to pay cash
dividends or other disbursements to Conseco and/or CDOC, which, in turn, would
limit Conseco's and/or CDOC'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 and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
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) statutory net gain
from operations or net income for the prior year; and (ii) 10 percent of
statutory 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. Also, we have agreed with the
Texas Department of Insurance to provide up to 30 days prior notice of the
payment of dividends by an insurance subsidiary to any non-insurance company
parent. As described under the caption "-- Statutory Information", we recently
were subject to consent orders with the Commissioner of Insurance for the State
of Texas that, among other things, restricted the ability of our insurance
subsidiaries to pay any dividends to any non-insurance company parent without
prior approval. If our financial condition were to deteriorate, we may be
required to enter into similar orders in the future. In addition, we may need to
contribute additional capital to improve the risk based capital ("RBC") ratios
of our insurance subsidiaries and this could affect the ability of our top tier
insurance subsidiary to pay dividends.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
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.
We have adopted several initiatives designed to reduce the expense levels
that exceed product pricing at our Conseco Insurance Group segment. These
initiatives include the elimination of duplicate processing systems by
converting all similar systems to a single system. We expect to spend over $35
million on capital expenditures in 2004 (including amounts related to the
aforementioned initiatives). We believe we have adequate cash flows from
operations to fund these initiatives.
Under our Senior Credit Facility, 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. We have also agreed to meet or maintain various financial
ratios. Our ability to meet these financial covenants may be affected by events
beyond our control. These requirements represent significant restrictions on the
manner in which we may operate our business. If we default under any of these
requirements (subject to certain remedies), the lenders could declare all
outstanding borrowings, accrued interest and fees to be immediately 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. In January 2004, the Senior Credit Facility was amended to remove
requirements that our insurance subsidiaries maintain minimum A.M. Best
financial strength ratings. In March 2004, the Senior Credit Facility was
amended to change the definition of a financial ratio we are required to
maintain. The change was needed to clarify how the ratio is calculated. The
definition in the amended facility is consistent with calculations used to
determine the original covenant levels.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At March 31, 2004, the amortized cost and estimated fair value of actively
managed fixed maturities and equity securities were as follows (dollars in
millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities................................................ $11,531.2 $572.5 $12.3 $12,091.4
United States Treasury securities and obligations of
United States government corporations and agencies................ 1,284.8 37.6 1.6 1,320.8
States and political subdivisions................................... 664.0 21.0 2.2 682.8
Debt securities issued by foreign governments....................... 96.7 4.3 - 101.0
Structured securities .............................................. 5,892.8 150.0 9.9 6,032.9
Below-investment grade (primarily corporate securities)................ 675.9 60.6 2.0 734.5
--------- ------ ----- ---------
Total actively managed fixed maturities............................. $20,145.4 $846.0 $28.0 $20,963.4
========= ====== ===== =========
Equity securities...................................................... $ 72.3 $ 5.2 $ .3 $ 77.2
========= ====== ===== =========
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our fixed maturity
securities by industry category as of March 31, 2004 (dollars in millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Mortgage-backed securities........................................................... $ 6,036.4 28.8%
Bank and finance..................................................................... 3,121.2 14.9
Services............................................................................. 2,566.0 12.2
Manufacturing........................................................................ 2,328.0 11.1
Utilities............................................................................ 1,340.3 6.4
Communications....................................................................... 1,066.7 5.1
Agriculture, forestry and mining..................................................... 809.7 3.9
Government (US)...................................................................... 798.1 3.8
Asset-backed securities.............................................................. 771.0 3.7
Transportation....................................................................... 605.7 2.9
Retail and wholesale................................................................. 567.6 2.7
Other................................................................................ 952.7 4.5
--------- -----
Total fixed maturity securities................................................... $20,963.4 100.0%
========= =====
Below-Investment Grade Securities
At March 31, 2004, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $675.9 million, or 3.4
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $734.5 million, or 109 percent of the
amortized cost. The value of these securities varies based on the economic terms
of the securities, structural considerations and the creditworthiness of the
issuer of the securities.
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
68
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 three months ended March 31, 2004, we recognized net realized
investment gains of $27.1 million. Such net realized investment gains during the
three months ended March 31, 2004 included: (i) $39.0 million of net gains from
the sales of investments (primarily fixed maturities) which generated proceeds
of $2.6 billion; net of (ii) $11.9 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. During the first three months of 2003, we recognized
net realized investment gains of $23.3 million. The net realized investment
gains during the first three months of 2003 included: (i) $44.3 million of net
gains from the sales of investments (primarily fixed maturities) which generated
proceeds of $2.4 billion; net of (ii) $21.0 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. At March 31, 2004, fixed maturity securities in
default as to the payment of principal or interest had an aggregate amortized
cost of $8.2 million and a carrying value of $17.1 million.
During the three months ended March 31, 2004, we sold $108.4 million of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $1.6 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.
Investments with Other-Than-Temporary Losses
During the three months ended March 31, 2004, we recorded writedowns of
fixed maturity investments, equity securities and other invested assets totaling
$11.9 million. No writedown of a single issuer exceeded $3.0 million.
Recognition of Losses
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value.
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time.
Our periodic assessment of whether unrealized losses are "other than
temporary" requires significant judgment. 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
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CONSECO, INC. AND SUBSIDIARIES
-------------------
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 March 31,
2004, 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 structured securities
shown below provide for periodic payments throughout their lives (dollars in
millions).
Estimated
Amortized fair
cost value
--------- ---------
Due in one year or less................................................................... $ 10.2 $ 10.1
Due after one year through five years..................................................... 58.3 56.1
Due after five years through ten years.................................................... 276.6 272.8
Due after ten years....................................................................... 475.8 463.8
-------- --------
Subtotal............................................................................... 820.9 802.8
Structured securities..................................................................... 1,064.2 1,054.3
-------- --------
Total.................................................................................. $1,885.1 $1,857.1
======== ========
There were no investments in our portfolio rated below-investment grade or
classified as equity-type securities in an unrealized loss position exceeding 20
percent of the cost basis at March 31, 2004.
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 investments with unrealized
losses at March 31, 2004, 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
-------------------
Structured Securities
At March 31, 2004, fixed maturity investments included $6.0 billion of
structured securities (or 29 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations, asset-backed securities and commercial mortgage-backed
securities. The yield characteristics of structured 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 the underlying mortgages
prepay faster than expected. When interest rates decline, the proceeds from the
prepayment of mortgage-backed securities may 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.
Pursuant to fresh start reporting, we were required to mark all of our
investments to market value. The current interest rate environment is much lower
than when most of our investments were purchased. Accordingly, the fresh start
values of our investments generally exceed the par values and the actual cost of
such investments. The amount of value exceeding par is referred to as a
"purchase premium" which is amortized against future income. If prepayments in
any period are higher than expected, purchase premium amortization is increased.
In periods of unexpectedly high prepayment activity, the increased amortization
will reduce net investment income.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral at March 31, 2004 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 154.8 $ 156.8 $ 159.7
4 percent - 5 percent............................................................... 1,451.5 1,383.8 1,436.8
5 percent - 6 percent............................................................... 1,020.2 1,011.9 1,050.6
6 percent - 7 percent............................................................... 2,594.6 2,685.4 2,717.7
7 percent - 8 percent............................................................... 550.4 583.7 595.9
8 percent and above................................................................. 69.5 73.8 75.7
-------- -------- --------
Total structured securities (a).............................................. $5,841.0 $5,895.4 $6,036.4
======== ======== ========
- ----------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $2.6 million and $3.5 million,
respectively.
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CONSECO, INC. AND SUBSIDIARIES
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The amortized cost and estimated fair value of structured securities at
March 31, 2004, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
----------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs and sequential and targeted amortization classes............ $3,611.1 $3,669.4 17%
Planned amortization classes and accretion-directed bonds................. 756.7 778.6 4
Commercial mortgage-backed securities..................................... 1,392.3 1,453.8 7
Subordinated classes and mezzanine tranches............................... 134.4 133.7 1
Other..................................................................... .9 .9 -
-------- -------- --
Total structured securities (a).................................... $5,895.4 $6,036.4 29%
======== ======== ==
- ------------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $2.6 million and $3.5 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 generally offers higher yields, 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 March 31, 2004, the mortgage loan balance was primarily comprised of
commercial loans. Less than one percent of the mortgage loan balance was
noncurrent at March 31, 2004.
Investment Borrowings
Our investment borrowings averaged approximately $473.7 million during the
first three months of 2004, compared with $738.9 million during the same period
of 2003 and were collateralized by investment securities with fair values
approximately equal to the loan value. The weighted average interest rates on
such borrowings were 1.1 percent and 1.4 percent during the first three months
of 2004 and 2003, respectively.
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CONSECO, INC. AND SUBSIDIARIES
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STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES)
As of the date of this filing, the consolidated statutory results of our
insurance subsidiaries for the three months ended March 31, 2004, have not been
finalized. The quarterly statutory financial statements of our insurance
subsidiaries are expected to be filed with the respective domiciliary insurance
regulators on or about May 14, 2004. Statutory accounting practices prescribed
or permitted by regulatory authorities for the Company's insurance subsidiaries
differ from GAAP. The consolidated statutory net loss (a non-GAAP measure) of
our insurance subsidiaries is expected to be approximately $2.0 million in the
first three months of 2004 compared to a net loss of $8.3 million in the same
period of 2003. Included in such net losses are net realized capital losses, net
of income taxes, of $13.1 million and $57.0 million in the first three months of
2004 and 2003, respectively. In addition, such net losses included interest
expense on surplus debentures of $43.6 million and nil in the first three months
of 2004 and 2003, respectively. The Company's insurance subsidiaries expect to
report the following amounts to regulatory agencies at March 31, 2004, after
appropriate eliminations of intercompany accounts among such subsidiaries
(dollars in millions):
Statutory capital and surplus .................................. $1,541.2
Asset valuation reserve......................................... 49.7
Interest maintenance reserve.................................... 231.0
--------
Total........................................................ $1,821.9
========
The statutory capital and surplus shown above included investments in
upstream affiliates of $159.0 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) statutory net gain from operations or statutory 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. No
dividends were paid in the first quarter of 2004.
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, AVR and certain other adjustments) to company
action level RBC: (i) if a company's total adjusted capital is less than 100
percent but greater than or equal to 75 percent of its RBC (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 75 percent but greater
than or equal to 50 percent of its RBC (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 taken; (iii) if a
company's total adjusted capital is less than 50 percent but greater than or
equal to 35 percent of its RBC (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 35 percent of its RBC (the "Mandatory Control Level"), the regulatory
authority must place the company under its control. In addition, the Model Act
provides for an annual trend test if a company's total adjusted capital is
between 100 percent and 125 percent of its RBC at the end of the year. The trend
test calculates the greater of the decrease in the margin of total adjusted
capital over RBC: (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 95 percent of its RBC would trigger a requirement to submit a comprehensive
plan as described above for the Company Action Level.
The 2003 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 subsidiaries to any regulatory
action. However, as a result of losses on the long-term care business within the
Other Business in Run-off segment, the RBC ratio of Conseco Senior was near the
level which would require it to submit a comprehensive plan aimed at improving
its capital position. See "-- Other
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CONSECO, INC. AND SUBSIDIARIES
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Business in Run-off" for additional discussion related to an order issued by the
Florida Office of Insurance Regulation regarding certain blocks of Conseco
Senior's long-term care business.
The consolidated RBC ratio for our insurance subsidiaries is estimated to
be 297 percent at March 31, 2004. We calculate the consolidated RBC ratio by
assuming all of the assets, liabilities, capital and surplus and other aspects
of the business of our insurance subsidiaries are combined together in one
insurance subsidiary, with appropriate intercompany eliminations.
Our insurance subsidiaries held principal protected senior notes of three
trusts which invested in fixed maturities, mortgages, preferred stock, common
stock and limited partnerships. We consolidated the trusts in our financial
statements prepared in accordance with GAAP at December 31, 2003. During the
fourth quarter of 2003, the trusts began liquidating their portfolios, a process
that was completed in the first quarter of 2004. Under statutory accounting
practices, which differ from GAAP, realized capital losses of $45.9 million were
recorded on the fourth quarter 2003 partial redemption of the senior notes
issued by the trusts that were owned by the insurance subsidiaries. Additional
statutory realized capital losses of $94.9 million were recorded at December 31,
2003 since a decision had been made to redeem the remaining senior notes at
amounts less than their amortized cost. The total statutory realized losses of
$140.8 million on the senior notes were included in the interest maintenance
reserve ("IMR") at December 31, 2003. The redemption of the remaining senior
notes resulted in realized gains of $7.2 million in the first quarter of 2004
which were also included in the IMR.
NEW ACCOUNTING STANDARDS
See "Recently Issued Accounting Standards" in the notes to consolidated
financial statements for a discussion of recently issued accounting standards.
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CONSECO, INC. AND SUBSIDIARIES
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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 Conseco's Form 10-K for the year ended December 31,
2003. There have been no material changes in the first three months of 2004 to
such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Conseco's management, under the supervision and with the participation of
the Chief Executive Officer and the Chief Financial Officer, evaluated the
effectiveness of Conseco's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended). Based on this evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of March 31, 2004, Conseco's disclosure
controls and procedures were effective to ensure that information required to be
disclosed by Conseco in reports that it files or submits under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission's rules and forms.
There were no significant changes in Conseco's internal controls over
financial reporting that occurred during the quarter ended March 31, 2004, that
have materially affected, or are reasonably likely to materially affect,
Conseco's internal controls over financial reporting.
PART II - OTHER INFORMATION
ITEM 1. LITIGATION AND OTHER LEGAL PROCEEDINGS.
We 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 former directors are defendants in
pending class action lawsuits asserting claims under the securities laws. The
ultimate outcome of these lawsuits cannot be predicted with certainty and we
have estimated the potential exposure for each of the matters and have recorded
a liability if a loss is deemed probable.
Securities Litigation
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 us as a defendant, along with certain of our
current and former officers. These lawsuits were filed on behalf of persons or
entities who purchased our Predecessor's common stock on various dates between
October 24, 2001 and August 9, 2002. In each case the plaintiffs allege claims
under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as
amended (the "Exchange Act") and allege material omissions and dissemination of
materially misleading statements regarding, among other things, the liquidity of
Conseco and alleged problems in CFC's manufactured housing division, allegedly
resulting in the artificial inflation of our Predecessor's stock price. On March
13, 2003, all of these cases were consolidated into one case in the United
States District Court for the Southern District of Indiana, captioned Franz
Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel
and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The lawsuits were stayed
as to all defendants by order of the United States Bankruptcy Court for the
Northern District of Illinois. The stay was lifted on October 15, 2003. The
plaintiffs have filed a consolidated class action complaint with respect to the
individual defendants. Our liability with respect to these lawsuits was
discharged in the Plan and our obligation to indemnify individual defendants who
were not serving as one of our officers or directors on the Effective Date of
the Plan is limited to $3 million in the aggregate under the Plan. Our liability
to indemnify individual defendants who were serving as an officer or director on
the Effective Date, of which there is one such defendant, is not limited by the
Plan. A motion to dismiss was filed on behalf of defendants Shea, Wendt and
Chokel on March 30, 2004. We believe these lawsuits are without merit and intend
to defend them vigorously. The ultimate outcome of these lawsuits cannot be
predicted with certainty.
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Other Litigation
Collection efforts by the Company and its wholly owned subsidiary, Conseco
Services, LLC, related to the 1996-1999 director and officer loan programs have
been commenced against various past board members and executives with
outstanding loan balances. In addition, certain former officers and directors
have sued the companies for declaratory relief concerning their liability for
the loans. Currently, we are involved in litigation with Stephen C. Hilbert,
James D. Massey, Dennis E. Murray, Sr., Rollin M. Dick, James S. Adams, Maxwell
E. Bublitz, Ngaire E. Cuneo, David R. Decatur, Donald F. Gongaware and Bruce A.
Crittenden. The specific lawsuits include: Hilbert v. Conseco, Case No. 03A
04283 (Bankr. Northern District, Illinois); Conseco Services v. Hilbert, Case
No. 29C01-0310 MF 1296 (Circuit Court, Hamilton County, Indiana); Murray and
Massey v. Conseco, Case No. 1:03-CV-1482 LJM-WTL (Southern District, Indiana);
Conseco Services v. Adams, et al, Case No. 29DO2- 0312-CC-1035(Circuit Court,
Hamilton County, Indiana); Conseco v. Adams, et al, Case No. 03A 04545, (Bankr.
Northern District, Illinois) Dick v. Conseco Services, Case No. 29
D01-0207-PL-549 (Superior Court, Hamilton County, Indiana); Conseco Services v.
Dick, et al., Case No. 06C01-0311-CC-356 (Circuit Court, Boone County, Indiana);
Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026
(Superior Court, Hamilton County, Indiana); Crittenden v. Conseco, Case No.
IP02-1823-C B/S (Southern District, Indiana); and Conseco v. Dick, Case No. 04L
002811 (Circuit Court, Cook County, Illinois). The Company and Conseco Services,
LLC believe that all amounts due under the director and officer loan programs,
including all applicable interest, are valid obligations owed to the companies.
As part of the Plan, we have agreed to pay 45 percent of any net proceeds
recovered in connection with these lawsuits, in an aggregate amount not to
exceed $30 million, to former holders of our Predecessor's trust preferred
securities that did not opt out of a settlement reached with the committee
representing holders of these securities. We are required to use the balance of
any net proceeds recovered in connection with these lawsuits to pay down our
Senior Credit Facility. Any remaining proceeds will be used to contribute
capital to our insurance subsidiaries. We intend to prosecute these claims to
obtain the maximum recovery possible. Further, with regard to the various claims
brought against the Company and Conseco Services, LLC by certain former
directors and officers, we believe that these claims are without merit and
intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be
predicted with certainty.
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 our Predecessor, Conseco Services, LLC and certain of our current and
former officers (Roderick Russell, et al. v. Conseco, Inc., et al., Case No.
1:02-CV-1639 LJM). The purported class action consists of all individuals whose
401(k) accounts held common stock of our Predecessor at any time since April 28,
1999. The complaint alleges, among other things, breaches of fiduciary duties
under ERISA by continuing to permit employees to invest in our Predecessor's
common stock without full disclosure of the Company's true financial condition.
We filed a motion to dismiss the complaint in December 2002. This lawsuit was
stayed as to all defendants by order of the Bankruptcy Court. The stay was
lifted on October 15, 2003. On March 22, 2004, plaintiffs filed an amended
complaint (which made our motion to dismiss moot) and added additional former
officers as named defendants and dismissed Conseco, Inc. as a party. On February
13, 2004, the Company's fiduciary insurance carrier, RLI Insurance Company,
filed a declaratory judgment action asking the court to find no liability under
its policy for the claims made in the Russell matter (RLI Insurance Company v.
Conseco, Inc., Stephen Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern
District, Indiana.)) On March 15, 2004, RLI filed an amended complaint adding
Conseco Services, LLC as an additional defendant. We believe the lawsuits are
without merit and intend to defend them vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against our Predecessor, Conseco Services, LLC and two former officers
in the Circuit Court of Boone County, Indiana (Inlow et al. v. Conseco, Inc., et
al., Cause No. 06C01-0206-CT-244). The heirs assert that unvested options to
purchase 756,248 shares of our Predecessor's common stock should have been
vested at Mr. Inlow's death. The heirs further claim that if such options had
been vested, they would have been exercised, and that the resulting shares of
common stock would have been sold for a gain of approximately $30 million based
upon a stock price of $58.125 per share, the highest stock price during the
alleged exercise period of the options. We believe the heirs' claims are without
merit and will defend the action vigorously. The maximum exposure to the Company
for this lawsuit is estimated to be $33 million. The heirs did not file a proof
of claim with 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 (now known as Conseco Life Insurance Company), both
purported nationwide class actions seeking unspecified damages, were
consolidated
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CONSECO, INC. AND SUBSIDIARIES
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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' request for a rehearing with respect
to this decision has been denied. Philadelphia Life has filed a summary judgment
motion with respect to the remaining claims. This summary judgment was denied in
February 2004. In March 2004, the remaining plaintiff filed a motion to
substitute plaintiff, to which Philadelphia Life has objected. We expect the
court to set a trial date during the June 2005 trial term. 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 paying via premium
modes other than annual. We retained liability for this litigation in connection
with the sale of Manhattan National Life in June 2002. We believe this lawsuit
is without merit and intend to defend it vigorously. 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 paying via 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. On
November 10, 2003, the court denied the motion for class certification. On
January 26, 2004, the plaintiff appealed the trial court's ruling denying class
certification. All further proceedings have been stayed pending the outcome of
the appeal. The defendants believe this lawsuit is without merit and intend to
defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted
with certainty.
The Company's subsidiaries, Conseco Life Insurance Company and Bankers Life
and Casualty Company, have recently been named in multiple purported class
actions and individual lawsuits alleging, among other things, breach of contract
with regard to a change made in the way monthly deductions are calculated for
insurance coverage. This change was the adjustment of a non-guaranteed element,
which was not in the applicable policy form. The specific lawsuits include:
David Barton v. Conseco Life Insurance Company, Case No. 04-20048-CIV-MORENO
(Southern District, Florida); Stephen Hook, an individual, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Bankers
Life and Casualty Company and Does 1 through 10, Case No. CGC-04-428872
(Superior Court, San Francisco County, California); Donald King, as Trustee of
the Irrevocable Trust of Arnold L. King v. Conseco Life Insurance Company, Case
No. 1: 04CV0163 (Northern District, Ohio); Michael S. Kuhn, on behalf of himself
and all others similarly situated v. Conseco Life Insurance Company and Does 1
through 100, Case No. 03-416786 (Superior Court, San Francisco County,
California); Sidney H. Levine and Judith A. Levine v. Conseco Life Insurance
Company, Mark F. Peters Insurance Services, Inc. Hon. John Garamendi (in his
capacity as Insurance Commissioner for the State of California) and Does 1
through 10, Case No. 04 CV 125 LAB (BLM) (Southern District, California); Edwin
Jacob "Jake" Garn et al. v. Conseco Life Insurance Company, Case No.
29D02-0312-PL-1034 (Superior Court, Hamilton County, Indiana); Edward M.
Medvene, an Individual, and Sherwin Samuels and Miles Rubin, as Trustees of the
Edward Medvene 2984 Insurance Trust v. Conseco Life Insurance Company, Case No.
CV04-846-AHM (MCX) (Central District, California); Edwin Jacob "Jake" Garn, on
Behalf of Himself and All Others Similarly Situated v. Conseco Life Insurance
Company, Case No. 1:04-CV-0514SEB-VSS (Southern District, Indiana); Steven Rose,
on Behalf of Himself and All Others Similarly Situated, and on Behalf of the
General Public for the State of California vs. Conseco Life Insurance Company,
Case No. GIC 827178 (Superior Court, San Diego County, California); Murray
Gomer, Murray Gomer Irrevocable Trust, individually, and on behalf of the class
of all others similarly situated, and on behalf of the General Public v. Conseco
Life Insurance Company, successor to Philadelphia Life Insurance Company and
formerly known as Massachusetts General Life Insurance Company, Case No.
CV04-1409-SJO (RNDX) (Central District, California); James S. Farley and Judy B.
Farley, individually and on behalf of all others similarly situated, and on
behalf of the general public vs. Conseco Life Insurance Company, Case No.
C-041563 ED (Northern District, California); H. Lee Druckman, Druckman, Trust,
individually and on behalf of class of all others similarly situated, and on
behalf of general public v. Conseco Life Insurance Company, Case No.
CV04-3031-DT-VBKX (Central District of California); and Myron L. Glucksman and
Dr. Ronald Einhorn as trustee of the Jonathan Alexander Irrevocable Trust, on
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CONSECO, INC. AND SUBSIDIARIES
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behalf of themselves and all others similarly situated v. Conseco Life Insurance
Company, Case No. 04C-3039 (Northern District of Illinois). In those cases
pending in Federal court, motions to stay and to consolidate have been or will
be filed pursuant to Federal multidistrict litigation rules. We believe these
lawsuits are without merit and intend to defend them vigorously. The ultimate
outcome of the lawsuits cannot be predicted with certainty.
On February 7, 2003, the Company's subsidiary, Conseco Life Insurance
Company, was named in a purported Texas statewide class action seeking
unspecified damages in the County Court of Cameron County, Texas (Lawrence
Onderdonk and Yolanda Carrizales v. Conseco Life Insurance Company, and Pete
Ramirez, III Cause No. 2003-CCL-102-C). On February 12, 2004, the complaint was
amended to allege a purported nationwide class and to name Conseco Services, LLC
as an additional defendant. On March 5, 2004, the complaint was amended a second
time naming additional plaintiffs. The purported class consists of all former
Massachusetts General Flexible Premium Adjustable Life Insurance Policy
policyholders who were converted to Conseco Life Flexible Premium Adjustable
Life Insurance Policies and whose accumulated values in the Massachusetts
General policies were applied to first year premiums on the Conseco Life
policies. The complaint alleges, among other things, civil conspiracy to convert
the accumulated cash values of the plaintiffs and the class, and the violation
of insurance laws nationwide. We believe this lawsuit is without merit and
intend to defend it vigorously. The ultimate outcome of the lawsuit cannot be
predicted with certainty.
On December 30, 2002 and December 31, 2002, five suits were filed in
various Mississippi counties against Conseco Life Insurance Company (Kathie
Allen, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Jones
County, Mississippi, Cause No. 2002-448-CV12; Malcolm Bailey, et al. v. Conseco
Life Insurance Company, et al., Circuit Court of Claiborne County, Mississippi,
Cause No. CV-2002-371; Anthony Cascio, et al. v. Conseco Life Insurance Company,
et al, Circuit Court of LeFlore County, Mississippi, Cause No.
CV-2002-0242-CICI; William Garrard, et al. v. Conseco Life Insurance Company, et
al., Circuit Court of Sunflower County, Mississippi, Cause No. CV-2002-0753-CRL;
and William Weaver, et al. v. Conseco Life Insurance Company, et al., Circuit
Court of LeFlore County, Mississippi, Cause No. CV-2002-0238-CICI) alleging,
among other things, a "vanishing premium" scheme. Conseco Life removed all of
the cases to the U.S. District Courts in Mississippi. In September 2003,
plaintiffs' motion to remand was denied in the Garrard and Weaver matters, but
granted in the Cascio matter. In November 2003, Conseco Life filed motions for
summary judgment in the Garrard and Weaver matters. No ruling has been made on
these motions. In November 2003, Conseco Life again removed the Cascio matter to
U.S. District Court. In April 2004, the Cascio matter was remanded to state
court. Conseco Life awaits the court's ruling on plaintiff's motion to remand in
the Allen matter. In Bailey the parties have agreed to a settlement. Conseco
Life believes the lawsuits are without merit and intends to defend them
vigorously. The ultimate outcome of the lawsuits cannot be predicted with
certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other arbitrations and lawsuits, including purported class actions,
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
Other Proceedings
On September 18, 2003, the Company received a grand jury subpoena from the
U.S. District Court for the Southern District of Indiana in connection with a
Department of Justice investigation requiring production of documents relating
to the valuation of interest-only securities held by CFC, our Predecessor's
former finance subsidiary, contemporaneous earnings estimates for the
Predecessor, certain personnel records and other accounting and financial
disclosure records for the period June 1, 1998 to June 30, 2000. The Company has
subsequently received follow-up grand jury document subpoenas concerning other
matters. All of these follow-up requests have been limited to the time period
prior to the December 17, 2002 bankruptcy filing. The Company has been advised
by the Department of Justice that neither it nor any of its current directors or
employees are subjects or targets of this investigation. The Company is
cooperating fully with the Department of Justice investigation.
On March 10, 2004, we entered into a settlement with the SEC in connection
with the SEC's investigation of 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 our Predecessor's writedown
and restatement in the spring of 2000, and were the subject of shareholder class
action litigation, which we settled in the second quarter of 2003. Without
admitting or denying the SEC's findings, we consented to the entry of a
cease-and-desist order requiring future compliance with periodic reporting,
record
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CONSECO, INC. AND SUBSIDIARIES
-------------------
keeping, internal control and other provisions of the securities laws. The
settlement did not impose any fine or monetary penalty, or require us to restate
any of our historical financial statements.
On October 29, 2003, the New York Attorney General served Conseco Life
Insurance Company of Texas ("Conseco Life") with a document subpoena concerning
customer transfers between mutual fund subaccounts offered by CVIC, a former
wholly-owned subsidiary of Conseco Life, that occurred prior to the sale of CVIC
to an unrelated third party in October 2002. The SEC served the Company with a
similar subpoena shortly after we received the Attorney General's subpoena.
Certain of our employees have also received subpoenas regarding duties they
previously performed in respect of annuity sales by CVIC. The purchase agreement
pursuant to which CVIC was sold contains indemnification provisions with respect
to certain liabilities relating to Conseco Life's period of ownership, including
provisions concerning certain business activities, including marketing
activities, of CVIC. Conseco Life and the Company have cooperated with the
Attorney General and the SEC in producing documents responsive to their
subpoenas. In January 2004, the Company received telephonic notification of a
potential enforcement action by the Attorney General and a Wells notification
from the SEC regarding alleged market timing on the part of holders of variable
annuity policies issued by CVIC. The Company and its affiliates have not issued
any variable annuity policies since the sale of CVIC. The Company and Conseco
Life believe, based on the information obtained and supplied to the
investigators to date, that CVIC violated no federal or state law prior to the
October 2002 sale. The investigations are continuing and their outcome cannot be
predicted with certainty. In other cases involving the investigation of market
timing allegedly permitted by mutual fund managers, the SEC and state regulators
have sought to impose penalties far in excess of the alleged losses to the
investing public, and we cannot assure you that they would not seek to do so
with us. The Company and Conseco Life are cooperating fully with the Attorney
General and the SEC in these investigations.
The deadline to file administrative claims in the bankruptcy proceeding was
October 9, 2003. The Plan provides that all such claims must be paid in full, in
cash. We are reviewing all timely filed administrative claims and may resolve
disputes regarding allowance of such claims in the Bankruptcy Court. The amount
of known disputed administrative claims as of April 27, 2004 was approximately
$.1 million.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a) Exhibits.
12.1 Computation of Ratio of Earnings to Fixed Charges and
Preferred Dividends.
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 January 12, 2004, was filed with the
Commission to report under Items 5 and 7, a press release announcing
the conversion price of its Class A Senior Cumulative Convertible
Exchangeable Preferred Stock.
A report on Form 8-K dated January 29, 2004, was filed with the
Commission to report under Items 7 and 9, a press release announcing
the filing of a registration statement with the Commission on Form
S-1.
A report on Form 8-K dated February 10, 2004, was filed with the
Commission to report under Items 7 and 9, a press release to announce
the declaration of a dividend on the outstanding shares of Class A
Senior Cumulative Convertible Exchangeable Preferred Stock.
A report on Form 8-K dated March 10, 2004, was filed with the
Commission to report under Items 9 and 12, a press release with an
announcement that the Company had entered into a settlement with the
Commission and with financial information for the year ended December
31, 2003.
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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: May 10, 2004 By: /s/ William J. Shea
---------------------------------
William J. Shea, President and
Chief Executive Officer
80