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 September 30, 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 November 1, 2004: 151,126,610
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
Successor
---------------------------------
September 30, December 31,
2004 2003
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
September 30, 2004 - $20,745.9; December 31, 2003 - $19,470.7)....................... $21,306.3 $19,840.1
Equity securities at fair value (cost: September 30, 2004 - $62.5;
December 31, 2003 - $71.8)........................................................... 67.6 74.5
Mortgage loans......................................................................... 1,089.4 1,139.5
Policy loans........................................................................... 465.9 503.4
Trading securities..................................................................... 908.9 915.1
Other invested assets ................................................................. 133.2 324.1
--------- ---------
Total investments.................................................................. 23,971.3 22,796.7
Cash and cash equivalents:
Unrestricted........................................................................... 1,078.0 1,228.7
Restricted............................................................................. 18.9 31.9
Accrued investment income................................................................. 318.1 315.5
Value of policies in force at the Effective Date.......................................... 2,706.9 2,949.5
Cost of policies produced................................................................. 327.7 101.8
Reinsurance receivables................................................................... 967.6 983.9
Income tax assets......................................................................... 12.2 24.6
Goodwill.................................................................................. 785.3 952.2
Other intangible assets................................................................... 149.4 155.2
Assets held in separate accounts.......................................................... 31.9 37.7
Other assets.............................................................................. 558.9 395.8
--------- ---------
Total assets....................................................................... $30,926.2 $29,973.5
========= =========
(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
--------------------------------
September 30, December 31,
2004 2003
---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products............................................................ $12,432.5 $12,480.4
Traditional products................................................................... 11,589.5 11,485.2
Claims payable and other policyholder funds............................................ 922.3 892.3
Liabilities related to separate accounts............................................... 31.9 37.7
Other liabilities........................................................................ 847.8 573.0
Investment borrowings.................................................................... 584.8 387.3
Notes payable - direct corporate obligations............................................. 788.6 1,300.0
--------- ---------
Total liabilities.................................................................. 27,197.4 27,155.9
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Preferred stock.......................................................................... 667.8 887.5
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: September 30, 2004 - 151,123,275; December 31, 2003 -
100,115,772)........................................................................... 1.5 1.0
Additional paid-in-capital............................................................... 2,535.8 1,641.9
Accumulated other comprehensive income................................................... 302.8 218.7
Retained earnings........................................................................ 220.9 68.5
--------- ---------
Total shareholders' equity......................................................... 3,728.8 2,817.6
--------- ---------
Total liabilities and shareholders' equity......................................... $30,926.2 $29,973.5
========= =========
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 One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Insurance policy income.............................................. $ 737.8 $256.2 $ 516.8
Net investment income:
General account invested assets.................................... 329.7 106.0 232.5
Policyholder and reinsurer accounts................................ (9.8) (2.1) 11.7
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc...................................... - (2.7) 2.0
Net realized investment gains (losses)............................. 6.0 6.7 (35.9)
Fee revenue and other income......................................... 5.2 2.2 9.0
-------- ------ ---------
Total revenues................................................... 1,068.9 366.3 736.1
-------- ------ ---------
Benefits and expenses:
Insurance policy benefits............................................ 688.4 243.3 390.9
Provision for losses................................................. - - 24.5
Interest expense (contractual interest of $73.7 for the two
months ended August 31, 2003)...................................... 12.9 7.0 55.4
Amortization......................................................... 91.9 26.9 61.3
Other operating costs and expenses................................... 170.8 51.3 108.0
Reorganization items................................................. - - (2,163.0)
-------- ------- ---------
Total benefits and expenses...................................... 964.0 328.5 (1,522.9)
-------- ------ ---------
Income before income taxes....................................... 104.9 37.8 2,259.0
Income tax expense on period income..................................... 37.6 13.6 17.7
-------- ------ ---------
Net income....................................................... 67.3 24.2 2,241.3
Preferred stock dividends............................................... 9.4 5.3 -
-------- ------ ---------
Net income applicable to common stock............................ $ 57.9 $ 18.9 $ 2,241.3
======== ====== =========
(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 One month
ended ended
September 30, September 30,
2004 2003
---- ----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 150,885,000 100,098,000
=========== ===========
Net income................................................. $.38 $.19
==== ====
Diluted:
Weighted average shares outstanding........................ 189,195,000 144,671,000
=========== ===========
Net income................................................. $.36 $.17
==== ====
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor Predecessor
-------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Insurance policy income............................................. $2,223.2 $256.2 $ 2,204.3
Net investment income:
General account invested assets................................... 960.1 106.0 928.4
Policyholder and reinsurer accounts............................... (8.9) (2.1) 30.1
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc..................................... - (2.7) 10.5
Net realized investment gains (losses)............................ 27.5 6.7 (5.4)
Fee revenue and other income........................................ 17.1 2.2 35.5
-------- ------ ---------
Total revenues.................................................. 3,219.0 366.3 3,203.4
-------- ------ ---------
Benefits and expenses:
Insurance policy benefits........................................... 2,074.6 243.3 2,136.4
Provision for losses................................................ - - 55.6
Interest expense (contractual interest of $268.5 for the eight months
ended August 31, 2003)............................................ 65.1 7.0 202.5
Amortization........................................................ 272.4 26.9 343.7
Gain on extinguishment of debt...................................... (2.8) - -
Other operating costs and expenses.................................. 485.6 51.3 423.5
Reorganization items................................................ - - (2,130.5)
-------- ------ ---------
Total benefits and expenses..................................... 2,894.9 328.5 1,031.2
-------- ------ ---------
Income before income taxes and discontinued operations.......... 324.1 37.8 2,172.2
Income tax expense (benefit) on period income.......................... 115.7 13.6 (13.5)
-------- ------ ---------
Income before discontinued operations........................... 208.4 24.2 2,185.7
Discontinued operations, net of income taxes........................... - - 16.0
-------- ------ ---------
Net income...................................................... 208.4 24.2 2,201.7
Preferred stock dividends.............................................. 56.0 5.3 -
-------- ------ ---------
Net income applicable to common stock........................... $ 152.4 $ 18.9 $ 2,201.7
======== ====== =========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor
---------------------------------
Nine months One month
ended ended
September 30, September 30,
2004 2003
---- ----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 126,016,000 100,098,000
=========== ===========
Net income................................................. $1.21 $.19
===== ====
Diluted:
Weighted average shares outstanding........................ 145,592,000 144,671,000
=========== ===========
Net income................................................. $1.15 $.17
===== ====
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital income (loss) (deficit)
----- ----- --------------- ------------- -------
Successor balance, January 1, 2004................... $ 2,817.6 $ 887.5 $ 1,642.9 $ 218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 208.4 - - - 208.4
Change in unrealized appreciation of
investments (net of applicable income tax
expense of $46.1)............................. 84.1 - - 84.1 -
---------
Total comprehensive income.................. 292.5
Issuance of shares for stock options and
for employee benefit plans.................... 12.2 - 12.2 - -
Issuance of mandatorily convertible
preferred stock, net.......................... 667.8 667.8 - - -
Redemption of cumulative convertible
exchangeable preferred stock.................. (928.9) (928.9) - - -
Issuance of common stock, net................... 882.2 - 882.2 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 41.4 41.4 - - -
Dividends on preferred stock.................... (56.0) - - - (56.0)
--------- ------- --------- ------- ---------
Successor balance, September 30, 2004................ $ 3,728.8 $ 667.8 $ 2,537.3 $ 302.8 $ 220.9
========= ======= ========= ======= =========
Predecessor balance, January 1, 2003................. $(2,050.4) $ 501.7 $ 3,497.0 $ 580.6 $(6,629.7)
Comprehensive income, net of tax:
Net income...................................... 2,201.7 - - - 2,201.7
Change in unrealized appreciation
of investments (net of applicable income tax
benefit of nil)............................... (151.6) - - (151.6) -
---------
Total comprehensive income.................. 2,050.1
Change in shares for employee benefit plans....... .3 - .3 - -
---------- -------- --------- ------- ---------
Predecessor balance, August 31, 2003................. - 501.7 3,497.3 429.0 (4,428.0)
Elimination of Predecessor's
equity securities................................. (3,999.0) (501.7) (3,497.3) - -
Issuance of Successor's
equity securities................................. 2,500.0 859.7 1,640.3 - -
Fresh start adjustments.............................. 3,999.0 - - (429.0) 4,428.0
--------- ------- --------- ------- ---------
Successor balance, August 31, 2003................... 2,500.0 859.7 1,640.3 - -
Comprehensive income, net of tax:
Net income...................................... 24.2 - - - 24.2
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $154.4)............................ 273.2 - - 273.2 -
---------
Total comprehensive income.................. 297.4
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 5.3 5.3 - - -
Dividends on preferred stock.................... (5.3) - - - (5.3)
--------- ------- --------- ------- ---------
Successor balance, September 30, 2003................ $ 2,797.4 $ 865.0 $ 1,640.3 $ 273.2 $ 18.9
========= ======= ========= ======= =========
The accompanying notes are an integral part
of the consolidated financial statements.
8
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Successor Predecessor
---------------------------------- --------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Cash flows from operating activities:
Insurance policy income............................................ $ 1,931.7 $ 223.7 $ 1,876.2
Net investment income.............................................. 1,082.6 103.6 928.6
Fee revenue and other income....................................... 17.1 2.2 35.5
Insurance policy benefits.......................................... (1,523.4) (178.1) (1,461.2)
Interest expense................................................... (60.4) - -
Policy acquisition costs........................................... (267.1) (25.6) (287.5)
Reorganization items............................................... - - (26.5)
Other operating costs.............................................. (418.8) (73.6) (362.0)
Taxes.............................................................. 11.7 .3 44.2
---------- --------- ---------
Net cash provided by operating activities........................ 773.4 52.5 747.3
---------- --------- ---------
Cash flows from investing activities:
Sales of investments............................................... 9,947.7 2,121.9 5,378.9
Maturities and redemptions of investments.......................... 1,450.0 288.7 1,854.7
Purchases of investments........................................... (12,396.4) (1,225.6) (7,385.9)
Consolidation of partnership which held General Motors building.... - 28.4 -
Change in restricted cash.......................................... 13.0 (17.0) 26.2
Other.............................................................. (35.5) 4.3 (19.6)
---------- --------- ---------
Net cash provided (used) by investing activities ................ (1,021.2) 1,200.7 (145.7)
---------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net..................................... 790.2 - -
Issuance of preferred stock, net................................... 667.8 - -
Issuance of common stock, net...................................... 882.3 - -
Payments on notes payable.......................................... (1,302.0) - -
Redemption of preferred stock...................................... (928.9) - -
Amounts received for deposit products.............................. 1,203.3 121.8 1,272.7
Withdrawals from deposit products.................................. (1,399.7) (133.1) (1,784.2)
Investment borrowings.............................................. 197.5 (700.0) (145.3)
Dividends paid on preferred stock.................................. (9.8) - -
Other.............................................................. (3.6) - -
---------- --------- ---------
Net cash provided (used) by financing activities............... 97.1 (711.3) (656.8)
---------- --------- ---------
Net increase (decrease) in cash and cash equivalents........... (150.7) 541.9 (55.2)
Cash and cash equivalents, beginning of period........................ 1,228.7 1,162.4 1,217.6
---------- --------- ---------
Cash and cash equivalents, end of period.............................. $ 1,078.0 $ 1,704.3 $ 1,162.4
========== ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
9
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 $70.9
million in the eight months ended August 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.
The balance sheet at December 31, 2003, presented herein, has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect various
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions in calculating values for the cost of policies produced, the
cost of policies purchased,
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
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.
REORGANIZATION ITEMS
Reorganization items represent amounts the Predecessor incurred as a result
of its Chapter 11 reorganization, and are presented separately in the
consolidated statement of operations. These items consist of the following
(dollars in millions):
Two months Eight months
ended ended
August 31, 2003 August 31, 2003
--------------- ---------------
Gain on discharge of prepetition liabilities......... $ 3,151.4 $ 3,151.4
Fresh start adjustments.............................. (950.0) (950.0)
Professional fees.................................... (38.4) (70.9)
--------- ---------
Total reorganization items....................... $ 2,163.0 $ 2,130.5
========= =========
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.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 $166.9 million and $189.4 million in the nine
months ended September 30, 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.
Changes in the carrying amount of goodwill are as follows (dollars in
millions):
Successor
-----------
Nine months
ended
September 30,
2004
----
Goodwill balance, beginning of period.................................. $ 952.2
Recognition of tax valuation reserve established at the
Effective Date.................................................... (166.9)
-------
Goodwill balance, end of period........................................ $ 785.3
=======
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 $908.9
million at September 30, 2004. The change in the market value of these
securities is recognized currently in investment income (classified as income
from policyholder and reinsurer accounts).
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Accumulated other comprehensive income is primarily comprised of unrealized
appreciation on actively managed fixed maturity investments. These amounts,
included in shareholders' equity as of September 30, 2004, and December 31,
2003, were as follows (dollars in millions):
Successor
------------------------------
September 30, December 31,
2004 2003
---- ----
Net unrealized appreciation on investments............................................ $ 568.1 $ 375.2
Adjustments to value of policies inforce at the Effective Date........................ (89.0) (33.5)
Adjustment to cost of policies produced............................................... (7.2) -
Deferred income tax liability......................................................... (169.1) (123.0)
------- -------
Accumulated other comprehensive income........................................... $ 302.8 $ 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). We recognized venture capital
investment income (losses) of $(2.7) million in the one month ended September
30, 2003; $2.0 million in the two months ended August 31, 2003; and $10.5
million in the eight months ended August 31, 2003, related to this investment.
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. Our future
estimated gross profits used to determine the value of policies inforce at the
Effective Date and the amortization of these costs, reflect assumptions that
current expense levels that exceed product pricing, will decline over time. If
we are unable to achieve such cost savings, the profitability of the policies
inforce at the Effective Date will be adversely affected.
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.
In accordance with Statement of Financial Accounting Standards No. 97
"Accounting and Reporting by Insurance Enterprises for Certain Long-Duration
Contracts and Realized Gains and Losses from the Sale of Investments" ("SFAS
97"), we are required to amortize the value of policies inforce in relation to
estimated gross profits for universal life-type products and investment-type
products. SFAS 97 also requires that estimates of expected gross profits used as
a basis for amortization be evaluated regularly, and that the total amortization
recorded to date be adjusted by a charge or credit to the statement of
operations, if actual experience or other evidence suggests that earlier
estimates should be revised.
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
During the second quarter of 2004, we evaluated certain amortization
assumptions used to estimate gross profits for universal life-type products and
investment-type products by comparing them to our actual experience. We made
refinements to the previous assumptions related to investment income to match
the actual experience and our estimates for future assumptions. The changes we
made did not affect our expectations for the total estimated profits to be
earned on this business, but did affect how we expect the profits to emerge over
time. These new assumptions resulted in a retroactive reduction to the
amortization of the value of policies inforce at the Effective Date of $7.7
million in the second quarter of 2004.
EARNINGS PER SHARE
A reconciliation of net income and shares used to calculate basic and
diluted earnings per share is as follows:
Successor
----------------------------------------------------
Three months Nine months One month
ended ended ended
September 30, September 30, September 30,
2004 2004 2003
---- ---- ----
(Dollars in millions and
shares in thousands)
Net income................................................. $67.3 $208.4 $24.2
Preferred stock dividends.................................. (9.4) (56.0) (5.3)
----- ------ ------
Net income applicable to common stock
for basic earnings per share.......................... 57.9 152.4 18.9
Effect of dilutive securities:
Preferred stock dividends............................... 9.4 14.7 5.3
----- ------ -----
Net income applicable to common stock for diluted
earnings per share.................................... $67.3 $167.1 $24.2
===== ====== =====
Shares:
Weighted average shares outstanding
for basic earnings per share.......................... 150,885 126,016 100,098
Effect of dilutive securities on weighted average shares:
Class B mandatorily convertible preferred stock....... 37,809 19,054 -
Class A convertible exchangeable preferred stock...... - - 44,566
Stock options and employee benefit plans.............. 501 522 7
------- ------- -------
Weighted average shares outstanding for diluted
earnings per share.................................... 189,195 145,592 144,671
======= ======= =======
For the nine months ended September 30, 2004, equivalent common shares of
26.5 million related to the assumed conversion of Class A convertible
exchangeable preferred stock were not included in the computation of diluted
earnings per share because doing so would have been antidilutive.
Basic earnings per common share is computed by dividing income applicable
to common stock by the weighted average number of common shares outstanding for
the period. Restricted shares are not included in basic earnings per share until
vested. Diluted earnings per share reflects the potential dilution that could
occur if outstanding stock options were exercised and restricted stock was
vested. The dilution from 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
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Net income, as reported ............................................. $67.3 $24.2 $2,241.3
Less stock-based employee compensation ..expense
determined under the fair value based method
for all awards, net of income taxes............................. (2.1) - 2.0
----- ----- --------
Pro forma net income................................................. $65.2 $24.2 $2,243.3
===== ===== ========
Earnings per share:
Basic, as reported.............................................. $ .38 $ .19
Basic, pro forma................................................ .37 .19
Diluted, as reported............................................ $ .36 $ .17
Diluted, pro forma.............................................. .34 .17
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Net income, as reported ............................................. $208.4 $24.2 $2,201.7
Less stock-based employee compensation ..expense
determined under the fair value based method
for all awards, net of income taxes............................. (3.2) - (7.2)
------ ----- --------
Pro forma net income................................................. $205.2 $24.2 $2,194.5
====== ===== ========
Earnings per share:
Basic, as reported.............................................. $ 1.21 $.19
Basic, pro forma................................................ 1.18 .19
Diluted, as reported............................................ $ 1.15 $.17
Diluted, pro forma.............................................. 1.13 .17
All outstanding stock options of the Predecessor were cancelled pursuant to
the Plan. Pro forma compensation expense in the two and eight months ended
August 31, 2003, has been reduced by $5.0 million due to the reversal of expense
for options that were not vested upon cancellation of the outstanding stock
options of the Predecessor.
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.
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Operating information regarding our segments was as follows (dollars in
millions):
Successor Predecessor
--------------------------------- -------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.............................................. $ 13.4 $ 5.0 $ 9.2
Supplemental health.................................... 295.1 95.5 191.2
Life................................................... 42.7 10.2 24.6
Other.................................................. 4.1 1.0 2.0
Net investment income (a)................................... 105.1 31.0 68.6
Fee revenue and other income (a)............................ .1 .4 .2
Net realized investment gains (a)........................... 2.5 2.8 1.7
--------- ------ ------
Total Bankers Life segment revenues................ 463.0 145.9 297.5
--------- ------ ------
Conseco Insurance Group:
Insurance policy income:
Annuities.............................................. 6.1 2.3 6.8
Supplemental health.................................... 178.7 62.4 123.2
Life................................................... 96.0 33.4 70.2
Other.................................................. 3.4 4.8 6.5
Net investment income (a)................................... 172.1 59.3 145.7
Fee revenue and other income (a)............................ 1.0 - 4.9
Net realized investment gains (losses) (a).................. 2.5 3.7 (36.9)
--------- ------ ------
Total Conseco Insurance Group
segment revenues............................... 459.8 165.9 320.4
--------- ------ ------
Other Business in Run-Off:
Insurance policy income - supplemental health............... 98.3 41.6 83.1
Net investment income (a)................................... 41.8 13.5 26.7
Fee revenue and other income (a)............................ .1 .3 .1
Net realized investment gains (a)........................... 1.0 .6 .9
--------- ------ ------
Total Other Business in Run-Off
segment revenues............................... 141.2 56.0 110.8
--------- ------ ------
Corporate:
Net investment income (a)................................... .9 .1 3.2
Venture capital income (loss) related to investment
in AWE................................................... - (2.7) 2.0
Fee and other income (a).................................... 4.0 1.5 3.8
Net realized investment gains (losses) (a).................. - (.4) (1.6)
--------- ------ ------
Total corporate segment revenues................... 4.9 (1.5) 7.4
--------- ------ ------
Total revenues..................................... 1,068.9 366.3 736.1
--------- ------ ------
(continued on next page)
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Successor Predecessor
------------------------------------ --------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits...................................... $318.1 $ 94.5 $ 205.3
Amortization................................................... 48.8 15.5 29.1
Interest expense on investment borrowings...................... .6 .2 .6
Other operating costs and expenses............................. 41.3 10.8 19.5
------ ------ ---------
Total Bankers Life segment expenses....................... 408.8 121.0 254.5
------ ------ ---------
Conseco Insurance Group:
Insurance policy benefits...................................... 274.0 105.8 4.5
Amortization................................................... 39.0 9.9 24.1
Interest expense on investment borrowings...................... 1.3 .4 1.3
Other operating costs and expenses............................. 77.5 29.0 59.7
------ ------ ---------
Total Conseco Insurance Group segment
expenses................................................ 391.8 145.1 89.6
------ ------ ---------
Other Business in Run-Off:
Insurance policy benefits...................................... 96.3 43.0 181.1
Amortization................................................... 4.1 1.5 8.1
Interest expense on investment borrowings...................... - - -
Other operating costs and expenses............................. 23.3 8.1 21.1
------ ------ ---------
Total Other Business in Run-Off segment
expenses............................................... 123.7 52.6 210.3
------ ------ ---------
Corporate:
Interest expense on corporate debt............................. 11.0 6.4 53.5
Provision for losses and interest expense related
to stock purchase plan...................................... - - 24.5
Gain on extinguishment of debt................................. - - -
Other operating costs and expenses............................. 28.7 3.4 7.7
Reorganization items........................................... - - (2,163.0)
------ ------ ---------
Total corporate segment expenses.......................... 39.7 9.8 (2,077.3)
------ ------ ---------
Total expenses............................................ 964.0 328.5 (1,522.9)
------ ------ ---------
Income (loss) before income taxes and discontinued operations:
Bankers Life................................................... 54.2 24.9 43.0
Conseco Insurance Group........................................ 68.0 20.8 230.8
Other Business in Run-Off...................................... 17.5 3.4 (99.5)
Corporate operations........................................... (34.8) (11.3) 2,084.7
------ ------ ---------
Income before income taxes and
discontinued operations................................. $104.9 $ 37.8 $ 2,259.0
====== ====== =========
- -------------------
(a) It is not practicable to provide additional components of revenue by product
or services.
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.............................................. $ 39.2 $ 5.0 $ 32.9
Supplemental health.................................... 881.4 95.5 760.4
Life................................................... 116.7 10.2 91.5
Other.................................................. 9.7 1.0 7.9
Net investment income (a)................................... 307.7 31.0 258.2
Fee revenue and other income (a)............................ .6 .4 .9
Net realized investment gains (a)........................... 13.9 2.8 5.5
-------- ------ --------
Total Bankers Life segment revenues................ 1,369.2 145.9 1,157.3
-------- ------ --------
Conseco Insurance Group:
Insurance policy income:
Annuities.............................................. 17.1 2.3 51.6
Supplemental health.................................... 550.4 62.4 499.0
Life................................................... 294.3 33.4 303.9
Other.................................................. 12.1 4.8 38.3
Net investment income (a)................................... 519.1 59.3 582.6
Fee revenue and other income (a)............................ 4.3 - 17.0
Net realized investment gains (losses) (a).................. 13.6 3.7 (17.1)
-------- ------ --------
Total Conseco Insurance Group
segment revenues............................... 1,410.9 165.9 1,475.3
-------- ------ --------
Other Business in Run-Off:
Insurance policy income - supplemental health............... 302.3 41.6 418.8
Net investment income (a)................................... 123.0 13.5 101.5
Fee revenue and other income (a)............................ .6 .3 .5
Net realized investment gains (a)........................... 2.8 .6 6.3
-------- ------ --------
Total Other Business in Run-Off
segment revenues............................... 428.7 56.0 527.1
-------- ------ --------
Corporate:
Net investment income (a)................................... 1.4 .1 16.2
Venture capital income (loss) related to investment
in AWE................................................... - (2.7) 10.5
Fee and other income (a).................................... 11.6 1.5 17.1
Net realized investment losses (a).......................... (2.8) (.4) (.1)
-------- ------ --------
Total corporate segment revenues................... 10.2 (1.5) 43.7
-------- ------ --------
Total revenues..................................... 3,219.0 366.3 3,203.4
-------- ------ --------
(continued on next page)
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Successor Predecessor
---------------------------------- --------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits..................................... $ 932.8 $ 94.5 $ 795.1
Amortization.................................................. 138.1 15.5 113.9
Interest expense on investment borrowings..................... 1.7 .2 3.4
Other operating costs and expenses............................ 120.9 10.8 85.3
-------- ------ ---------
Total Bankers Life segment expenses...................... 1,193.5 121.0 997.7
-------- ------ ---------
Conseco Insurance Group:
Insurance policy benefits..................................... 848.3 105.8 746.3
Amortization.................................................. 120.7 9.9 201.8
Interest expense on investment borrowings..................... 3.4 .4 4.7
Other operating costs and expenses............................ 235.7 29.0 222.6
-------- ------ ---------
Total Conseco Insurance Group segment
expenses............................................... 1,208.1 145.1 1,175.4
-------- ------ ---------
Other Business in Run-Off:
Insurance policy benefits..................................... 293.5 43.0 595.0
Amortization.................................................. 13.6 1.5 28.0
Interest expense on investment borrowings..................... .1 - .2
Other operating costs and expenses............................ 71.7 8.1 75.2
-------- ------ ---------
Total Other Business in Run-Off segment
expenses.............................................. 378.9 52.6 698.4
-------- ------ ---------
Corporate:
Interest expense on corporate debt............................ 59.9 6.4 194.2
Provision for losses and interest expense related
to stock purchase plan..................................... - - 55.6
Gain on extinguishment of debt................................ (2.8) - -
Other operating costs and expenses............................ 57.3 3.4 40.4
Reorganization items.......................................... - - (2,130.5)
-------- ------ ---------
Total corporate segment expenses......................... 114.4 9.8 (1,840.3)
-------- ------ ---------
Total expenses........................................... 2,894.9 328.5 1,031.2
-------- ------ ---------
Income (loss) before income taxes and discontinued operations:
Bankers Life.................................................. 175.7 24.9 159.6
Conseco Insurance Group....................................... 202.8 20.8 299.9
Other Business in Run-Off..................................... 49.8 3.4 (171.3)
Corporate operations.......................................... (104.2) (11.3) 1,884.0
-------- ------ ---------
Income before income taxes and
discontinued operations................................ $ 324.1 $ 37.8 $ 2,172.2
======== ====== =========
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
20
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 $33.8 million in the first nine months of 2004; $5.2
million in the one month ended September 30, 2003; and $53.5 million in the
eight months ended August 31, 2003. 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 $20.3 million in the first nine months of 2004; $(3.1) million in the one
month ended September 30, 2003; and $83.6 million in the eight months ended
August 31, 2003. 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 $28.4 million and $119.6 million at September 30, 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 $204.7 million and $214.7
million at September 30, 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 September 30, 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 $31.4 million and $27.2 million at September 30, 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. In addition, we hold loans to
participants for interest on the loans which exceed $250 million. The former
bank loans and the
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
interest loans are collectively referred to as the "D&O loans." We regularly
evaluate the collectibility of these loans in light of the collateral we hold,
the credit worthiness of the participants and the current status of various
legal actions we have taken to collect the D&O loans. At September 30, 2004, we
have estimated that approximately $50.0 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 $23.0
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 two of the Company's former Chief Executive
Officer's employment agreements, certain wholly-owned subsidiaries of the
Company are the guarantors of the former executives' nonqualified supplemental
retirement benefits. The liability for such benefits at September 30, 2004 and
December 31, 2003 was $21.8 million and $18.1 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 $197.3 million in the first nine
months of 2004; $25.0 million in the one month ended September 30, 2003; and
$196.4 million in the eight months ended August 31, 2003. 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
$225.8 million in the first nine months of 2004; $24.9 million in the one month
ended September 30, 2003; and $199.2 million in the eight months ended August
31, 2003.
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 $53.1 million in the first nine months of 2004; $10.6 million in
the one month ended September 30, 2003; and $57.3 million in the eight months
ended August 31, 2003.
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 One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Current tax provision (benefit).................................. $(2.2) $ .6 $17.7
Deferred tax provision........................................... 39.8 13.0 -
----- ----- -----
Income tax expense on period income........................... $37.6 $13.6 $17.7
===== ===== =====
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Current tax provision (benefit).................................. $ .8 $ .6 $(13.5)
Deferred tax provision........................................... 114.9 13.0 -
------ ----- ------
Income tax expense (benefit) on period income................. $115.7 $13.6 $(13.5)
====== ===== ======
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
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
U.S. statutory corporate rate......................................... 35.0% 35.0% 35.0%
Valuation allowance................................................... - - 25.8
Gain on debt restructuring............................................ - - (39.7)
Subsidiary stock basis adjustment..................................... - - (21.8)
Other nondeductible expenses.......................................... .6 .1 (.1)
State taxes........................................................... .1 .9 .2
---- ---- -----
Effective tax rate........................................... 35.7% 36.0% (.6)%
==== ==== =====
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
Successor
--------------------------------
September 30, December 31,
2004 2003
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to worthless investment in Conseco Finance Corp........... $ 1,545.6 $ 1,183.0
Other.......................................................................... 177.0 84.2
Capital loss carryforwards........................................................ 396.8 411.2
Deductible temporary differences:
Insurance liabilities.......................................................... 1,677.0 1,688.0
Reserve for loss on loan guarantees............................................ 207.3 217.2
--------- ---------
Gross deferred tax assets.................................................... 4,003.7 3,583.6
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (79.6) (80.9)
Cost of policies purchased and cost of policies produced....................... (738.8) (716.3)
Unrealized appreciation of investments......................................... (169.1) (123.0)
Other.......................................................................... (328.3) (301.3)
--------- ---------
Gross deferred tax liabilities............................................... (1,315.8) (1,221.5)
--------- ---------
Valuation allowance............................................................ (2,687.9) (2,362.1)
--------- ---------
Net deferred tax assets...................................................... - -
Current income taxes prepaid.......................................................... 12.2 24.6
--------- ---------
Net income tax assets................................................................. $ 12.2 $ 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. At the request of the Company, the IRS has commenced its
examination of the Company for years ending December 31, 2002 through 2003. 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, and is expected to resolve the Section 382
limitation and the life insurance limitation issues more fully discussed later.
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 deferred tax assets totaled $2.7 billion at September 30,
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 an ongoing 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 September 30, 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
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. Changes in our valuation allowance
are summarized as follows (dollars in millions):
Balance at December 31, 2003............................................. $2,362.1
Realization of deferred income taxes recognized
in the current period(a)............................................ (114.9)
Release of tax valuation reserve related to unrealized
gains during the period(a).......................................... (46.1)
Recovery of amounts related to our bankruptcy and
state taxes(a)...................................................... (5.9)
Increase in deferred tax assets related to the worthlessness
of CFC as further discussed below................................... 500.1
Other.................................................................. (7.4)
--------
Balance at September 30, 2004............................................ $2,687.9
========
- --------------
(a) Goodwill has a corresponding reduction for these items.
As of September 30, 2004, we had $4.9 billion of net operating loss
carryforwards and $1.1 billion of capital 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 (dollars in millions):
Operating loss carryforwards Capital loss carryforwards
------------------------------------------- -----------------------------------------
Year of expiration Subject to ss.382 Not subject to ss.382 Subject to ss.382 Not subject to ss.382
------------------ ----------------- --------------------- ----------------- ---------------------
2005........................... $ .2 $ - $ 2.7 $ -
2006........................... .1 - 5.5 -
2007........................... 5.8 - 484.4 -
2008 .......................... 1.5 - 583.7 -
2009........................... 10.5 - - 57.4
2010........................... 3.6 - - -
2011........................... .5 - - -
2016........................... 20.9 - - -
2017........................... 51.3 - - -
2018........................... 57.8 4,452.4 - -
2019........................... .7 - - -
2020........................... .7 - - -
2023........................... 292.4 - - -
2024........................... - 23.1 - -
------ -------- -------- -----
Total.......................... $446.0 $4,475.5 $1,076.3 $57.4
====== ======== ======== =====
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.
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
At the fresh-start date, we were required to estimate our tax basis in CFC
in order to determine the tax loss carryforward related to the worthlessness of
CFC. The determination of this amount and how the loss is recognized was subject
to varied interpretations of various tax laws and regulations. During the third
quarter of 2004, the Company and the IRS entered into a closing agreement which
determined that the tax loss recognized on the worthlessness of CFC was $6.7
billion, instead of our original estimate of $5.4 billion. This determination
resulted in $500.1 million of additional deferred tax assets being recognized.
We also recognized a $500.1 million valuation allowance, as we have deemed it
more likely than not that the deferred tax assets will not be realized. As this
increase relates to the period prior to our emergence from bankruptcy, a
reduction of any portion of the deferred income tax valuation allowance will be
accounted for as a reduction of goodwill pursuant to SOP 90-7.
The closing agreement with the IRS also determined that the loss recognized
on the worthlessness of CFC is an ordinary loss for tax purposes and not a
capital loss.
The following paragraphs summarize some of the unresolved limitations and
contingencies which exist with respect to the future utilization of the net
operating loss carryforwards.
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 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 address this matter during its examination of our tax returns for
calendar years 2002-2003.
The timing and manner in which the Company will be able to utilize some or
all of its net operating loss 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).
When the Company filed its 2003 federal income tax return, it elected to
specifically identify transactions in each period and record it in the period it
actually occurred. We believe this election will result in 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. The IRS has informed the
Company that it will address this matter during its examination of our tax
returns for calendar years 2002-2003.
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CHANGES IN DIRECT CORPORATE OBLIGATIONS
Notes payable representing direct corporate obligations of the Company at
September 30, 2004 and December 31, 2003, were as follows (dollars in millions):
Successor
-------------------------------
September 30, December 31,
2004 2003
---- ----
$800.0 million secured credit agreement ("Credit Facility")............................. $798.0 $ -
$1.3 billion credit agreement ("Previous Credit Facility").............................. - 1,300.0
Unamortized issuance costs.............................................................. (9.4) -
------ --------
Direct corporate obligations....................................................... $788.6 $1,300.0
====== ========
In the second quarter of 2004, our Previous Credit Facility was repaid as
follows: (i) $620.0 million from the proceeds from our issuance of common and
preferred stock as further discussed in the note entitled "Changes in Common
Stock and Preferred Stock"; (ii) $674.3 million from amounts borrowed under our
Credit Facility; as further described below; and (iii) a $5.7 million required
prepayment pursuant to a provision in the Previous Credit Facility. The
repayment of the Previous Credit Facility resulted in a gain from the
extinguishment of debt totaling $2.8 million. The gain resulted from the release
of a $6.3 million accrual for a fee that would have been required to be paid
under the Previous Credit Facility, partially offset by the write-off of
unamortized amendment fees.
In January 2004, our Previous 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 Previous Credit
Facility was further amended to change the definition of a financial ratio we
were required to maintain. The change was made to clarify how the ratio was
calculated. The definition in the amended facility was consistent with
calculations used to determine the original covenant levels. The fees incurred
to obtain these amendments totaled $3.6 million which was amortized as interest
expense until the Previous Credit Facility was repaid in full.
On June 22, 2004, we entered into the Credit Facility with a principal
balance of $800.0 million. The Credit Facility is a six-year term loan, the
proceeds of which were used: (i) to refinance in full all indebtedness,
including accrued interest, under the Previous Credit Facility; (ii) to
repurchase $106.6 million of certain affiliated preferred stock; and (iii) for
other general corporate purposes.
We are required to make quarterly principal payments of $2.0 million
commencing on September 30, 2004, and continuing until March 31, 2010. The
remaining balance of $754.0 million is due on June 22, 2010. The borrowings bear
interest, payable at least quarterly, based on either a eurodollar rate or a
base rate. The eurodollar rate is equal to LIBOR plus 4 percent. The base rate
is equal to: (i) the greater of: (a) the Federal funds rate plus .50 percent; or
(b) Bank of America's prime rate; plus (ii) 3 percent. The margins on the
eurodollar rate and the base rate were each reduced by .5 percent during the
third quarter of 2004 as the Company's senior secured long-term debt was rated
at least B2 by Moody's Investors Service, Inc. ("Moody's") and BB- by S&P, in
each case with a stable outlook. On September 30, 2004, the interest rate on our
Credit Facility was 5.33 percent.
Pursuant to the Credit Facility, as long as the interest coverage ratio (as
defined in the Credit Facility) is less than 4.0:1.0, the Company is required to
make mandatory prepayments with all or a portion of the proceeds from the
following transactions or events including: (i) the issuance of certain
indebtedness; (ii) equity issuances; (iii) certain asset sales or casualty
events; and (iv) excess cash flow as defined in the Credit Facility. The Company
may make optional prepayments at any time in minimum amounts of $3.0 million. In
the event that the Company refinances or otherwise repays in full the
outstanding principal balance of the Credit Facility prior to June 22, 2005, we
are subject to a one percent prepayment fee on the then outstanding principal
amount of the Credit Facility.
The Credit Facility requires the Company to maintain various financial
ratios and balances, as defined in the agreement including: (i) a debt to total
capitalization ratio of not more than 25 percent at all times (such ratio was 19
percent at September 30, 2004); (ii) an interest coverage ratio greater than or
equal to 1.85:1.0 for the quarter ending September 30,
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
2004, 2.00:1.0 for each rolling four quarters ending (or, if less, the number of
full quarters commencing after June 22, 2004) during the period October 1, 2004
through June 30, 2007, and 2.50:1.0 for the four quarters ending September 30,
2007 and for each rolling four quarters thereafter (such ratio exceeded 2.85:1.0
for the quarter ending September 30, 2004); (iii) EBITDA, as defined in the
Credit Facility, greater than or equal to $725.0 million for each rolling four
quarters ending during the period July 1, 2004 through December 31, 2005, $775.0
million for each rolling four quarters ending during the period January 1, 2006
through December 31, 2006, and $825.0 million for each rolling four quarters
thereafter (such amount was greater than $1.0 billion for the four quarters
ended September 30, 2004); (iv) an aggregate risk-based capital ratio, as
defined in the Credit Facility, greater than or equal to 240 percent for each
quarter ending during the period from September 30, 2004 through March 31, 2005,
245 percent for each quarter ending during the period June 30, 2005 through
March 31, 2006, and 250 percent for each quarter ending thereafter (such ratio
exceeded the minimum risk-based capital requirement at September 30, 2004); (v)
a combined statutory capital and surplus level, as defined in the Credit
Facility of greater than $1,270.0 million (combined statutory capital and
surplus at September 30, 2004 exceeded such requirement); and (vi) specified
investment portfolio requirements (such investment portfolio requirements were
met at September 30, 2004).
The Credit Facility prohibits or restricts, among other things: (i) the
payment of cash dividends on the Company's common stock; (ii) the repurchase of
our common stock; (iii) the issuance of additional debt or capital stock; (iv)
liens; (v) asset dispositions; (vi) affiliate transactions; (vii) certain
investment activities; (viii) change in business; and (ix) prepayment of
indebtedness (other than the Credit Facility). The obligations under our Credit
Facility are guaranteed by Conseco's current and future domestic subsidiaries,
other than: (i) its insurance companies; (ii) subsidiaries of the insurance
companies; or (iii) certain immaterial subsidiaries as defined in the Credit
Facility. This guarantee was secured by granting liens on substantially all the
assets of the guarantors including the capital stock of our top tier insurance
company, Conseco Life Insurance Company of Texas.
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CHANGES IN COMMON STOCK AND PREFERRED STOCK
In the second quarter of 2004, we completed the public offerings, including
underwriter over-allotments, of 50.6 million shares of our common stock at an
offering price of $18.25 per share and 27.6 million shares of our 5.5 percent
Class B mandatorily convertible preferred stock (the "Preferred Stock") at an
offering price of $25 per share. Proceeds from the offerings, net of issuance
costs of $63.4 million, totaled $1,550.1 million. Such proceeds were used as
follows:
o $928.9 million to redeem all outstanding shares of our class A
preferred stock.
o $620.7 million to repay indebtedness under our Previous Credit
Facility, including accrued interest of $.7 million.
o $.5 million for general corporate purposes.
The Preferred Stock has a par value of $.01 per share and a liquidation
preference of $25 per share. Dividends are payable in cash at a rate of 5.5
percent of the liquidation preference per share, payable quarterly on February
15, May 15, August 15 and November 15.
The Preferred Stock is mandatorily convertible into common stock of Conseco
on May 15, 2007. The conversion rate for each share of Preferred Stock will
range from 1.1228 and 1.3699 shares of Conseco common stock depending on the
applicable market value of our common stock, as defined in the certificate of
designations, on the mandatory conversion date. At any time prior to May 15,
2007, the holders of the Preferred Stock may convert such shares at the minimum
conversion rate of 1.1228 shares of our common stock for each share of Preferred
Stock. If at any time prior to May 15, 2007, the closing price of our common
stock exceeds 150 percent of the threshold appreciation price of $22.27, subject
to adjustment under certain circumstances, for a certain period of time, the
Company, at its option, may elect to convert all outstanding Preferred Stock at
the minimum conversion rate of 1.1228 shares of our common stock for each share
of Preferred Stock. In addition, if the Company elects such conversion, it must
pay the holders of the Preferred Stock, in cash, an amount equal to the present
value of all remaining unpaid dividend payments on the Preferred Stock through
and including May 15, 2007.
If the Company is involved in a merger prior to May 15, 2007, in which at
least 30 percent of the consideration for our common stock consists of cash or
cash equivalents, then the holders of the Preferred Stock have the right to
convert their shares into shares of our common stock at the conversion rate in
effect immediately prior to such merger.
Holders of the Preferred Stock are only entitled to voting rights in
limited circumstances as further described in the certificate of designations.
EXECUTIVE TERMINATION
In the third quarter of 2004, the Company terminated the employment of
William J. Shea, the Company's former Chief Executive Officer. Pursuant to Mr.
Shea's employment agreement dated May 27, 2003 and other compensation
arrangements, Mr. Shea received or is entitled to the following amounts or
benefits:
(i) A $6.25 million cash severance payment.
(ii) Mr. Shea became immediately vested in 240,753 shares of restricted
stock and 240,753 stock options with an exercise price of $16.40 per
share. The stock options may be exercised at any time through
November 11, 2004. All remaining stock options or restricted stock
granted to Mr. Shea did not vest and were cancelled. We recognized
compensation expense of $2.0 million during the third quarter of
2004 related to the vesting of the aforementioned restricted shares
and stock options.
(iii) A pro rata portion of his 2004 bonus which is estimated to be $.6
million.
(iv) Certain supplemental retirement, insurance and other benefits for
which we recognized expenses of $2.4 million during the third
quarter of 2004.
29
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
EXECUTIVE HIRING
In the third quarter of 2004, the Company hired William S. Kirsch as its
President and Chief Executive Officer. Pursuant to the terms of his employment
agreement, Mr. Kirsch received a payment of $1.7 million and was granted options
to purchase an aggregate of 400,000 shares of Conseco common stock at a price of
$16.20 per share (the closing price on the New York Stock Exchange on the date
of the grant). The options vest over four years with one-fourth vesting on each
anniversary of the grant date. The options expire on August 17, 2014. The
Company also issued 400,000 shares of restricted stock to Mr. Kirsch with
one-half vesting on the second anniversary of the grant date and an additional
one-fourth vesting on the third and fourth anniversary of the grant date,
respectively. The value of the restricted shares ($6.5 million) will be
recognized as an expense to the Company over the four year vesting period. The
Company also incurred $.6 million of professional fees and other expenses
related to the executive transition.
RECENTLY ISSUED ACCOUNTING STANDARDS
In March 2004, the Emerging Issues Task Force issued Emerging Issues Task
Force Topic No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments" ("EITF 03-01"). EITF 03-01 provides
additional guidance on determining whether an impairment of an investment is
other-than-temporary. EITF 03-01 also includes guidance on accounting for an
investment subsequent to an other-than-temporary impairment and requires certain
disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments. The guidance in EITF 03-01 is effective for
the quarter ended September 30, 2004. However, certain guidance related to
determining when an impairment of an investment is other than temporary has been
delayed pending the issuance of additional guidance. The guidance effective for
the quarter ended September 30, 2004 did not significantly change our procedures
for evaluating impairments, although additional disclosures have been added to
the notes to the consolidated financial statements. We will evaluate the impact
of the additional guidance when it is finalized.
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 Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts were not outstanding after the Effective Date. We reviewed the
guidance
30
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
of SFAS 150 in determining that the Class B mandatorily convertible preferred
stock issued in the second quarter of 2004 is properly classified as a component
of shareholders' equity.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants issued Statement of Position 03-01 "Accounting and
Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration
Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01
provides guidance on several insurance company disclosure and accounting matters
including the appropriate accounting for: (i) separate accounts; (ii) additional
interest (for example, persistency bonus) accruing to the investment contract
holder; (iii) the liability for contracts where the amounts assessed against the
contract holder each period are assessed in a manner that is expected to result
in profits in earlier years and losses in subsequent years; (iv) potential
benefits to annuity holders in addition to their account balance; (v) sales
inducements to contract holders; and (vi) other provisions. The Company sold
most of its separate account business in 2002. Accordingly, the new guidance
related to separate accounts 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 $317.2 million at September 30, 2004.
In January 2003, the FASB issued Interpretation No. 46 "Consolidation of
Variable Interest Entities" ("FIN 46"), which requires expanded disclosures for
and, in some cases, consolidation of significant investments in variable
interest entities ("VIE"). A VIE is an entity in which the equity investors do
not have the characteristics of a controlling financial interest, or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. Under FIN 46, a
company is required to consolidate a VIE if it is the primary beneficiary of the
VIE. FIN 46 defines primary beneficiary as the party which will absorb a
majority of the VIE's expected losses or receive a majority of the VIE's
expected residual returns, or both.
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.
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
31
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 eight months ended August 31, 2003, we reduced the accrual for such
estimated costs by $16.0 million (after income taxes of $.7 million). We
recorded the reduction of such accrual as income from discontinued operations.
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 lawsuit was 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 this lawsuit 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 and has been set for hearing on November 19, 2004. We believe this
lawsuit is without merit and intend to defend it vigorously. The ultimate
outcome of this lawsuit cannot be predicted with certainty.
Other Litigation
Collection efforts by the Company and its wholly owned subsidiary, Conseco
Services, LLC ("Conseco Services"), related to the 1996-1999 director and
officer loan programs have been commenced against various past board members and
executives with outstanding loan balances. In addition, certain former officers
and directors have sued the companies for declaratory relief concerning their
liability for the loans. Currently, we are involved in litigation with Stephen
C. Hilbert, James D. Massey, Dennis E. Murray, Sr., 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,
32
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Hamilton County, Indiana); Murray and Massey v. Conseco, Case No.
1:03-CV-1701-LJM-VSS (Southern District, Indiana); Conseco v. Adams, et al.,
Case No. 03A 04545 9 (Bankr. Northern District, Illinois); Conseco Services v.
Dick, et al., Case No. 06C01-0311-CC-536 (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); Conseco v. Dick, Case No. 04L
002811 (Circuit Court, Cook County, Illinois) Conseco Services v. Adams, Case
No. 29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton
County, Indiana); Conseco Services v. Cuneo, et al., Case No.
1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray.,
Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County,
Indiana); Conseco Services v. Gongaware, Case No. 29D02-0404-CC-380 (Superior
Court, Hamilton County, Indiana). David Decatur filed for bankruptcy on May 12,
2004. The Company and Conseco Services believe that all amounts due under the
director and officer loan programs, including all applicable interest, are valid
obligations owed to the companies. As part of 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 intend
to prosecute these claims to obtain the maximum recovery possible. Further, with
regard to the various claims brought against the Company and Conseco Services by
certain former directors and officers, we believe that these claims are without
merit and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty. We have reached a settlement agreement with
Thomas J. Kilian. On October 20, 2004, the judge in the Conseco Services v.
Hilbert case granted partial final summary judgment in favor of Conseco Services
in the amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of
appeal.
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 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.
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 and added additional former officers as named defendants and
dismissed Conseco, Inc. as a party. We filed a motion to dismiss the amended
complaint on June 1, 2004. On July 30, 2004, the Russell matter was dismissed.
On August 25, 2004, the plaintiffs filed a notice of appeal in the 7th Circuit
Court of Appeals. 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 as an additional defendant.
On July 28, 2004, we filed a motion to stay the RLI matter until Russell is
resolved. On September 2, 2004, RLI filed a motion for judgment on all
counterclaims. On October 5, 2004, our motion to stay this matter was granted.
We believe the lawsuits are without merit and intend to defend them vigorously.
The ultimate outcome of the lawsuits 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 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 asserted 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 claimed 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. The maximum exposure to the Company for
this lawsuit was estimated to be $33 million. The heirs did not file a proof of
claim with the Bankruptcy Court. A settlement agreement has been reached by all
of the parties.
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
33
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
against both named plaintiffs, which motion was granted in June 2002. Plaintiffs
appealed to the 11th Circuit Court of Appeals. The 11th Circuit, in July 2003,
affirmed in part and reversed in part, allowing two fraud counts with respect to
one plaintiff to survive. The plaintiffs' request for a rehearing with respect
to this decision has been denied. Philadelphia Life 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. On September 27,
2004, Philadelphia Life was named in a purported nationwide class action filed
by the same plaintiff's attorney seeking unspecified damages in the District
Court of Clark County, Nevada (Emma Gilbertson individually and on behalf of
others similarly situated v. Conseco Life Insurance Company f/k/a Philadelphia
Life Insurance Company, Cause No. A492738), alleging breach of contract
pertaining to notice of premium increases. Philadelphia Life believes both
lawsuits are without merit and intends to defend them vigorously. The ultimate
outcome of the lawsuits 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 and its subsidiaries, Conseco Life Insurance Company and
Bankers Life and Casualty Company, have been named in purported class actions
and an individual lawsuit alleging, among other things, breach of contract with
regard to a change made in the way monthly deductions are calculated for
insurance coverage. Many of these nationwide purported class action lawsuits
were filed in Federal courts across the United States. The Judicial Panel on
Multidistrict Litigation consolidated these lawsuits into the case now referred
to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No.
MDL 1610 (Central District, California). Other nationwide purported class
actions and an individual lawsuit are filed in Illinois, Indiana and California
state courts. The case filed in Illinois state court is Barry A. Feinberg,
Trustee of the Linda Leventhal Irrevocable Trust, individually and on behalf of
all other persons and entities similarly situated v. Conseco Life Insurance
Company, f/k/a Massachusetts General Life Insurance Company, Case No. 04CH17937
(Circuit Court, Cook County, Illinois). Those cases filed in Indiana state
courts have been consolidated into the case now referred to as Alene P.
Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211
(Superior Court, Hamilton County, Indiana). Those cases filed in California
state courts are as follows: 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); 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 Peters Insurance Services, Inc., Hon. John Garamendi (in
his capacity as Insurance Commissioner for the State of California) and Does 1
through 10, Case 04 CV 125 LAB (BLM) (Superior Court, San Diego County,
California); Steven Rose, on Behalf of Himself and All Others Similarly
Situated, and on Behalf of the General Public for the State of California v.
Conseco Life Insurance Company, Case No. GIC 827178 (Superior Court, San Diego
County, California); Alfonso Tamayo, individually and on behalf of all others
similarly situated and on behalf of the General Public v. Conseco Life Insurance
Co., Inc., an Indiana Corp., successor to Philadelphia Life Insurance Co. and
formerly doing business as Massachusetts General Life Insurance Company, Case No
04-431660 (Superior Court, San Francisco County, California). We have filed a
motion with the Judicial Council of California requesting consolidation of all
the California state court cases.
34
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 as
an additional defendant. On March 5, 2004, the complaint was amended a second
time naming additional plaintiffs. The purported class consists of all former
Massachusetts General Flexible Premium Adjustable Life Insurance Policy
policyholders who were converted to Conseco Life Flexible Premium Adjustable
Life Insurance Policies and whose accumulated values in the Massachusetts
General policies were applied to first year premiums on the Conseco Life
policies. The complaint alleged, among other things, civil conspiracy to convert
the accumulated cash values of the plaintiffs and the class, and the violation
of insurance laws nationwide. The parties have reached a settlement agreement on
a class wide basis. On October 14, 2004, the judge signed an order preliminarily
approving the settlement. The hearing for final approval is set for January 31,
2005.
On December 30, 2002 and December 31, 2002, four 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; 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.
In August 2004, the parties agreed to a settlement of these four suits.
On September 21, 1999, Conseco Health Insurance Company ("Conseco Health"),
Conseco Services, Performance Matters Associates (one of our subsidiaries), and
a subsidiary officer were named in an action seeking damages in the United
States District Court for the Northern District of Alabama (Danny McFarlin;
Tennessee Capitol Associates, Inc.; Neal Nielsen; Group Marketing Services,
Inc.; Eleanor D. Newman; Dick Manley; Commonwealth General Group, Inc.; Robert
E. Taylor; Benefits of America Limited, Inc.; and Daniel Smith v. Conseco, Inc.;
Conseco Services, LLC.; Conseco Health Insurance f/k/a Capitol American Life
Insurance Company; Consolidated Marketing Group; Suncoast Fringe Benefits, Inc.;
Performance Matters Associates, Inc.; Christopher L. Weaver; Jim Hobbs, Mike
Foster and David King; Cause No: 99-CV-2282-S) alleging among other things
fraud, tortious interference with business and contractual relations,
conspiracy, breach of contract, unjust enrichment, extortion and interstate
travel in aid of extortion under the Racketeer Influenced and Corrupt
Organization Act ("RICO") and mail/wire fraud under RICO. The case concerns the
consolidation of plaintiffs' independent marketing organizations under a wholly
owned subsidiary of Conseco. In May 2003, the Court dismissed the tortious
interference claim as to Conseco Health, the breach of contract claims as to all
defendants other than Conseco Health, and the extortion-related RICO claims as
to all defendants on summary judgment. The case was on appeal to the 11th
Circuit Court of Appeals but was recently remanded to the district court and is
currently set for trial in March 2005. Conseco believes the lawsuit is without
merit and intends to defend it vigorously. The ultimate outcome of the lawsuit
cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other 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.
35
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Successor Predecessor
--------------------------------- --------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Cash flows from operating activities:
Net income...................................................... $ 208.4 $ 24.2 $ 2,201.7
Adjustments to reconcile net income to net cash provided
by operating activities:
Provision for losses........................................ - - 55.6
Amortization and depreciation............................... 294.8 30.3 372.1
Income taxes................................................ 127.4 13.9 31.4
Insurance liabilities....................................... 239.4 35.8 263.5
Accrual and amortization of investment income............... 151.7 (.7) 43.2
Deferral of policy acquisition costs........................ (267.1) (25.6) (287.5)
Reorganization items........................................ - - (2,157.0)
Net realized investment (gains) losses...................... (27.5) (6.7) 5.4
Discontinued operations..................................... - - (16.7)
Gain on extinguishment of debt.............................. (2.8) - -
Other....................................................... 49.1 (18.7) 235.6
------- ------ ---------
Net cash provided by operating activities................. $ 773.4 $ 52.5 $ 747.3
======= ====== =========
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............................................... $12.2 $ - $.3
Issuance of convertible exchangeable preferred shares......... 41.4 5.3 -
At September 30, 2004, restricted cash consisted of: (i) $15.0 million held
in an escrow account pursuant to a settlement with the Securities and Exchange
Commission and the New York Attorney General concerning their joint
investigation into market timing in variable annuities issued by a former
subsidiary of Old Conseco; (ii) $3.8 million held in trust for the payment of
bankruptcy-related professional fees; and (iii) $.1 million of segregated cash
held for the benefit of the former holders of TOPrS.
36
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 invested
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 were 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.
The three investment trusts were VIEs under FIN 46 because the trusts'
equity represented 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 were 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.
37
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at September 30, 2004, and the consolidated results of operations for: (i) the
three and nine months ended September 30, 2004; (ii) the one month ended
September 30, 2003; (iii) the two months ended August 31, 2003; and (iv) the
eight months ended August 31, 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 trends in
Conseco's operations or financial results, as well as other statements, contain
forward-looking statements, within the meaning of the federal securities laws
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 Credit Facility or future credit facilities;
o our ability to improve the financial strength ratings of our insurance
company subsidiaries and the impact of prior 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 expense reductions 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 our ability to satisfy the requirements of Section 404 of the Sarbanes
Oxley Act in a timely manner;
38
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 Life Insurance Company ("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.
39
CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
While we believe that we currently have adequate internal control
procedures in place, we are subject to uncertainties related to recent
legislation requiring companies to evaluate internal controls for financial
reporting under Section 404 of the Sarbanes Oxley Act of 2002.
We are continuing to take action to comply with the requirements of Section
404 of the Sarbanes Oxley Act of 2002 ("Section 404"), which will require us to
include a report in our Form 10-K for the year ending December 31, 2004
containing an assessment of the effectiveness of our internal control structure
and procedures for financial reporting as of December 31, 2004. Our external
auditors are required to attest to, and report on, the assessment made by
management. We have substantially completed procedures to document our internal
controls and have implemented various enhancements which are designed to improve
our internal controls. We are currently testing our internal controls to confirm
that such controls are designed properly and operating effectively. When our
testing identifies potential weaknesses, we are taking necessary remediation
actions. After our tests are completed, our external auditors perform additional
procedures and tests of our internal controls.
Our efforts to comply with Section 404 are complicated by the substantial
number of acquisitions undertaken by our Predecessor and the resulting number of
policy administration systems we use to process our business. We have several
initiatives underway to eliminate duplicate processing systems by converting
similar business accounted for on multiple systems to a fewer number of systems.
However, many of these initiatives have only recently been adopted, and will not
be implemented prior to the required attestation as of December 31, 2004.
The new regulations have resulted in increased expenses and the commitment
of significant managerial resources. We have retained a large international
accounting firm and a number of consultants to assist us in completing the
required procedures.
While we anticipate being able to fully satisfy the requirements of Section
404 in a timely manner, we cannot be certain as to the timing of completion of
our evaluation, testing and remediation actions or the impact of these actions
on our operations. In addition, since the new rules are subject to varying
interpretations, there is uncertainty regarding how compliance will be measured.
If we are unable to timely assess the effectiveness of our internal
controls under Section 404, or if we or our external auditors discover any
material weaknesses related to our internal controls which would preclude us
from determining that our internal controls are effective, investor confidence
could be adversely affected and cause our stock price to decline.
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
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CONSECO, INC. AND SUBSIDIARIES
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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 and 2002
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.
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 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 have 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.
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
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 and the first half of
2004. We also experienced increased agent attrition, which
41
CONSECO, INC. AND SUBSIDIARIES
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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. Such financial strength ratings were upgraded in the
second quarter of 2004, and again in the third quarter of 2004 by Moody's, for
our primary insurance subsidiaries, other than Conseco Senior Health Insurance
Company ("Conseco Senior"). The current financial strength ratings of our
primary insurance subsidiaries from A.M. Best, S&P and Moody's are "B++ (Very
Good)," "BB+" and "Ba1," respectively, except that the current financial
strength ratings of Conseco Senior 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
fifth highest of sixteen possible ratings, and a "B" rating from A.M. Best is
the seventh highest of sixteen possible ratings. A "BB+" rating from S&P is the
eleventh highest of twenty-one possible ratings, and a "CCC" rating from S&P is
the eighteenth highest of twenty-one possible ratings. A "Ba1" rating from
Moody's is the eleventh 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 continue to improve our ratings to be competitive.
Our Plan contemplated that our insurance subsidiaries would achieve an "A"
category rating from A.M. Best approximately by the end of 2004. Based on recent
discussions with A.M. Best, they will not review our insurance subsidiaries for
a possible upgrade until at least June 2005. We believe the following past and
expected future accomplishments will warrant an upgrade to an "A" category
rating from A.M. Best: (i) the improved capital position of our insurance
subsidiaries; (ii) our lower debt to capital ratio following the completion of
the offerings referred to in the notes to our consolidated financial statements
included in this Form 10-Q entitled "Changes in Common Stock and Preferred
Stock"; (iii) our current expectation of future financial results; and (iv) the
results of various other initiatives. However, 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 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 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 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.
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CONSECO, INC. AND SUBSIDIARIES
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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. 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 to any non-insurance company parent without prior
approval. 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 orders 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
====== ======
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 September 30, 2004, we had $798.0 million of indebtedness
under our Credit Facility. The following table sets forth the aggregate amount
of our debt payment obligations, including estimated interest, for the periods
indicated (dollars in millions):
Three months
ended
December 31,
2004 2005 2006 2007 2008 Total
---- ---- ---- ---- ---- -----
Scheduled principal payments.......................... $ 2.0 $ 8.0 $ 8.0 $ 8.0 $ 8.0 $ 34.0
Projected interest payments .......................... 10.9 42.9 42.4 42.0 41.6 179.8
----- ----- ----- ----- ----- ------
Total debt service................................ $12.9 $50.9 $50.4 $50.0 $49.6 $213.8
===== ===== ===== ===== ===== ======
As of September 30, 2004, our debt to total capital ratio was 17 percent.
This ratio is higher than the ratio of some of our competitors.
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 we 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.
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CONSECO, INC. AND SUBSIDIARIES
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S&P and Moody's have assigned ratings on our senior secured debt of "BB-
(Marginal)" and "B2 (Poor)", respectively. In S&P's view, an obligation rated
"BB-" is less vulnerable to 0nonpayment than other speculative issues, 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 "BB-" rating
is the thirteenth highest rating. In Moody's view, an obligation rated "B"
generally lacks characteristics of a desirable investment, and any assurance of
interest or principal payments or of maintenance of other terms of the contract
over any long period of time may be small. 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 "B2" rating is the fifteenth highest
rating. Our current senior debt ratings may restrict our access to capital.
If we fail to meet or maintain various covenants and financial ratios under
our 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 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 Credit Facility, of greater than or equal to $725.0
million for each rolling four quarters ending during the period July
1, 2004 through December 31, 2005, $775.0 million for each rolling
four quarters ending during the period January 1, 2006 through
December 31, 2006, and $825.0 million for each rolling four quarters
thereafter. This amount was greater than $1.0 billion for the four
quarters ended September 30, 2004;
o have a debt to total capitalization ratio, as defined in the Credit
Facility, of not more than 25 percent at all times. At September 30,
2004, our debt to total capitalization ratio was 19 percent;
o have an interest coverage ratio of greater than or equal to 1.85:1.0
for the quarter ending September 30, 2004, 2.00:1.0 for each rolling
four quarters ending (or, if less, the number of full quarters
commencing after June 22, 2004) during the period October 1, 2004
through June 30, 2007, and 2.50:1.0 for the four quarters ending
September 30, 2007 and for each rolling four quarters thereafter. Such
ratio exceeded 2.85:1.0 for the quarter ending September 30, 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 $798.0 million as of September 30, 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 Credit Facility.
Our 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;
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CONSECO, INC. AND SUBSIDIARIES
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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 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 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.
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 103 percent during the nine
months ended September 30, 2004. We will have to raise rates or take other
actions with respect to some of these policies or 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.
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CONSECO, INC. AND SUBSIDIARIES
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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, that
affects approximately 11,000 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.
On July 1, 2004, the Florida Office of Insurance Regulation issued a similar
order impacting approximately 4,500 home health care policies which are
obligations of one of our other insurance subsidiaries, Washington National
Insurance Company ("Washington National"). The orders also require Conseco
Senior and Washington National to pursue a similar course of action with respect
to approximately 24,000 home health care policies issued 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 increases 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 claim experience on its long-term care blocks has generally been
lower than its pricing expectations. However, the lapses on these policies have
been lower than our pricing expectations which is expected to result in higher
loss ratios in the future. 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 103 percent in the nine months ended September 30,
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.
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Our reserves for future insurance policy benefits and claims may prove to
be inadequate, requiring us to increase liabilities and resulting in
reduced net income and shareholders' equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on assumptions made by our actuaries. For our
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 assumptions and estimates of
factors: (i) established at the fresh-start date for business inforce at that
time; or (ii) that we consider when we set premium rates for business written
after that date. 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
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 Credit
Facility.
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 and the first nine months of 2004.
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,
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CONSECO, INC. AND SUBSIDIARIES
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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.
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 similar business currently accounted for on multiple
systems to a much smaller number of systems. 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.
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CONSECO, INC. AND SUBSIDIARIES
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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 3.7 percent of our
actively managed fixed maturity investments as of September 30, 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: $17.8 million
in the nine months ended September 30, 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 3.7 percent at
September 30, 2004;
o implementing conservative portfolio compliance guidelines which
generally limit our exposure to single issuer risks; and
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 25 percent of our
actively managed fixed maturity investments at September 30, 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-
49
CONSECO, INC. AND SUBSIDIARIES
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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.
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 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,
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CONSECO, INC. AND SUBSIDIARIES
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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 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 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 requirements, restricted the ability
of our insurance subsidiaries to pay any dividends or other amounts to any
non-insurance company parent without prior approval. Notwithstanding the release
of these consent orders, we 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. 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 ratios of certain insurance subsidiaries and this
could affect the ability of our top tier insurance subsidiary to pay dividends.
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, 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.
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,
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CONSECO, INC. AND SUBSIDIARIES
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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
a purported nationwide class action lawsuits alleging fraudulent sales practices
and seeking unspecified damages in Florida federal court. 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 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
multiple 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.
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 Genworth Financial, John
Hancock Financial Services, 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
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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 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 policyholder benefits. 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
the shares currently outstanding. 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
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CONSECO, INC. AND SUBSIDIARIES
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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.
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 One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Earnings (losses) before taxes:
Bankers Life (a)................................................. $ 54.2 $ 24.9 $ 43.0
Conseco Insurance Group (b)...................................... 68.0 20.8 230.8
Other Business in Run-off (c).................................... 17.5 3.4 (99.5)
Corporate operations (d)......................................... (34.8) (11.3) 2,084.7
------ ------ --------
Income before income taxes and
discontinued operations....................................... $104.9 $ 37.8 $2,259.0
====== ====== ========
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Earnings (losses) before taxes:
Bankers Life (a)................................................. $ 175.7 $ 24.9 $ 159.6
Conseco Insurance Group (b)...................................... 202.8 20.8 299.9
Other Business in Run-off (c).................................... 49.8 3.4 (171.3)
Corporate operations (d)......................................... (104.2) (11.3) 1,884.0
------- ------ --------
Income before income taxes and
discontinued operations....................................... $ 324.1 $ 37.8 $2,172.2
======= ====== ========
- ----------------
(a) The earnings before taxes of the Bankers Life segment included realized
gains (losses), net of related amortization, of $(1.6) million and $9.8
million for the three and nine months ended September 30, 2004,
respectively; $2.8 million in the one month ended September 30, 2003; $1.4
million in the two months ended August 31, 2003; and $5.0 million in the
eight months ended August 31, 2003.
(b) The earnings before taxes of the Conseco Insurance Group segment included
realized gains (losses), net of related amortization, of $.4 million and
$6.1 million for the three and nine months ended September 30, 2004,
respectively; $3.7 million in the one month ended September 30, 2003;
$(36.1) million in the two months ended August 31, 2003; and $(16.2)
million in the eight months ended August 31, 2003.
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(c) The earnings (losses) before taxes of the Other Business in Run-off segment
included realized gains (losses), net of related amortization, of $1.0
million and $2.8 million for the three and nine months ended September 30,
2004, respectively; $.6 million in the one month ended September 30, 2003;
$.9 million in the two months ended August 31, 2003; and $6.3 million in
the eight months ended August 31, 2003.
(d) The losses before taxes in our Corporate operations segment included: (i)
realized gains (losses) of nil and $(2.8) million for the three and nine
months ended September 30, 2004, respectively; $(.4) million in the one
month ended September 30, 2003; $(1.6) million in the two months ended
August 31, 2003; and $(.1) million in the eight months ended August 31,
2003; and (ii) venture capital income (loss) of $(2.7) million in the one
month ended September 30, 2003; $2.0 million in the two months ended August
31, 2003; and $10.5 million in the eight months ended August 31, 2003.
There was no venture capital income (loss) in the 2004 periods.
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.
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions)
Successor Predecessor
--------------------------------- -----------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums and asset accumulation product collections:
Annuities..................................................... $ 254.2 $ 63.5 $ 149.4
Supplemental health........................................... 294.3 96.6 191.6
Life.......................................................... 46.4 12.0 30.3
-------- -------- --------
Total premium collections................................... $ 594.9 $ 172.1 $ 371.3
======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based........................................... $ 357.7 $ 324.6 $ 290.6
Equity-linked............................................. 278.4 262.3 264.0
Deposit based............................................. 3,569.4 3,112.9 3,035.3
Health...................................................... 2,832.6 2,597.0 1,965.7
Life:
Interest sensitive........................................ 336.4 333.3 328.1
Non-interest sensitive.................................... 748.1 743.9 653.7
-------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded...................... $8,122.6 $7,374.0 $6,537.4
======== ======== ========
Revenues:
Insurance policy income....................................... $ 355.3 $ 111.7 $ 227.0
Net investment income:
General account invested assets............................. 108.0 32.4 66.9
Equity-indexed products based on the change
in value of the S&P 500 Call Options...................... (2.9) (1.4) 1.7
Trading account income related to policyholder
and reinsurer accounts.................................... 9.7 6.4 -
Change in value of embedded derivatives
related to modified coinsurance agreements................ (9.7) (6.4) -
Net realized investment gains................................. 2.5 2.8 1.7
Fee revenue and other income.................................. .1 .4 .2
-------- -------- --------
Total revenues............................................ 463.0 145.9 297.5
-------- -------- --------
Expenses:
Insurance policy benefits..................................... 281.6 83.1 177.8
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below.................... 37.8 12.6 24.2
Equity-indexed products based on
S&P 500 Index............................................. (1.3) (1.2) 3.3
Amortization expense.......................................... 48.8 15.5 29.1
Interest expense on investment borrowings..................... .6 .2 .6
Other operating costs and expenses............................ 41.3 10.8 19.5
-------- -------- --------
Total benefits and expenses............................... 408.8 121.0 254.5
-------- -------- --------
Income before income taxes and
discontinued operations......................................... $ 54.2 $ 24.9 $ 43.0
======== ======== ========
(continued)
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
--------------------------------- ------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Health loss ratios:
All health lines:
Insurance policy benefits................................... $235.5 $73.0 $147.5
Loss ratio (a).............................................. 78.70% 75.73% 76.36%
Medicare Supplement:
Insurance policy benefits................................... $112.3 $35.3 $63.5
Loss ratio (a).............................................. 70.19% 66.50% 59.83%
Long-Term Care:
Insurance policy benefits................................... $120.3 $37.2 $82.1
Loss ratio (a).............................................. 89.10% 87.81% 96.60%
Interest-adjusted loss ratio (b)............................ 62.01% 62.37% 79.27%
Other:
Insurance policy benefits................................... $2.9 $.5 $1.9
Loss ratio (a).............................................. 68.58% 52.48% 92.61%
- ----------------
(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.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums and asset accumulation product collections:
Annuities..................................................... $ 661.9 $ 63.5 $ 698.4
Supplemental health........................................... 890.6 96.6 759.6
Life.......................................................... 130.5 12.0 102.7
-------- -------- --------
Total premium collections................................... $1,683.0 $ 172.1 $1,560.7
======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based........................................... $ 357.1 $ 324.6 $ 286.5
Equity-linked............................................. 272.2 262.3 264.8
Deposit based............................................. 3,421.2 3,112.9 2,847.7
Health...................................................... 2,772.7 2,597.0 1,916.3
Life:
Interest sensitive........................................ 333.1 333.3 324.4
Non-interest sensitive.................................... 751.9 743.9 652.4
-------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded...................... $7,908.2 $7,374.0 $6,292.1
======== ======== ========
Revenues:
Insurance policy income....................................... $1,047.0 $ 111.7 $ 892.7
Net investment income:
General account invested assets............................. 309.7 32.4 253.4
Equity-indexed products based on the change
in value of the S&P 500 Call Options...................... (2.0) (1.4) 4.8
Trading account income related to policyholder
and reinsurer accounts.................................... 2.8 6.4 -
Change in value of embedded derivatives
related to modified coinsurance agreements................ (2.8) (6.4) -
Net realized investment gains................................. 13.9 2.8 5.5
Fee revenue and other income.................................. .6 .4 .9
-------- -------- --------
Total revenues............................................ 1,369.2 145.9 1,157.3
-------- -------- --------
Expenses:
Insurance policy benefits..................................... 820.9 83.1 692.4
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below.................... 109.7 12.6 89.5
Equity-indexed products based on
S&P 500 Index............................................. 2.2 (1.2) 13.2
Amortization expense.......................................... 138.1 15.5 113.9
Interest expense on investment borrowings..................... 1.7 .2 3.4
Other operating costs and expenses............................ 120.9 10.8 85.3
-------- -------- --------
Total benefits and expenses............................... 1,193.5 121.0 997.7
-------- -------- --------
Income before income taxes and
discontinued operations......................................... $ 175.7 $ 24.9 $ 159.6
======== ======== ========
(continued)
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Health loss ratios:
All health lines:
Insurance policy benefits................................... $691.6 $73.0 $578.5
Loss ratio (a).............................................. 77.61% 75.73% 75.30%
Medicare Supplement:
Insurance policy benefits................................... $329.6 $35.3 $283.3
Loss ratio (a).............................................. 68.26% 66.50% 66.39%
Long-Term Care:
Insurance policy benefits................................... $355.3 $37.2 $287.2
Loss ratio (a).............................................. 89.16% 87.81% 86.08%
Interest-adjusted loss ratio (b)............................ 62.41% 62.37% 69.26%
Other:
Insurance policy benefits................................... $6.7 $.5 $8.0
Loss ratio (a).............................................. 68.36% 52.48% 101.05%
- ----------------
(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 $594.9 million and $1,683.0 million in the
three and nine months ended September 30, 2004, respectively; $172.1 million in
the one month ended September 30, 2003; $371.3 million in the two months ended
August 31, 2003; and $1,560.7 million in the eight months ended August 31, 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. Sales of annuity products in the third quarter of 2004 were
favorably impacted by attractive minimum guarantee crediting rates. See "--
Premium and Asset Accumulation Product Collections" for further analysis of
Bankers Life's premium collections.
Average liabilities for insurance and asset accumulation products, net of
reinsurance ceded were $8.1 billion and $7.9 billion in the three and nine
months ended September 30, 2004, respectively; $7.4 billion in the one month
ended September 30, 2003; $6.5 billion in the two months ended August 31, 2003;
and $6.3 billion in the eight months ended August 31, 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.
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $108.0 million and $309.7
million in the three and nine months ended September 30, 2004, respectively;
$32.4 million in the one month ended September 30, 2003; $66.9 million in the
two months ended August 31, 2003; and $253.4 million in the eight months ended
August 31, 2003. The average balance of general account invested assets was $7.8
billion and $7.5 billion in the three and nine months ended September 30, 2004,
respectively; $6.9 billion in the one month ended September 30, 2003; $6.8
billion in the two months ended August 31, 2003; and $6.6 billion in the eight
months ended August 31, 2003. The yield on these assets was 5.5 percent in both
the three and nine months ended September 30, 2004; 5.6 percent in the one month
ended September 30, 2003; 5.9 percent in the two months ended August 31, 2003;
and 5.7 percent in the eight months ended August 31, 2003. 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. In the
third quarter of 2004, net investment income was favorably impacted by: (i)
prepayments on mortgage loans which had a cost basis below the principal amount
of the loan (due to the application of fresh start accounting); and (ii) income
from nontraditional investments.
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 $1.3 million and $4.9 million in the three and nine months ended
September 30, 2004, respectively; $.8 million in the one month ended September
30, 2003; $1.5 million in the two months ended August 31, 2003; and $7.7 million
in the eight months ended August 31, 2003. 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 $(1.6) million and $2.9 million in the three and nine
months ended September 30, 2004, respectively; $(.6) million in the one month
ended September 30, 2003; $3.2 million in the two months ended August 31, 2003;
and $12.5 million in the eight months ended August 31, 2003. 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 nine months ended September 30, 2004, net realized investment gains
in our Bankers Life segment included: (i) $17.9 million of net gains from the
sales of investments (primarily fixed maturities); net of (ii) $4.0 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. During the one month ended
September 30, 2003, we recognized net realized investment gains in our Bankers
Life segment of $2.8 million related to the net gains from the sales of
investments (primarily fixed maturities). There were no writedowns of fixed
maturity investments in the one month period. During the first eight months of
2003, we recognized net investment gains of $5.5 million. During the first eight
months of 2003, the net realized investment gains included: (i) $20.5 million of
net gains from the sales of investments (primarily fixed maturities); net of
(ii) $15.0 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.
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
nine months of 2004 continues to be within our pricing targets. Losses have
increased in the 2004 periods compared to favorable experience in 2003.
Governmental
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 individual products and not less than 75 percent on group
products. We experience quarterly fluctuations in this ratio from time to time.
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. We have recently been experiencing lower than expected
lapses on this business, which has also caused the loss ratio to increase. 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 2004
periods, 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 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 $37.8 million and $109.7 million in the
three and nine months ended September 30, 2004, respectively; $12.6 million in
the one month ended September 30, 2003; $24.2 million in the two months ended
August 31, 2003; and $89.5 million in the eight months ended August 31, 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 3.9 percent in both the three and nine
months ended September 30, 2004; 4.4 percent in the one month ended September
30, 2003; and 4.2 percent in the eight months ended August 31, 2003.
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 periods is not
comparable to the 2003 periods due to the application of fresh start accounting
effective August 31, 2003. Amortization expense was $46.8 million in the fourth
quarter of 2003, $45.7 million in the first quarter of 2004, $43.6 million in
the second quarter of 2004 and $48.8 million in the third quarter of 2004. Such
amounts are in line with our expectations given the related premium revenue and
gross profits for the periods.
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 (decrease) in the
amortization of insurance intangibles of $4.1 million in both the three and nine
months ended September 30, 2004; $.3 million in the two months ended August 31,
2003; and $.5 million in the eight months ended August 31, 2003. There was no
such amortization in the one month ended September 30, 2003.
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 $183.7 million during the
first nine months of 2004; $208.1 million during the one month ended September
30, 2003; and $263.7 million during the eight months ended August 31, 2003. The
weighted average interest rates on such borrowings were 1.3 percent during the
first nine months of 2004; 1.1 percent during the one month ended September 30,
2003; and 1.9 percent during the eight months ended August 31, 2003.
Other operating costs and expenses in our Bankers Life segment increased in
the 2004 periods due to higher sales and agent related costs and a decrease in
deferrable acquisition expenses.
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions)
Successor Predecessor
--------------------------------- -------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums and asset accumulation product collections:
Annuities....................................................... $ 16.1 $ 5.2 $ 11.5
Supplemental health............................................. 180.3 65.0 128.3
Life............................................................ 93.7 34.5 73.8
---------- --------- ---------
Collections on insurance products............................. $ 290.1 $ 104.7 $ 213.6
========== ========= =========
Average liabilities for insurance and asset accumulation:
Annuities:
Mortality based............................................... $ 238.4 $ 244.0 $ 168.2
Equity-linked................................................. 1,463.1 1,566.6 1,460.6
Deposit based................................................. 3,752.1 4,057.5 4,073.8
Separate accounts and investment trust liabilities............ 32.7 62.6 271.9
Health.......................................................... 2,333.2 2,276.9 2,040.1
Life:
Interest sensitive............................................ 3,223.2 3,347.3 3,322.2
Non-interest sensitive........................................ 1,443.5 1,501.7 1,493.1
--------- --------- ---------
Total average liabilities for insurance and
asset accumulation products, net of
reinsurance ceded......................................... $12,486.2 $13,056.6 $12,829.9
========= ========= =========
Revenues:
Insurance policy income........................................... $ 284.2 $ 102.9 $ 206.7
Net investment income:
General account invested assets................................. 179.0 60.0 135.7
Equity-indexed products based on the change in
value of the S&P 500 Call Options............................. (15.4) (6.9) 10.0
Trading account income related to policyholder
and reinsurer accounts........................................ 11.2 8.4 -
Change in value of embedded derivatives related
to modified coinsurance agreements............................ (2.7) (2.2) -
Net realized investment gains (losses)............................ 2.5 3.7 (36.9)
Fee revenue and other income...................................... 1.0 - 4.9
--------- --------- ---------
Total revenues................................................ 459.8 165.9 320.4
--------- --------- ---------
Expenses:
Insurance policy benefits......................................... 213.7 83.8 (67.6)
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below........................ 64.6 25.0 52.8
Equity-indexed products based on S&P 500 Index.................. (4.3) (3.0) 19.3
Amortization expense.............................................. 39.0 9.9 24.1
Interest expense on investment borrowings......................... 1.3 .4 1.3
Other operating costs and expenses................................ 77.5 29.0 59.7
--------- --------- ---------
Total benefits and expenses................................... 391.8 145.1 89.6
--------- --------- ---------
Income before income taxes and discontinued
operations........................................................ $ 68.0 $ 20.8 $ 230.8
========= ========= =========
(continued)
62
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
-------------------------------- -------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Health loss ratios:
All health lines:
Insurance policy benefits..................................... $127.3 $44.5 $100.5
Loss ratio (a)................................................ 69.88% 66.17% 77.40%
Medicare Supplement:
Insurance policy benefits..................................... $55.4 $22.0 $38.8
Loss ratio (a)................................................ 63.41% 68.24% 61.73%
Specified Disease:
Insurance policy benefits..................................... $70.3 $18.3 $49.7
Loss ratio (a)................................................ 76.98% 60.68% 82.48%
Interest-adjusted loss ratio (b).............................. 47.86% 30.90% 52.32%
- -------------
(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.
63
CONSECO, INC. AND SUBSIDIARIES
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums and asset accumulation product collections:
Annuities....................................................... $ 45.4 $ 5.2 $ 74.0
Supplemental health............................................. 553.0 65.0 525.3
Life............................................................ 285.7 34.5 280.7
--------- --------- ----------
Collections on insurance products............................. $ 884.1 $ 104.7 $ 880.0
========= ========= ==========
Average liabilities for insurance and asset accumulation:
Annuities:
Mortality based............................................... $ 239.5 $ 244.0 $ 171.0
Equity-linked................................................. 1,502.3 1,566.6 1,514.7
Deposit based................................................. 3,829.2 4,057.5 4,245.4
Separate accounts and investment trust liabilities............ 34.4 62.6 401.3
Health.......................................................... 2,323.2 2,276.9 2,045.4
Life:
Interest sensitive............................................ 3,273.4 3,347.3 3,407.8
Non-interest sensitive........................................ 1,448.2 1,501.7 1,495.3
--------- --------- ---------
Total average liabilities for insurance and
asset accumulation products, net of
reinsurance ceded......................................... $12,650.2 $13,056.6 $13,280.9
========= ========= =========
Revenues:
Insurance policy income........................................... $ 873.9 $ 102.9 $ 892.8
Net investment income:
General account invested assets................................. 526.0 60.0 557.3
Equity-indexed products based on the change in
value of the S&P 500 Call Options............................. (11.5) (6.9) 25.3
Trading account income related to policyholder
and reinsurer accounts........................................ 6.0 8.4 -
Change in value of embedded derivatives related
to modified coinsurance agreements............................ (1.4) (2.2) -
Net realized investment gains (losses)............................ 13.6 3.7 (17.1)
Fee revenue and other income...................................... 4.3 - 17.0
--------- --------- ---------
Total revenues................................................ 1,410.9 165.9 1,475.3
--------- --------- ---------
Expenses:
Insurance policy benefits......................................... 641.6 83.8 456.4
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below........................ 196.3 25.0 218.4
Equity-indexed products based on S&P 500 Index.................. 10.4 (3.0) 71.5
Amortization expense.............................................. 120.7 9.9 201.8
Interest expense on investment borrowings......................... 3.4 .4 4.7
Other operating costs and expenses................................ 235.7 29.0 222.6
--------- --------- ---------
Total benefits and expenses................................... 1,208.1 145.1 1,175.4
--------- --------- ---------
Income before income taxes and discontinued
operations........................................................ $ 202.8 $ 20.8 $ 299.9
========= ========= =========
(continued)
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
--------------------------------- -------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Health loss ratios:
All health lines:
Insurance policy benefits..................................... $374.0 $44.5 $381.3
Loss ratio (a)................................................ 66.49% 66.17% 70.95%
Medicare Supplement:
Insurance policy benefits..................................... $173.2 $22.0 $167.2
Loss ratio (a)................................................ 62.43% 68.24% 65.49%
Specified Disease:
Insurance policy benefits..................................... $192.4 $18.3 $184.6
Loss ratio (a)................................................ 70.49% 60.68% 75.77%
Interest-adjusted loss ratio (b).............................. 40.51% 30.90% 46.33%
- -------------
(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 $290.1 million and $884.1 million in
the three and nine months ended September 30, 2004, respectively; $104.7 million
in the one month ended September 30, 2003; $213.6 million in the two months
ended August 31, 2003; and $880.0 million in the eight months ended August 31,
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 $12.5 billion and $12.7 billion in the three and nine
months ended September 30, 2004, respectively; $13.1 billion in the one month
ended September 30, 2003; $12.8 billion in the two months ended August 31, 2003;
and $13.3 billion in the eight months ended August 31, 2003. The decrease in
such liabilities is primarily due to the increase in policyholder redemptions
and lapses. The liabilities for insurance and asset accumulation products in
this segment were not significantly affected by the adoption of fresh start
accounting.
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 $179.0 million and $526.0
million in the three and nine months ended September 30, 2004, respectively;
$60.0 million in the one month ended September 30, 2003; $135.7 million in the
two months ended August 31, 2003; and $557.3 million in the eight months ended
August 31, 2003. The average balance of general account invested assets was
$12.5 billion
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
in both the three and nine months ended September 30, 2004; $12.7 billion in the
one month ended September 30, 2003; $13.2 billion in the two months ended August
31, 2003; and $13.7 billion in the eight months ended August 31, 2003. The yield
on these assets was 5.7 percent and 5.6 percent in the three and nine months
ended September 30, 2004, respectively; 5.7 percent in the one month ended
September 30, 2003; 6.2 percent in the two months ended August 31, 2003; and 6.1
percent in the eight months ended August 31, 2003. Net investment income on
general account invested assets in the 2004 periods is not comparable to the
2003 periods 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. In the
third quarter of 2004, net investment income was favorably impacted by: (i)
prepayments on mortgage loans which had a cost basis below the principal amount
of the loan (due to the application of fresh start accounting); and (ii) income
from nontraditional investments. Net investment income 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 through the first half 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 $9.3 million and $28.9 million in the
three and nine months ended September 30, 2004, respectively; $4.4 million in
the one month ended September 30, 2003; $10.5 million in the two months ended
August 31, 2003; and $45.8 million in the eight months ended August 31, 2003.
These costs are reflected in the change in market value of the S&P 500 Call
Options included in the investment income amounts. Net investment income (loss)
related to equity-indexed products before this expense was $(6.1) million and
$17.4 million in the three and nine months ended September 30, 2004,
respectively; $(2.5) million in the one month ended September 30, 2003; $20.5
million in the two months ended August 31, 2003; and $71.1 million in the eight
months ended August 31, 2003. 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 nine months ended September 30, 2004, we recognized net realized
investment gains in our Conseco Insurance Group segment which included: (i)
$23.9 million of net gains from the sales of investments (primarily fixed
maturities); net of (ii) $10.3 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 one month ended September 30, 2003, we
recognized net realized investment gains in our Conseco Insurance Group segment
of $3.7 million related to the net gains from the sales of investments
(primarily fixed maturities). There were no writedowns of fixed maturity
investments in the one month period. During the first eight months of 2003, the
net realized investment losses included: (i) $16.8 million of net
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
gains from the sales of investments (primarily fixed maturities); net of (ii)
$33.9 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.
Fee revenue and other income in the 2003 periods primarily included 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 nine months 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 periods. In addition, the higher rates caused some
policyholders to lapse their policies. The release of the policy benefit reserve
related to the lapsed business also contributed to the lower loss ratio in the
2004 periods. 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. We experience
quarterly fluctuations in this ratio from time to time.
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. In the third quarter of 2004, we changed the criteria
pursuant to which we consider a specified disease policy to be lapsed. Although
our specified disease policies generally may be lapsed for non-payment of
premiums after being delinquent for 90 days, policyholders are permitted to
reinstate their coverage by paying past due premiums prior to our final lapse
notice. In addition, timing differences and delays in billing, receipt and
processing of premiums can affect whether a policy has, in fact, lapsed. We
revised our previous methodology of determining policies which have lapsed to
consider the fact that many policyholders whose payments are delinquent past
their grace periods, may in fact, reinstate their coverage through payment of
past due premiums. These changes resulted in an increase to reserves of
approximately $6 million. The effect of variances in lapse rates from our
expectations are partially offset by reduced amortization of insurance
intangibles of $2.2 million.
In the first quarter of 2004, the Conseco Insurance Group segment
experienced higher than expected death claims. In the second and third quarters
of 2004, our death claim experience returned to the level we generally expect.
In August 2003, we decided to change a non-guaranteed element of certain
Conseco Insurance Group policies. This element was not required by the policy
and the change will eliminate the former practice of reducing the cost of
insurance charges to amounts below the level permitted under the provisions of
the policies. As a result of this decision, our estimates of future expected
gross profits on these products used as a basis for amortization of insurance
intangibles and the establishment of insurance liabilities has changed. We
adjusted the total amortization and reserve charge we had recorded since the
acquisition of these policies as a result of the change to our earlier estimates
in accordance with Statement of Financial Accounting Standards No. 97,
"Accounting and Reporting by Insurance Enterprises of Certain Long-Duration
Contracts and for Realized Gains and Losses from the Sale of Investments." The
effect of the change in estimate was a $220.2 million reduction to insurance
policy benefits and a $39.8 million reduction to amortization recorded in the
two and eight months ended August 31, 2003.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $64.6 million and $196.3 million in the
three and nine months ended September 30, 2004, respectively; $25.0 million in
the one month ended September 30, 2003; $52.8 million in the two months ended
August 31, 2003; and $218.4 million in the eight months ended August 31, 2003.
The decrease is primarily due to a smaller block of annuity business inforce and
67
CONSECO, INC. AND SUBSIDIARIES
-------------------
changes in the weighted average crediting rates. The weighted average crediting
rates for these products were 3.8 percent in both the three and nine months
ended September 30, 2004; 4.2 percent in the one month ended September 30, 2003;
and 4.4 percent in the eight months ended August 31, 2003.
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, $47.7 million in the first quarter of 2004, $34.0 million in
the second quarter of 2004 and $39.0 million in the third quarter of 2004.
In accordance with SFAS 97, we are required to amortize the value of
policies inforce in relation to estimated gross profits for universal life-type
products and investment-type products. SFAS 97 also requires that estimates of
expected gross profits used as a basis for amortization be evaluated regularly,
and that the total amortization recorded to date be adjusted by a charge or
credit to the statement of operations, if actual experience or other evidence
suggests that earlier estimates should be revised. Accordingly, 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 and our
expectations of future profits.
During the second quarter of 2004, we evaluated certain amortization
assumptions used to estimate gross profits for universal life-type products and
investment-type products by comparing them to our actual experience. We made
refinements to the previous assumptions related to investment income to match
the actual experience and our estimates for future assumptions. The changes we
made did not affect our expectations for the total estimated profits to be
earned on this business, but did affect how we expect the profits to emerge over
time. These new assumptions resulted in a retroactive reduction to the
amortization of insurance intangibles of $7.7 million in the second quarter of
2004.
Amortization expense decreased in the first quarter of 2004 as a result of
the higher than expected death claims. 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 (decrease) in the
amortization of insurance intangibles of $2.1 million and $7.5 million in the
three and nine months ended September 30, 2004, respectively; $(.8) million in
the two months ended August 31, 2003; and $(.9) million in the eight months
ended August 31, 2003. There was no such amortization in the one month ended
September 30, 2003.
Interest expense on investment borrowings fluctuates along with Conseco
Insurance Group's investment borrowing activities and the interest rates
thereon. Average investment borrowings were $335.3 million during the first nine
months of 2004; $308.4 million during the one month ended September 30, 2003;
and $403.4 million during the eight months ended August 31, 2003. The weighted
average interest rates on such borrowings were 1.3 percent during the first nine
months of 2004; 1.5 percent during the one month ended September 30, 2003; and
1.7 percent during the eight months ended August 31, 2003.
Other operating costs and expenses in the 2004 periods were lower than the
comparable 2003 periods primarily due to lower: (i) compensation costs; and (ii)
marketing and agency related expenses.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-Off (dollars in millions)
Successor Predecessor
--------------------------------- -----------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums and asset accumulation product collections:
Long-term care.................................................. $ 92.7 $ 30.1 $ 70.6
Major medical.................................................. 3.6 17.9 31.8
-------- -------- --------
Total premium collections.................................. $ 96.3 $ 48.0 $ 102.4
======== ======== ========
Average liabilities for other business in run-off:
Long-term care.................................................. $3,277.5 $3,294.5 $2,047.5
Major medical................................................... 71.4 108.6 110.5
-------- -------- ---------
Total average liabilities for other business
in run-off, net of reinsurance ceded...................... $3,348.9 $3,403.1 $2,158.0
======== ======== ========
Revenues:
Insurance policy income......................................... $ 98.3 $ 41.6 $ 83.1
Net investment income on general account
invested assets............................................... 41.8 13.5 26.7
Net realized investment gains................................... 1.0 .6 .9
Fee revenue and other income.................................... .1 .3 .1
-------- -------- --------
Total revenues.............................................. 141.2 56.0 110.8
-------- -------- --------
Expenses:
Insurance policy benefits....................................... 96.3 43.0 181.1
Amortization expense............................................ 4.1 1.5 8.1
Other operating costs and expenses.............................. 23.3 8.1 21.1
-------- -------- --------
Total benefits and expenses................................. 123.7 52.6 210.3
-------- -------- --------
Income (loss) before income taxes and
discontinued operations................................... $ 17.5 $ 3.4 $ (99.5)
======== ======== ========
Health loss ratios:
Insurance policy benefits..................................... $ 96.3 $ 43.0 $ 181.1
Loss ratio (a)................................................ 97.93% 103.24% 217.91%
Interest-adjusted loss ratio (b).............................. 56.45% 74.39% 188.54%
- -----------
(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 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
69
CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums and asset accumulation product collections:
Long-term care.................................................. $ 283.4 $ 30.1 $ 268.0
Major medical....................................................... 15.0 17.9 156.4
-------- -------- --------
Total premium collections.................................. $ 298.4 $ 48.0 $ 424.4
======== ======== ========
Average liabilities for other business in run-off:
Long-term care.................................................. $3,284.5 $3,294.5 $1,977.9
Major medical................................................... 77.4 108.6 120.0
-------- -------- --------
Total average liabilities for other business
in run-off, net of reinsurance ceded...................... $3,361.9 $3,403.1 $2,097.9
======== ======== ========
Revenues:
Insurance policy income......................................... $ 302.3 $ 41.6 $ 418.8
Net investment income on general account
invested assets............................................... 123.0 13.5 101.5
Net realized investment gains................................... 2.8 .6 6.3
Fee revenue and other income.................................... .6 .3 .5
-------- -------- --------
Total revenues.............................................. 428.7 56.0 527.1
-------- -------- --------
Expenses:
Insurance policy benefits....................................... 293.5 43.0 595.0
Amortization expense............................................ 13.6 1.5 28.0
Interest expense on investment borrowings....................... .1 - .2
Other operating costs and expenses.............................. 71.7 8.1 75.2
-------- -------- --------
Total benefits and expenses................................. 378.9 52.6 698.4
-------- -------- --------
Income (loss) before income taxes and
discontinued operations................................... $ 49.8 $ 3.4 $ (171.3)
======== ======== ========
Health loss ratios:
Insurance policy benefits..................................... $ 293.5 $ 43.0 $ 595.0
Loss ratio (a)................................................ 97.06% 103.24% 142.06%
Interest-adjusted loss ratio (b).............................. 57.42% 74.39% 119.40%
- -----------
(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 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
70
CONSECO, INC. AND SUBSIDIARIES
-------------------
(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 $96.3 million and $298.4
million in the three and nine months ended September 30, 2004, respectively;
$48.0 million in the one month ended September 30, 2003; $102.4 million in the
two months ended August 31, 2003; and $424.4 million in the eight months ended
August 31, 2003. We have ceased marketing the long-term care business included
in this segment. Accordingly, collected premiums will decrease over time.
Changes in long-term care premium collections are the result of policy lapses,
partially offset by premium rate increases. 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 $3.3 billion and $3.4 billion in the three and nine months ended September
30, 2004, respectively; $3.4 billion in the one month ended September 30, 2003;
$2.2 billion in the two months ended August 31, 2003; and $2.1 billion in the
eight months ended August 31, 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 $41.8 million
and $123.0 million in the three and nine months ended September 30, 2004,
respectively; $13.5 million in the one month ended September 30, 2003; $26.7
million in the two months ended August 31, 2003; and $101.5 million in the eight
months ended August 31, 2003. The average balance of general account invested
assets was $3.0 billion in both the three and nine months ended September 30,
2004; $2.8 billion in the one month ended September 30, 2003; $2.5 billion in
the two months ended August 31, 2003; and $2.5 billion in the eight months ended
August 31, 2003. The yield on these assets was 5.6 percent and 5.5 percent in
the three and nine months ended September 30, 2004, respectively; 5.8 percent in
the one month ended September 30, 2003; 6.3 percent in the two months ended
August 31, 2003; and 6.1 percent in the eight months ended August 31, 2003. Net
investment income on general account invested assets in the 2004 periods is not
comparable to the 2003 periods 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
through the first half 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
nine months ended September 30, 2004, net realized investment gains in our Other
Business in Run-off segment included: (i) $3.4 million of net gains from the
sales of investments (primarily fixed maturities); net of (ii) $.6 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 one month ended September 30, 2003, we recognized net
realized investment gains of $.6 million in our Other Business in Run-off
segment related to the net gains from the sales of investments (primarily fixed
maturities). There were no writedowns of fixed maturity investments in the one
month period. During the first eight months of 2003, we recognized net realized
investment gains of $6.3 million. During the first eight months of 2003, the net
realized investment gains included: (i) $8.7 million of net gains from the sales
of investments (primarily fixed maturities); net of (ii) $2.4 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.
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.
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CONSECO, INC. AND SUBSIDIARIES
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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 expectations. 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 care policies. In addition,
during 2004, we have been actively managing our long-term care cases and claim
adjudication processes. On April 20, 2004, the Florida Office of Insurance
Regulation issued an order to our subsidiary, Conseco Senior, that affects
approximately 11,000 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.
We currently expect to complete the process of notifying our home health care
policyholders of these choices in early 2005. We should know which options these
policyholders have selected by September 30, 2005.
On July 1, 2004, the Florida Office of Insurance Regulation issued a similar
order impacting approximately 4,500 home health care policies which are
obligations of Washington National. The orders also require Conseco Senior and
Washington National to pursue a similar course of action with respect to
approximately 24,000 home health care policies 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 ratios for the 2004 periods reflect: (i) unfavorable claims
experience on our long-term care products; partially offset by (ii) the
elimination of $1.5 million in the third quarter of 2004 ($11.5 million in the
first nine months of 2004) of reserve redundancies related to our major medical
policies. The decrease in the loss ratios as compared to the 2003 periods 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 expense includes amortization of insurance intangibles. The
decrease in amortization expense in the 2004 periods 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 $23.3 million and $71.7 million in
the three and nine months ended September 30, 2004, respectively; $8.1 million
in the one month ended September 30, 2003; $21.1 million in the two months ended
August 31, 2003; and $75.2 million in the eight months ended August 31, 2003.
The decreases in expenses were due primarily to expense reductions in the major
medical operations.
72
CONSECO, INC. AND SUBSIDIARIES
-------------------
Corporate (dollars in millions)
Successor Predecessor
--------------------------------- -----------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Corporate operations:
Interest expense on corporate debt............................... $(11.0) $ (6.4) $ (53.5)
Net investment income ........................................... .9 .1 3.2
Provision for losses and expense related to stock
purchase plan.................................................. - - (24.5)
Venture capital income (loss) related to investment in
AWE, net of related expenses................................... - (2.7) 2.0
Fee revenue and other income..................................... 4.0 1.5 3.8
Net realized investment losses................................... - (.4) (1.6)
Other operating costs and expenses............................... (28.7) (3.4) (7.7)
Reorganization items............................................. - - 2,163.0
------ ------ --------
Income (loss) before income taxes.............................. $(34.8) $(11.3) $2,084.7
====== ====== ========
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Corporate operations:
Interest expense on corporate debt............................... $ (59.9) $ (6.4) $ (194.2)
Net investment income ........................................... 1.4 .1 16.2
Provision for losses and expense related to stock
purchase plan.................................................. - - (55.6)
Venture capital income (loss) related to investment in
AWE, net of related expenses................................... - (2.7) 10.5
Fee revenue and other income..................................... 11.6 1.5 17.1
Net realized investment losses................................... (2.8) (.4) (.1)
Gain on extinguishment of debt................................... 2.8 - -
Other operating costs and expenses............................... (57.3) (3.4) (40.4)
Reorganization items............................................. - - 2,130.5
------- ------ --------
Income (loss) before income taxes.............................. $(104.2) $(11.3) $1,884.0
======= ====== ========
Interest expense on corporate debt in the 2004 periods includes interest
expense on the Credit Facility and Previous Credit Facility, including a credit
agreement charge of $3.8 million (none of which was recognized in the third
quarter of 2004). Interest expense in the one month ended September 30, 2003
reflected interest expense on the Previous Credit Facility. Interest expense in
the eight months ended August 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 2004 periods, as compared to
the same periods 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 eight months ended August 31, 2003, we
established a provision of
73
CONSECO, INC. AND SUBSIDIARIES
-------------------
$55.6 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 loans which exceed $250 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
September 30, 2004, we have estimated that approximately $50.0 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) related 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 fluctuate from period to period. In
the first nine months of 2004, we recognized a writedown of $2.9 million due to
an other-than-temporary decline in value.
Gain on extinguishment of debt of $2.8 million resulted from the repayment
of our Previous Credit Facility as further described in the note to the
consolidated financial statements entitled "Changes in Direct Corporate
Obligations". The gain resulted from the release of a $6.3 million accrual for a
fee that would have been required to be paid under the Previous Credit Facility,
partially offset by the write-off of unamortized amendment fees.
Other operating costs and expenses include general corporate expenses, net
of amounts charged to subsidiaries for services provided by the corporate
operations. In the third quarter of 2004, we incurred expenses of $13.5 million
related to our executive transition as further discussed in the notes to the
consolidated financial statements under the captions entitled "Executive
Termination" and "Executive Hiring". In addition, general corporate expenses in
the three and nine months ended September 30, 2004 included severance expense of
$.4 million and $7.2 million, respectively.
Reorganization items in the two months ended August 31, 2003 included: (i)
$3,151.4 million related to the gain on the discharge of prepetition
liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii)
$(38.4) million related to professional fees associated with our bankruptcy
proceedings which are expensed as incurred in accordance with SOP 90-7. The
reorganization items in the eight months ended August 31, 2003 included: (i)
$3,151.4 million related to the gain on the discharge of prepetition
liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii)
$(70.9) million related to professional fees.
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. In the second quarter of 2004, the financial
strength ratings of our primary insurance subsidiaries (with the exception of
Conseco Senior) were upgraded by A.M. Best, S&P and Moody's. In the third
quarter of 2004, Moody's again upgraded the financial strength ratings of our
primary insurance subsidiaries (with the exception of Conseco Senior). The
current financial strength ratings of our primary insurance subsidiaries (with
the exception of Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very
Good)",
74
CONSECO, INC. AND SUBSIDIARIES
-------------------
"BB+" and "Ba1", respectively. The current financial strength ratings of
Conseco Senior from A.M. Best, S&P and Moody's are "B (Fair)", "CCC" and "Caa1",
respectively. For a description of the 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 continue to improve our ratings to be
competitive.
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.
Total premiums and accumulation product collections were as follows:
75
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Successor Predecessor
--------------------------------- ------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)..................................... $ 13.4 $ .6 $ 2.5
------ ------ ------
Other fixed (first-year)........................................ 240.5 62.7 146.6
Other fixed (renewal)........................................... .3 .2 .3
------ ------ ------
Subtotal - other fixed annuities.............................. 240.8 62.9 146.9
------ ------ ------
Total annuities............................................... 254.2 63.5 149.4
------ ------ ------
Supplemental health:
Medicare supplement (first-year)................................ 17.4 4.7 9.5
Medicare supplement (renewal)................................... 138.6 48.3 94.4
------ ------ ------
Subtotal - Medicare supplement................................ 156.0 53.0 103.9
------ ------ ------
Long-term care (first-year)..................................... 17.7 6.0 12.2
Long-term care (renewal)........................................ 117.6 36.6 73.2
------ ------ ------
Subtotal - long-term care..................................... 135.3 42.6 85.4
------ ------ ------
Other health (first-year)....................................... .2 - .2
Other health (renewal).......................................... 2.8 1.0 2.1
------ ------ ------
Subtotal - other health....................................... 3.0 1.0 2.3
------ ------ ------
Total supplemental health..................................... 294.3 96.6 191.6
------ ------ ------
Life insurance:
First-year...................................................... 12.5 3.9 8.3
Renewal......................................................... 33.9 8.1 22.0
------ ------ ------
Total life insurance.......................................... 46.4 12.0 30.3
------ ------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products...................................................... 301.7 77.9 179.3
Total renewal premium collections on insurance
products...................................................... 293.2 94.2 192.0
------ ------ ------
Total collections on insurance products....................... $594.9 $172.1 $371.3
====== ====== ======
76
CONSECO, INC. AND SUBSIDIARIES
-------------------
Successor Predecessor
--------------------------------- -------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)................................... $ 27.3 $ .6 $ 10.0
-------- ------ --------
Other fixed (first-year)...................................... 633.3 62.7 685.4
Other fixed (renewal)......................................... 1.3 .2 3.0
-------- ------ --------
Subtotal - other fixed annuities............................ 634.6 62.9 688.4
-------- ------ --------
Total annuities............................................. 661.9 63.5 698.4
-------- ------ --------
Supplemental health:
Medicare supplement (first-year).............................. 51.5 4.7 37.6
Medicare supplement (renewal)................................. 427.6 48.3 381.5
-------- ------ --------
Subtotal - Medicare supplement.............................. 479.1 53.0 419.1
-------- ------ --------
Long-term care (first-year)................................... 52.4 6.0 48.7
Long-term care (renewal)...................................... 349.7 36.6 282.8
-------- ------ --------
Subtotal - long-term care................................... 402.1 42.6 331.5
-------- ------ --------
Other health (first-year)..................................... .7 - .8
Other health (renewal)........................................ 8.7 1.0 8.2
-------- ------ --------
Subtotal - other health..................................... 9.4 1.0 9.0
-------- ------ --------
Total supplemental health................................... 890.6 96.6 759.6
-------- ------ --------
Life insurance:
First-year.................................................... 36.3 3.9 25.1
Renewal....................................................... 94.2 8.1 77.6
-------- ------ --------
Total life insurance........................................ 130.5 12.0 102.7
-------- ------ --------
Collections on insurance products:
Total first-year premium collections on insurance
products.................................................... 801.5 77.9 807.6
Total renewal premium collections on insurance
products.................................................... 881.5 94.2 753.1
-------- ------ --------
Total collections on insurance products..................... $1,683.0 $172.1 $1,560.7
======== ====== ========
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 were $254.2 million and $661.9 million in the
three and nine months ended September 30, 2004, respectively; $63.5 million in
the one month ended September 30, 2003; $149.4 million in the two months ended
August 31, 2003; and $698.4 million in the eight months ended August 31, 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 and the first nine months of 2004, the minimum guaranteed crediting rates
on certain of our annuity products were very attractive.
77
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 were $156.0 million and $479.1 million in the three and nine months
ended September 30, 2004, respectively; $53.0 million in the one month ended
September 30, 2003; $103.9 million in the two months ended August 31, 2003; and
$419.1 million in the eight months ended August 31, 2003.
Premiums collected on Bankers Life's long-term care policies were $135.3
million and $402.1 million in the three and nine months ended September 30,
2004, respectively; $42.6 million in the one month ended September 30, 2003;
$85.4 million in the two months ended August 31, 2003; and $331.5 million in the
eight months ended August 31, 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 2004 periods were
comparable to the 2003 periods.
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 were $46.4 million and $130.5 million in the
three and nine months ended September 30, 2004, respectively; $12.0 million in
the one month ended September 30, 2003; $30.3 million in the two months ended
August 31, 2003; and $102.7 million in the eight months ended August 31, 2003.
Collected premiums have been impacted by increases in new sales.
78
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions)
Successor Predecessor
---------------------------------- ------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)..................................... $ 7.9 $ 1.4 $ 1.3
Equity-indexed (renewal)........................................ 2.6 .9 5.7
------ ------ ------
Subtotal - equity-indexed annuities........................... 10.5 2.3 7.0
------ ------ ------
Other fixed (first-year)........................................ 2.7 .6 1.4
Other fixed (renewal)........................................... 2.9 2.3 3.1
------ ------ ------
Subtotal - other fixed annuities.............................. 5.6 2.9 4.5
------ ------ ------
Total annuities............................................... 16.1 5.2 11.5
------ ------ ------
Supplemental health:
Medicare supplement (first-year)................................ 4.8 4.0 8.4
Medicare supplement (renewal)................................... 81.2 25.8 57.3
------ ------ ------
Subtotal - Medicare supplement................................ 86.0 29.8 65.7
------ ------ ------
Specified disease (first-year).................................. 8.3 2.4 2.6
Specified disease (renewal)..................................... 82.3 27.1 50.9
------ ------ ------
Subtotal - specified disease.................................. 90.6 29.5 53.5
------ ------ ------
Other health (first-year)....................................... - 1.9 6.1
Other health (renewal).......................................... 3.7 3.8 3.0
------ ------ ------
Subtotal - other health....................................... 3.7 5.7 9.1
------ ------ ------
Total supplemental health..................................... 180.3 65.0 128.3
------ ------ ------
Life insurance:
First-year...................................................... 4.3 1.7 4.0
Renewal......................................................... 89.4 32.8 69.8
------ ------ ------
Total life insurance.......................................... 93.7 34.5 73.8
------ ------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products...................................................... 28.0 12.0 23.8
Total renewal premium collections on insurance
products...................................................... 262.1 92.7 189.8
------ ------ ------
Total collections on insurance products....................... $290.1 $104.7 $213.6
====== ====== ======
79
CONSECO, INC. AND SUBSIDIARIES
-------------------
Successor Predecessor
--------------------------------- --------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums collected:
Annuities:
Equity-indexed (first-year)..................................... $ 20.1 $ 1.4 $ 32.8
Equity-indexed (renewal)........................................ 9.8 .9 12.1
------ ------ ------
Subtotal - equity-indexed annuities........................... 29.9 2.3 44.9
------ ------ ------
Other fixed (first-year)........................................ 5.9 .6 14.3
Other fixed (renewal)........................................... 9.6 2.3 14.8
------ ------ ------
Subtotal - other fixed annuities.............................. 15.5 2.9 29.1
------ ------ ------
Total annuities............................................... 45.4 5.2 74.0
------ ------ ------
Supplemental health:
Medicare supplement (first-year)................................ 18.3 4.0 36.5
Medicare supplement (renewal)................................... 249.0 25.8 213.9
------ ------ ------
Subtotal - Medicare supplement................................ 267.3 29.8 250.4
------ ------ ------
Specified disease (first-year).................................. 25.0 2.4 19.7
Specified disease (renewal)..................................... 248.3 27.1 216.7
------ ------ ------
Subtotal - specified disease.................................. 273.3 29.5 236.4
------ ------ ------
Other health (first-year)....................................... .1 1.9 9.7
Other health (renewal).......................................... 12.3 3.8 28.8
------ ------ ------
Subtotal - other health....................................... 12.4 5.7 38.5
------ ------ ------
Total supplemental health..................................... 553.0 65.0 525.3
------ ------ ------
Life insurance:
First-year...................................................... 14.9 1.7 20.6
Renewal......................................................... 270.8 32.8 260.1
------ ------ ------
Total life insurance.......................................... 285.7 34.5 280.7
------ ------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products...................................................... 84.3 12.0 133.6
Total renewal premium collections on insurance
products...................................................... 799.8 92.7 746.4
------ ------ ------
Total collections on insurance products....................... $884.1 $104.7 $880.0
====== ====== ======
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 were $16.1 million and $45.4 million in the three and
nine months ended September 30, 2004, respectively; $5.2 million in the one
month ended September 30, 2003; $11.5 million in the two months ended August 31,
2003; and $74.0 million in the eight months ended August 31, 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
80
CONSECO, INC. AND SUBSIDIARIES
-------------------
percent compound average interest rate over the term of the contracts). These
annuities provide for potentially higher returns based on a percentage of the
change in the S&P 500 Index during each year of their term. We purchase S&P 500
Call Options in an effort to hedge increases to policyholder benefits resulting
from increases in the S&P 500 Index. Total collected premiums for this product
were $10.5 million and $29.9 million in the three and nine months ended
September 30, 2004, respectively; $2.3 million in the one month ended September
30, 2003; $7.0 million in the two months ended August 31, 2003; and $44.9
million in the eight months ended August 31, 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 were $5.6 million and $15.5
million in the three and nine months ended September 30, 2004, respectively;
$2.9 million in the one month ended September 30, 2003; $4.5 million in the two
months ended August 31, 2003; and $29.1 million in the eight months ended August
31, 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 were $86.0 million and $267.3 million in the three and nine months
ended September 30, 2004, respectively; $29.8 million in the one month ended
September 30, 2003; $65.7 million in the two months ended August 31, 2003; and
$250.4 million in the eight months ended August 31, 2003. New Medicare
supplement sales have been affected by increases in premium rates.
Premiums collected on specified disease products were $90.6 million and
$273.3 million in the three and nine months ended September 30, 2004,
respectively; $29.5 million in the one month ended September 30, 2003; $53.5
million in the two months ended August 31, 2003; and $236.4 million in the eight
months ended August 31, 2003. The 2004 periods were favorably impacted by a
slight increase in new sales.
Other health products include disability income, dental and various other
health insurance products. We no longer actively market many of these products.
Premiums collected were $3.7 million and $12.4 million in the three and nine
months ended September 30, 2004, respectively; $5.7 million in the one month
ended September 30, 2003; $9.1 million in the two months ended August 31, 2003;
and $38.5 million in the eight months ended August 31, 2003.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected were $93.7 million
and $285.7 million in the three and nine months ended September 30, 2004,
respectively; $34.5 million in the one month ended September 30, 2003; $73.8
million in the two months ended August 31, 2003; and $280.7 million in the eight
months ended August 31, 2003. Our A.M. Best rating has negatively affected our
sales of life products. We stopped actively marketing certain of our life
insurance products sold through the professional independent producer channel in
the second quarter of 2003.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-Off (dollars in millions)
Successor Predecessor
---------------------------------- -------------
Three months One month Two months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums collected:
Long-term care:
First-year......................................................... $ - $ .2 $ .5
Renewal............................................................ 92.7 29.9 70.1
----- ----- ------
Subtotal - long-term care........................................ 92.7 30.1 70.6
----- ----- ------
Major medical:
Group (first-year)................................................. - - -
Group (renewal).................................................... 2.7 17.4 28.6
----- ----- ------
Subtotal - group major medical................................... 2.7 17.4 28.6
----- ----- ------
Individual (first-year)............................................ - - -
Individual (renewal)............................................... .9 .5 3.2
----- ----- ------
Subtotal - individual major medical.............................. .9 .5 3.2
----- ----- ------
Total major medical.............................................. 3.6 17.9 31.8
----- ----- ------
Collections on insurance products:
Total first-year premium collections on insurance
products......................................................... - .2 .5
Total renewal premium collections on insurance
products......................................................... 96.3 47.8 101.9
----- ----- ------
Total collections on insurance products.......................... $96.3 $48.0 $102.4
===== ===== ======
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CONSECO, INC. AND SUBSIDIARIES
-------------------
Successor Predecessor
--------------------------------- ------------
Nine months One month Eight months
ended ended ended
September 30, September 30, August 31,
2004 2003 2003
---- ---- ----
Premiums collected:
Long-term care:
First-year...................................................... $ .2 $ .2 $ 3.2
Renewal......................................................... 283.2 29.9 264.8
------ ----- ------
Subtotal - long-term care..................................... 283.4 30.1 268.0
------ ----- ------
Major medical:
Group (first-year).............................................. - - -
Group (renewal)................................................. 12.3 17.4 152.4
------ ----- ------
Subtotal - group major medical................................ 12.3 17.4 152.4
------ ----- ------
Individual (first-year)......................................... - - -
Individual (renewal)............................................ 2.7 .5 4.0
------ ----- ------
Subtotal - individual major medical........................... 2.7 .5 4.0
------ ----- ------
Total major medical........................................... 15.0 17.9 156.4
------ ----- ------
Collections on insurance products:
Total first-year premium collections on insurance
products..................................................... .2 .2 3.2
Total renewal premium collections on insurance
products...................................................... 298.2 47.8 421.2
------ ----- ------
Total collections on insurance products....................... $298.4 $48.0 $424.4
====== ===== ======
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 were $92.7 million and
$283.4 million in the three and nine months ended September 30, 2004,
respectively; $30.1 million in the one month ended September 30, 2003; $70.6
million in the two months ended August 31, 2003; and $268.0 million in the eight
months ended August 31, 2003. 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 orders issued by
the Florida Office of Insurance Regulation regarding certain blocks of our
long-term care business.
Group major medical premiums were $2.7 million and $12.3 million in the
three and nine months ended September 30, 2004, respectively; $17.4 million in
the one month ended September 30, 2003; $28.6 million in the two months ended
August 31, 2003; and $152.4 million in the eight months ended August 31, 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 are not significant. 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.
83
CONSECO, INC. AND SUBSIDIARIES
-------------------
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between September 30, 2004 and
December 31, 2003, primarily reflect: (i) the issuance of common stock and
preferred stock and the use of proceeds from such offerings, as further
described in the note to the consolidated financial statements entitled "Changes
in Common Stock and Preferred Stock"; (ii) the refinancing of our Previous
Credit Facility, as further described in the note to the consolidated financial
statements entitled "Changes in Direct Corporate Obligations"; (iii) our net
income for the nine months ended September 30, 2004; and (iv) changes in the
fair value of actively managed fixed maturity securities.
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 September 30, 2004, and December 31,
2003, we increased the carrying value of such investments by $568.1 million and
$375.2 million, respectively, as a result of this fair value adjustment.
Our capital structure as of September 30, 2004, and December 31, 2003, was
as follows (dollars in millions):
Successor
-----------------------------
September 30, December 31,
2004 2003
---- ----
Total capital:
Corporate notes payable................................................ $ 788.6 $1,300.0
Shareholders' equity:
Preferred stock..................................................... 667.8 887.5
Common stock........................................................ 1.5 1.0
Additional paid-in-capital.......................................... 2,535.8 1,641.9
Accumulated other comprehensive income.............................. 302.8 218.7
Retained earnings................................................... 220.9 68.5
-------- --------
Total shareholders' equity....................................... 3,728.8 2,817.6
-------- --------
Total capital.................................................... $4,517.4 $4,117.6
======== ========
The following table summarizes certain financial ratios as of and for the
nine months ended September 30, 2004 and as of and for the four months ended
December 31, 2003:
Successor
---------------------------
September 30, December 31,
2004 2003
---- ----
Book value per common share.................................................................. $20.25 $19.28
Book value per common share, excluding accumulated other comprehensive income(1)............. 18.25 17.09
Ratio of earnings to fixed charges........................................................... 1.85x 1.79x
Ratio of earnings to fixed charges and preferred dividends................................... 1.51x 1.46x
Debt to total capital ratios:
Corporate debt to total capital........................................................... 17% 32%
Corporate debt to total capital, excluding accumulated other comprehensive income(1)...... 19% 33%
Corporate debt and preferred stock to total capital....................................... 32% 53%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income(1).............................................................. 35% 56%
- -----------------------
(1) This non-GAAP measure differs from the corresponding GAAP measure presented
immediately above, because accumulated other comprehensive income (loss)
has been excluded from the value of capital used to determine this measure.
Management believes this non-GAAP measure is useful, because it removes the
volatility from changes in accumulated other comprehensive income (loss) in
the value of capital. Such volatility is often caused by changes in the
estimated fair value of our investment portfolio resulting from changes in
general market interest rates rather than the business decisions made by
management. However, this measure does not replace the corresponding GAAP
measure.
84
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 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. On June 25, 2004,
A.M. Best upgraded the financial strength ratings of our primary insurance
subsidiaries from "B (Fair)" to "B++ (Very Good)", with the exception of Conseco
Senior, whose "B (Fair)" rating was affirmed by A.M. Best. According to A.M.
Best, these rating actions reflected the substantial recapitalization of our
balance sheet, improved absolute and risk-adjusted capital on a statutory basis
and improving operating fundamentals. The "B++" rating is assigned to companies
that have a good ability, in A.M. Best's opinion, to meet their ongoing
obligations to policyholders.
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, which was assigned a "CCC"
rating. On May 27, 2004, S&P upgraded the financial strength ratings of our
primary insurance companies from "BB-" to "BB+", with the exception of Conseco
Senior, 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, which was assigned a
"Caa1" rating. On May 27, 2004, Moody's upgraded the financial strength rating
of our primary insurance companies from "Ba3" to "Ba2" with the exception of
Conseco Senior, which was assigned a "Caa1" rating. On August 9, 2004, Moody's
again upgraded the financial strength rating of our primary insurance companies
from "Ba2" to "Ba1" and reaffirmed the "Caa1" rating of Conseco Senior. 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, 2003 and the first half of 2004. 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.
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 Texas
Department of Insurance, on October 30, 2002, which were formally released on
November 19, 2003. The consent orders applied to all of our insurance
subsidiaries and, among other requirements, restricted the ability of our
insurance subsidiaries to pay any dividends or other amounts to any
non-insurance company parent without prior approval. Notwithstanding the release
of the
85
CONSECO, INC. AND SUBSIDIARIES
-------------------
consent orders, we 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. 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.
Liquidity of the Holding Companies
On June 22, 2004, we entered into the Credit Facility with a principal
balance of $800.0 million. The Credit Facility is a six-year term loan, the
proceeds of which were used: (i) to refinance in full all indebtedness,
including accrued interest, under the Previous Credit Facility; (ii) to
repurchase $106.6 million of certain affiliated preferred stock; and (iii) for
other general corporate purposes. We are required to make quarterly principal
payments of $2.0 million commencing on September 30, 2004, and continuing until
March 31, 2010. The remaining balance of $754.0 million is due on June 22, 2010.
See the note to the consolidated financial statements entitled "Changes in
Direct Corporate Obligations" for further discussion related to the Credit
Facility.
At September 30, 2004, Conseco Inc. and CDOC held unrestricted cash of
$74.9 million. In addition, our other non-life insurance companies held
unrestricted cash of approximately $59.4 million which could be upstreamed to
the parent companies if needed.
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 which 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. We recently were subject to consent orders with the Commissioner of
Insurance for the State of Texas that, among other requirements, 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 ratios of certain insurance subsidiaries and this could affect the
ability of our top tier insurance subsidiary to pay dividends.
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 similar systems to a much smaller number of systems. We expect to
spend over $35 million on capital expenditures in 2004
86
CONSECO, INC. AND SUBSIDIARIES
-------------------
(including amounts related to the aforementioned initiatives). We believe we
have adequate cash flows from operations to fund these initiatives.
Under our 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.
INVESTMENTS
At September 30, 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................................................ $12,158.0 $423.3 $21.4 $12,559.9
United States Treasury securities and obligations of
United States government corporations and agencies................ 1,635.2 24.9 2.5 1,657.6
States and political subdivisions................................... 747.3 15.8 4.8 758.3
Debt securities issued by foreign governments....................... 115.9 3.7 .1 119.5
Structured securities .............................................. 5,338.9 90.9 5.8 5,424.0
Below-investment grade (primarily corporate securities)................ 750.6 43.3 6.9 787.0
--------- ------ ----- ---------
Total actively managed fixed maturities............................. $20,745.9 $601.9 $41.5 $21,306.3
========= ====== ===== =========
Equity securities...................................................... $62.5 $5.2 $.1 $67.6
===== ==== === =====
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our fixed maturity
securities by industry category as of September 30, 2004 (dollars in millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 5,426.9 25.4%
Bank and finance..................................................................... 3,478.2 16.4
Services............................................................................. 2,702.0 12.7
Manufacturing........................................................................ 2,471.3 11.6
Utilities............................................................................ 1,421.8 6.7
Communications....................................................................... 1,059.4 5.0
Government (US)...................................................................... 898.1 4.2
Agriculture, forestry and mining..................................................... 830.0 3.8
Asset-backed securities.............................................................. 724.7 3.4
Retail and wholesale................................................................. 659.7 3.1
Transportation....................................................................... 593.4 2.8
Other................................................................................ 1,040.8 4.9
--------- -----
Total fixed maturity securities................................................... $21,306.3 100.0%
========= =====
87
CONSECO, INC. AND SUBSIDIARIES
-------------------
Below-Investment Grade Securities
At September 30, 2004, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $750.6 million, or 3.6
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $787.0 million, or 105 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 creditors
of the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and are more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than are investment grade
issuers. The Company attempts to reduce the overall risk in the below-investment
grade portfolio, as in all investments, through careful credit analysis, strict
investment policy guidelines, and diversification by issuer and/or guarantor and
by industry.
Net Realized Investment Gains (Losses)
During the first nine months of 2004, we recognized net realized investment
gains of $27.5 million. The net realized investment gains during the first nine
months of 2004 included: (i) $45.3 million of net gains from the sales of
investments (primarily fixed maturities) which generated proceeds of $9.9
billion; net of (ii) $17.8 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. During the one month ended September 30, 2003, we recognized net
realized investment gains of $6.7 million resulting from the sales of
investments (primarily fixed maturities) which generated proceeds of $2.1
billion. There were no writedowns of fixed maturity investments as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary. During the first eight months of 2003, we recognized
net realized investment losses of $5.4 million. The net realized investment
losses during the first eight months of 2003 included: (i) $45.9 million of net
gains from the sales of investments (primarily fixed maturities) which generated
proceeds of $5.4 billion; net of (ii) $51.3 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. At September 30, 2004, fixed maturity securities in
default as to the payment of principal or interest had an aggregate amortized
cost of $5.1 million and a carrying value of $6.9 million.
During the nine months ended September 30, 2004, we sold $2.0 billion of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $34.5 million. Securities sold at a loss are sold for a number
of reasons including but not limited to: (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 nine months ended September 30, 2004, we recorded writedowns of
fixed maturity investments, equity securities and other invested assets totaling
$17.8 million. During the nine months ended September 30, 2004, we recognized a
loss of $3.5 million related to an issuer in the airline industry rated
Caa/CCC-. Although this investment is in a major airline, this company remains
highly leveraged and the entire industry is currently facing a difficult
operating environment including rising fuel prices. Accordingly, we concluded
that the decline in fair value was other than temporary. In addition to the
specific investment discussed above, we recorded $14.3 million of writedowns
related to various other investments. No other 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.
88
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time.
Our periodic assessment of whether unrealized losses are "other than
temporary" requires significant judgment. Factors considered include: (i) the
extent to which market value is less than the cost basis; (ii) the length of
time that the market value has been less than cost; (iii) whether the unrealized
loss is event driven, credit-driven or a result of changes in market interest
rates; (iv) the near-term prospects for improvement in the issuer and/or its
industry; (v) whether the investment is investment-grade and our view of the
investment's rating and whether the investment has been downgraded since its
purchase; (vi) whether the issuer is current on all payments in accordance with
the contractual terms of the investment and is expected to meet all of its
obligations under the terms of the investment; (vii) our ability and intent to
hold the investment for a period of time sufficient to allow for any anticipated
recovery; and (viii) the underlying current and prospective asset and enterprise
values of the issuer and the extent to which our investment may be affected by
changes in such values.
If a decline in value is determined to be other than temporary and the cost
basis of the security is written down to fair value, we review the circumstances
which caused us to believe that the decline was other than temporary with
respect to other investments in our portfolio. If such circumstances exist with
respect to other investments, those investments are also written down to fair
value. Future events may occur, or additional or updated information may become
available, which may necessitate future realized losses of securities in our
portfolio. Significant losses in the carrying value of our investments could
have a material adverse effect on our earnings in future periods.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at September
30, 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................................................................... $ 62.4 $ 62.2
Due after one year through five years..................................................... 345.8 341.9
Due after five years through ten years.................................................... 848.7 836.4
Due after ten years....................................................................... 816.6 797.3
-------- --------
Subtotal............................................................................... 2,073.5 2,037.8
Structured securities..................................................................... 1,001.3 995.5
-------- --------
Total.................................................................................. $3,074.8 $3,033.3
======== ========
At September 30, 2004, we had no investments in fixed maturities rated
below-investment grade or classified as equity-type securities in an unrealized
loss position exceeding 20 percent of the cost basis.
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 or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. 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. As described in the note to our consolidated financial statements
entitled "Recently Issued Accounting Standards", certain guidance related to
determining when an impairment of an investment is other than temporary is being
considered by the Emerging Issues Task Force. Depending on the ultimate guidance
issued, including guidance regarding management's assertion about intent and
ability to hold actively managed fixed maturities for a period of time
sufficient to allow for any anticipated recovery, the Company's practice of
selling securities at a loss could result in a
89
CONSECO, INC. AND SUBSIDIARIES
-------------------
requirement to report unrealized losses in a different manner, including
reflecting unrealized losses in the income statement as other-than-temporary
impairments.
The following table summarizes the gross unrealized losses and fair value
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position at
September 30, 2004 (dollars in millions).
Less than 12 months 12 months or greater Total
---------------------- --------------------- -----------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies........ $ 210.5 $ (2.5) $ .5 $ - $ 211.0 $ (2.5)
States and political subdivisions... 161.4 (4.7) 1.7 (.1) 163.1 (4.8)
Debt securities issued by
foreign governments.............. 15.3 (.1) - - 15.3 (.1)
Corporate securities................ 1,624.6 (27.5) 23.8 (.8) 1,648.4 (28.3)
Structured securities............... 980.3 (5.3) 15.2 (.5) 995.5 (5.8)
-------- ------ ----- ----- -------- ------
Total actively managed
fixed maturities................. $2,992.1 $(40.1) $41.2 $(1.4) $3,033.3 $(41.5)
======== ====== ===== ===== ======== ======
Equity securities................... $3.0 $(.1) $3.0 $(.1)
==== ==== ==== ====
Based on management's current assessment of investments with unrealized
losses at September 30, 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.
Structured Securities
At September 30, 2004, fixed maturity investments included $5.4 billion of
structured securities (or 25 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 in some
respects from those of traditional fixed-income securities. For example,
interest and principal payments for mortgage-backed securities occur more
frequently, often monthly. In addition, 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 in absolute terms and also 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
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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 September 30, 2004 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 196.7 $ 198.2 $ 201.3
4 percent - 5 percent............................................................... 1,415.6 1,363.2 1,381.6
5 percent - 6 percent............................................................... 1,607.2 1,599.1 1,630.7
6 percent - 7 percent............................................................... 1,731.9 1,795.0 1,821.7
7 percent - 8 percent............................................................... 323.8 339.5 343.9
8 percent and above................................................................. 43.2 46.0 47.7
-------- -------- --------
Total structured securities (a).............................................. $5,318.4 $5,341.0 $5,426.9
======== ======== ========
- ---------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $2.1 million and $2.9 million,
respectively.
The amortized cost and estimated fair value of structured securities at
September 30, 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............ $3,084.9 $3,129.1 15%
Planned amortization classes and accretion-directed bonds................. 754.8 763.3 3
Commercial mortgage-backed securities..................................... 1,466.8 1,500.4 7
Subordinated classes and mezzanine tranches............................... 33.9 33.5 -
Other..................................................................... .6 .6 -
-------- -------- --
Total structured securities (a).................................... $5,341.0 $5,426.9 25%
======== ======== ==
- --------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $2.1 million and $2.9 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
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CONSECO, INC. AND SUBSIDIARIES
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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 September 30, 2004, the mortgage loan balance was primarily comprised of
commercial loans. Less than one percent of the mortgage loan balance was
noncurrent at September 30, 2004.
Investment Borrowings
Our investment borrowings averaged approximately $529.6 million during the
first nine months of 2004; $531.5 million during the one month ended September
30, 2003; and $689.1 million during the eight months ended August 31, 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 1.3 percent during the first nine months of 2004; 1.3 percent during the
one month ended September 30, 2003; and 1.8 percent during the eight months
ended August 31, 2003.
STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES)
As of the date of this filing, the consolidated statutory results of our
insurance subsidiaries for the nine months ended September 30, 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 November 15, 2004. Statutory accounting practices
prescribed or permitted by regulatory authorities for the Company's insurance
subsidiaries differ from GAAP. The consolidated statutory net income (loss) (a
non-GAAP measure) of our insurance subsidiaries is expected to be approximately
$(37.1) million in the first nine months of 2004 compared to $255.6 million in
the same period of 2003. Included in such net income (loss) are net realized
capital gains (losses), net of income taxes, of approximately $(50.8) million
and $33.3 million in the first nine months of 2004 and 2003, respectively. In
addition, such net income included interest expense on surplus debentures of
$148.0 million and nil in the first nine months of 2004 and 2003, respectively.
The Company's insurance subsidiaries expect to report the following amounts to
regulatory agencies at September 30, 2004, after appropriate eliminations of
intercompany accounts among such subsidiaries (dollars in millions):
Statutory capital and surplus .................................. $1,552.2
Asset valuation reserve......................................... 56.7
Interest maintenance reserve.................................... 269.4
--------
Total........................................................ $1,878.3
========
The statutory capital and surplus shown above included investments in
upstream affiliates of $52.4 million, all of which were eliminated in the
consolidated financial statements prepared in accordance with GAAP. In the
second quarter of 2004, $106.6 million of affiliated preferred stock held by our
insurance subsidiaries was redeemed by the parent using the proceeds from the
refinancing of our Previous Credit Facility.
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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 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 statutory net income for
the prior year; or (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. No dividends were paid to the parent company in the first nine
months of 2004.
The National Association of Insurance Commissioners' Risk-Based Capital
("RBC") 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 its 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 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.
At September 30, 2004, the consolidated Company Action Level RBC ratio for
our insurance subsidiaries exceeds the minimum risk-based capital requirement
included in our Credit Facility. See the note to the consolidated financial
statements entitled "Changes in Direct Corporate Obligations" for further
discussion of various financial ratios and balances we are required to maintain.
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 by the insurance subsidiaries on the fourth quarter 2003 partial
redemption of the senior notes. 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 $9.9
million in the first nine months 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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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 nine months of 2004 to
such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure 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 September 30, 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 the Securities and Exchange Commission's rules and forms.
Evaluation of Internal Controls. Section 404 of the Sarbanes Oxley Act of
2002 will require us to include a report in our Form 10-K for the year ending
December 31, 2004 containing an assessment of the effectiveness of our internal
control structure and procedures for financial reporting as of December 31,
2004. Our external auditors are required to attest to, and report on, the
assessment made by management. We are currently undergoing a comprehensive
effort to test our internal controls to confirm that such controls are designed
properly and operating effectively. When our testing identifies potential
weaknesses, we are taking necessary remediation actions. While we anticipate
being able to fully satisfy the requirements of Section 404 in a timely manner,
we cannot be certain as to the timing of completion of our evaluation, testing
and remediation actions or the impact of these actions on our operations. In
addition, since the new rules are subject to varying interpretations, there is
uncertainty regarding how compliance will be measured.
Changes to Internal Controls and Procedures for Financial Reporting. There
were no significant changes in Conseco's internal controls over financial
reporting that occurred during the quarter ended September 30, 2004, that have
materially affected, or are reasonably likely to materially affect, Conseco's
internal controls over financial reporting.
PART II - OTHER INFORMATION
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 lawsuit was 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 this lawsuit was discharged
in the Plan and our obligation to
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CONSECO, INC. AND SUBSIDIARIES
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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 and has been set for hearing on
November 19, 2004. We believe this lawsuit is without merit and intend to defend
it vigorously. The ultimate outcome of this lawsuit cannot be predicted with
certainty.
Other Litigation
Collection efforts by the Company and its wholly owned subsidiary, Conseco
Services, LLC ("Conseco Services"), related to the 1996-1999 director and
officer loan programs have been commenced against various past board members and
executives with outstanding loan balances. In addition, certain former officers
and directors have sued the companies for declaratory relief concerning their
liability for the loans. Currently, we are involved in litigation with Stephen
C. Hilbert, James D. Massey, Dennis E. Murray, Sr., 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-1701-LJM-VSS
(Southern District, Indiana); Conseco v. Adams, et al., Case No. 03A 04545 9
(Bankr. Northern District, Illinois); Conseco Services v. Dick, et al., Case No.
06C01-0311-CC-536 (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); Conseco v. Dick, Case No. 04L 002811 (Circuit
Court, Cook County, Illinois) Conseco Services v. Adams, Case No.
29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton
County, Indiana); Conseco Services v. Cuneo, et al., Case No.
1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray.,
Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County,
Indiana); Conseco Services v. Gongaware, Case No. 29D02-0404-CC-380 (Superior
Court, Hamilton County, Indiana). David Decatur filed for bankruptcy on May 12,
2004. The Company and Conseco Services believe that all amounts due under the
director and officer loan programs, including all applicable interest, are valid
obligations owed to the companies. As part of 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 intend
to prosecute these claims to obtain the maximum recovery possible. Further, with
regard to the various claims brought against the Company and Conseco Services by
certain former directors and officers, we believe that these claims are without
merit and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty. We have reached a settlement agreement with
Thomas J. Kilian. On October 20, 2004, the judge in the Conseco Services v.
Hilbert case granted partial final summary judgment in favor of Conseco Services
in the amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of
appeal.
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 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.
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 and added additional former officers as named defendants and
dismissed Conseco, Inc. as a party. We filed a motion to dismiss the amended
complaint on June 1, 2004. On July 30, 2004, the Russell matter was dismissed.
On August 25, 2004, the plaintiffs filed a notice of appeal in the 7th Circuit
Court of Appeals. 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 as an additional defendant.
On July 28, 2004, we filed a motion to stay the RLI matter until Russell is
resolved. On September 2, 2004, RLI filed a motion for judgment on all
counterclaims. On October 5, 2004, our motion to stay this matter was granted.
We
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CONSECO, INC. AND SUBSIDIARIES
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believe the lawsuits are without merit and intend to defend them vigorously. The
ultimate outcome of the lawsuits 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 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 asserted 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 claimed 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. The maximum exposure to the Company for
this lawsuit was estimated to be $33 million. The heirs did not file a proof of
claim with the Bankruptcy Court. A settlement agreement has been reached by all
of the parties.
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 Court of Appeals.
The 11th Circuit, in July 2003, affirmed in part and reversed in part, allowing
two fraud counts with respect to one plaintiff to survive. The plaintiffs'
request for a rehearing with respect to this decision has been denied.
Philadelphia Life 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. On September 27, 2004, Philadelphia Life was named in
a purported nationwide class action filed by the same plaintiff's attorney
seeking unspecified damages in the District Court of Clark County, Nevada (Emma
Gilbertson individually and on behalf of others similarly situated v. Conseco
Life Insurance Company f/k/a Philadelphia Life Insurance Company, Cause No.
A492738), alleging breach of contract pertaining to notice of premium increases.
Philadelphia Life believes both lawsuits are without merit and intends to defend
them vigorously. The ultimate outcome of the lawsuits 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 and its subsidiaries, Conseco Life Insurance Company and
Bankers Life and Casualty Company, have been named in purported class actions
and an individual lawsuit alleging, among other things, breach of contract with
regard to a change made in the way monthly deductions are calculated for
insurance coverage. Many of these nationwide purported class action lawsuits
were filed in Federal courts across the United States. The Judicial Panel on
Multidistrict Litigation consolidated these lawsuits into the case now referred
to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No.
MDL 1610 (Central District, California). Other nationwide purported class
actions and an individual lawsuit are filed in Illinois, Indiana and California
state courts. The case filed in Illinois state court is Barry A. Feinberg,
Trustee of the Linda Leventhal Irrevocable Trust, individually and on behalf of
all other persons and entities similarly situated v. Conseco Life Insurance
Company, f/k/a Massachusetts General Life Insurance Company, Case No. 04CH17937
(Circuit Court, Cook
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CONSECO, INC. AND SUBSIDIARIES
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County, Illinois). Those cases filed in Indiana state courts have been
consolidated into the case now referred to as Alene P. Mangelson, et al. v.
Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211 (Superior Court,
Hamilton County, Indiana). Those cases filed in California state courts are as
follows: 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); 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
Peters Insurance Services, Inc., Hon. John Garamendi (in his capacity as
Insurance Commissioner for the State of California) and Does 1 through 10, Case
04 CV 125 LAB (BLM) (Superior Court, San Diego County, California); Steven Rose,
on Behalf of Himself and All Others Similarly Situated, and on Behalf of the
General Public for the State of California v. Conseco Life Insurance Company,
Case No. GIC 827178 (Superior Court, San Diego County, California); Alfonso
Tamayo, individually and on behalf of all others similarly situated and on
behalf of the General Public v. Conseco Life Insurance Co., Inc., an Indiana
Corp., successor to Philadelphia Life Insurance Co. and formerly doing business
as Massachusetts General Life Insurance Company, Case No 04-431660 (Superior
Court, San Francisco County, California). We have filed a motion with the
Judicial Council of California requesting consolidation of all the California
state court cases. 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 as
an additional defendant. On March 5, 2004, the complaint was amended a second
time naming additional plaintiffs. The purported class consists of all former
Massachusetts General Flexible Premium Adjustable Life Insurance Policy
policyholders who were converted to Conseco Life Flexible Premium Adjustable
Life Insurance Policies and whose accumulated values in the Massachusetts
General policies were applied to first year premiums on the Conseco Life
policies. The complaint alleged, among other things, civil conspiracy to convert
the accumulated cash values of the plaintiffs and the class, and the violation
of insurance laws nationwide. The parties have reached a settlement agreement on
a class wide basis. On October 14, 2004, the judge signed an order preliminarily
approving the settlement. The hearing for final approval is set for January 31,
2005.
On December 30, 2002 and December 31, 2002, four 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; 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.
In August 2004, the parties agreed to a settlement of these four suits.
On September 21, 1999, Conseco Health Insurance Company ("Conseco Health"),
Conseco Services, Performance Matters Associates (one of our subsidiaries), and
a subsidiary officer were named in an action seeking damages in the United
States District Court for the Northern District of Alabama (Danny McFarlin;
Tennessee Capitol Associates, Inc.; Neal Nielsen; Group Marketing Services,
Inc.; Eleanor D. Newman; Dick Manley; Commonwealth General Group, Inc.; Robert
E. Taylor; Benefits of America Limited, Inc.; and Daniel Smith v. Conseco, Inc.;
Conseco Services, LLC.; Conseco Health Insurance f/k/a Capitol American Life
Insurance Company; Consolidated Marketing Group; Suncoast Fringe Benefits, Inc.;
Performance Matters Associates, Inc.; Christopher L. Weaver; Jim Hobbs, Mike
Foster and David King; Cause No: 99-CV-2282-S) alleging among other things
fraud, tortious interference with business and contractual relations,
conspiracy, breach of contract, unjust enrichment, extortion and interstate
travel in aid of extortion under the Racketeer Influenced and Corrupt
Organization Act ("RICO") and mail/wire fraud under RICO. The case concerns the
consolidation of plaintiffs' independent marketing organizations under a wholly
owned subsidiary of Conseco. In May 2003, the Court dismissed the tortious
interference claim as to Conseco Health, the breach of contract claims as to all
defendants other than Conseco Health, and the extortion-related RICO claims as
to all defendants on summary judgment. The case was on appeal to the 11th
Circuit Court of Appeals but was recently remanded to the district court and is
currently set for trial in March 2005. Conseco believes the lawsuit is without
merit and intends to defend it vigorously. The ultimate outcome of the lawsuit
cannot be predicted with certainty.
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CONSECO, INC. AND SUBSIDIARIES
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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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
At the Company's annual meeting on August 24, 2004, the shareholders
elected Debra J. Perry, Philip R. Roberts and Michael T. Tokarz to serve as
directors for terms ending in 2005. Directors whose class was not up for
election and whose term of office continued after the meeting are R. Glenn
Hilliard, Neal Schneider, Michael Shannon and John G. Turner. The results of the
voting were as follows (there were no broker non-votes):
For Withheld
--- --------
Debra J. Perry........................................... 129,310,726 1,769,475
Philip R. Roberts........................................ 129,294,770 1,785,431
Michael T. Tokarz........................................ 129,735,183 1,345,018
At the annual meeting, the shareholders also ratified the appointment of
PricewaterhouseCoopers LLP as the Company's auditors for 2004 as follows:
For Against Abstain
--- ------ -------
128,168,245 2,854,722 57,235
ITEM 6. EXHIBITS.
10.15 Employment Agreement dated as of July 19, 2004 between
Conseco Services, LLC, and Dewette Ingham.
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.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: November 9, 2004 By: /s/ Eugene M. Bullis
-------------------------------
Eugene M. Bullis
Executive Vice President and
Chief Financial Officer
(authorized officer and principal
financial officer)
99