Exhibit 99.1
INTRODUCTION
On June 30, 1998, Conseco, Inc. ("Conseco" or the "Company") completed its
merger (the "Green Tree Merger") with Green Tree Financial Corporation ("Green
Tree"). The Green Tree Merger has been accounted for as a pooling of interests
and, accordingly, the amounts for all periods reported in this supplemental
filing are reported on a combined basis including both Conseco and Green Tree.
1
SELECTED SUPPLEMENTAL CONSOLIDATED FINANCIAL DATA (a).
Years ended December 31,
---------------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
(Amounts in millions, except per share data)
STATEMENT OF OPERATIONS DATA
Insurance policy income..................................... $3,410.8 $1,654.2 $1,465.0 $1,285.6 $1,293.8
Gain on sale of finance receivables......................... 569.1 388.1 443.3 318.6 201.5
Net investment income:
Assets held by insurance subsidiaries..................... 1,825.3 1,302.5 1,142.6 385.7 896.2
Finance receivables....................................... 214.5 138.1 124.7 78.1 57.7
Interest-only securities.................................. 130.3 77.2 51.3 33.3 54.8
Net investment gains (losses) .............................. 266.5 60.8 204.1 (30.5) 242.6
Total revenues.............................................. 6,656.4 3,789.8 3,561.2 2,357.6 3,002.3
Interest expense:
Corporate................................................. 109.4 108.1 119.4 59.3 58.0
Finance and investment borrowings......................... 202.9 92.1 79.5 49.3 61.8
Total benefits and expenses................................. 5,170.7 2,974.0 2,738.5 1,732.9 2,192.0
Income before income taxes, minority interest and
extraordinary charge...................................... 1,485.7 815.8 822.7 624.7 810.3
Extraordinary charge on extinguishment of debt, net of tax.. 6.9 26.5 2.1 4.0 11.9
Net income.................................................. 866.4 452.2 470.9 330.5 413.1
Preferred stock dividends and charge related to induced
conversions of convertible preferred stock................ 21.9 27.4 18.4 18.6 20.6
Net income applicable to common stock....................... 844.5 424.8 452.5 311.9 392.5
PER SHARE DATA (b)
Net income, basic........................................... $2.72 $1.85 $ 2.19 $ 1.39 $ 1.82
Net income, diluted......................................... 2.52 1.69 2.03 1.32 1.63
Dividends declared per common share......................... .313 .083 .046 .125 .075
Book value per common share outstanding..................... 16.45 13.47 8.52 5.58 6.27
Shares outstanding at year-end.............................. 310.0 293.4 205.2 212.7 224.1
Weighted average shares outstanding for diluted earnings.... 338.7 267.7 232.3 250.5 251.8
BALANCE SHEET DATA - PERIOD END
Total assets................................................ $40,629.9 $28,692.7 $19,510.1 $12,302.3 $15,266.3
Notes payable and commercial paper:
Corporate................................................. 2,354.9 1,094.9 871.4 191.8 413.0
Consumer and commercial finance........................... 1,866.3 762.5 383.6 309.3 515.0
Notes payable of affiliates, not direct
obligations of Conseco................................. - - 584.7 611.1 290.3
Total liabilities........................................... 34,031.4 23,778.2 17,075.1 10,509.2 13,350.8
Minority interests in consolidated subsidiaries:
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts.............. 1,383.9 600.0 - - -
Preferred stock........................................... - 97.0 110.7 130.1 -
Common stock.............................................. .7 .7 292.6 191.6 223.8
Shareholders' equity ....................................... 5,213.9 4,216.8 2,031.7 1,471.4 1,691.7
OTHER FINANCIAL DATA (b) (c)
Premiums collected (d)...................................... $5,055.7 $3,280.2 $3,106.5 $1,879.1 $2,140.1
Operating earnings (e)...................................... 874.0 467.5 381.8 331.8 278.1
Operating earnings per diluted common share (e)............. 2.58 1.75 1.64 1.33 1.10
Assets under management and managed receivables
(at fair value) (g)....................................... 60,036.0 51,182.0 38,613.0 32,934.0 25,454.0
Shareholders' equity excluding unrealized appreciation
(depreciation) of fixed maturity securities (f)........... 5,036.7 4,177.0 1,919.1 1,609.1 1,604.3
Book value per common share outstanding, excluding
unrealized appreciation (depreciation) of fixed
maturity securities (f)................................... 15.88 13.33 7.97 6.23 5.88
2
- --------------------
<FN>
(a) Comparison of selected supplemental consolidated financial data in the
table above is significantly affected by: (i) the acquisitions
consummated by Conseco Capital Partners, L.P. and Conseco Capital
Partners II, L.P. ("Partnership II"); (ii) the sale of Western National
Corporation ("Western National"); (iii) the transactions affecting
Conseco's ownership interest in Bankers Life Holding Corporation ("BLH")
and CCP Insurance, Inc. ("CCP"); (iv) the acquisition of Life Partners
Group, Inc. ("LPG"); (v) the acquisition of American Travellers
Corporation (the "ATC Merger"); (vi) the acquisition of Transport
Holdings Inc. (the "THI Merger"); (vii) the acquisition of Capitol
American Financial Corporation (the "CAF Merger"); (viii) the acquisition
of Pioneer Financial Services, Inc., (the "PFS Merger"); (ix) the
acquisition of (the "Colonial Penn Purchase") of Colonial Penn Life
Insurance Company and Providential Life Insurance Company and certain
other assets (collectively referred to as "Colonial Penn"); and (x) the
acquisition of Washington National Corporation (the "WNIC Merger").
Conseco did not have unilateral control to direct all of CCP's activities
during 1993 and 1994 and, therefore, did not consolidate the financial
statements of CCP with the financial statements of Conseco. As a result
of the purchase by Conseco of all the shares of common stock of CCP it
did not already own on August 31, 1995, the financial statements of CCP's
subsidiaries are consolidated with the financial statements of Conseco,
effective January 1, 1995. Conseco has included BLH in its financial
statements since November 1, 1992. Through December 31, 1993, the
financial statements of Western National were consolidated with the
financial statements of Conseco. Following the completion of the initial
public offering of Western National (and subsequent disposition of
Conseco's remaining equity interest in Western National), the financial
statements of Western National were no longer consolidated with the
financial statements of Conseco. As of September 29, 1994, Conseco began
to include in its financial statements the newly acquired Partnership II
subsidiary, American Life Holdings, Inc. As of July 1, 1996, Conseco
began to include in its financial statements its newly acquired
subsidiary, LPG. Effective December 31, 1996, Conseco began to include in
its financial statements its subsidiaries acquired in the ATC Merger and
the THI Merger. As of January 1, 1997, Conseco began to include in its
financial statements its subsidiaries acquired in the CAF Merger. As of
April 1, 1997, Conseco began to include in its financial statements its
subsidiaries acquired in the PFS Merger. Effective September 30, 1997,
Conseco began to include in its financial statements its subsidiaries
acquired in the Colonial Penn Purchase. Effective December 1, 1997,
Conseco began to include in its financial statements its subsidiaries
acquired in the WNIC Merger. Such business combinations are described in
the notes to Conseco's supplemental consolidated financial statements
included in this supplemental filing.
(b) All share and per-share amounts have been restated to reflect the
two-for-one stock splits paid on February 11, 1997 and April 1, 1996.
Prior period earnings per share amounts have been restated to comply with
the new reporting standards as described in note 1 to the consolidated
financial statements.
(c) Amounts under this heading are included to assist the reader in analyzing
the Company's financial position and results of operations. Such amounts
are not intended to, and do not, represent insurance policy income, net
income, net income per share, shareholders' equity or book value per
share prepared in accordance with generally accepted accounting
principles ("GAAP").
(d) Includes premiums received from universal life products and products
without mortality or morbidity risk. Such premiums are not reported as
revenues under GAAP and were $2,099.4 million in 1997; $1,881.3 million
in 1996; $1,757.5 million in 1995; $634.6 million in 1994; and $891.9
million in 1993.
(e) Represents income before extraordinary charge, excluding net investment
gains (losses) of our life insurance and corporate segments (less that
portion of change in future policy benefits, amortization of cost of
policies purchased and cost of policies produced and income taxes
relating to such gains (losses)) and nonrecurring charges (net of income
taxes).
(f) Excludes the effects of reporting fixed maturities at fair value and
recording the unrealized gain or loss on such securities as a component
of shareholders' equity, net of tax and other adjustments. Such
adjustments are in accordance with Statement of Financial Accounting
Standards No. 115 "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115"), as described in note 1 to the consolidated
financial statements.
(g) Represents: (i) the total market value of the investment portfolios
managed by Conseco Capital Management, Inc. ("CCM") including assets of
Conseco's subsidiaries of $27.0 billion, $18.5 billion, $13.7 billion,
$11.5 billion and $7.4 billion at December 31, 1997, 1996, 1995, 1994 and
1993, respectively, and assets of unaffiliated parties of $5.1 billion,
$12.6 billion, $11.0 billion, $11.6 billion and $10.9 billion at December
31, 1997, 1996, 1995, 1994 and 1993, respectively; and (ii) the total
fixed and revolving credit receivables that Green Tree manages, including
receivables on its balance sheet and receivables applicable to the
holders of asset-backed securities sold by Green Tree.
</FN>
3
SUPPLEMENTAL MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The supplemental management's discussion and analysis reviews the
consolidated financial condition of Conseco and Green Tree on a combined basis
at December 31, 1997 and 1996, the supplemental consolidated results of
operations for the three years ended December 31, 1997, and where appropriate,
factors that may affect future financial performance. This discussion should be
read in conjunction with the accompanying supplemental consolidated financial
statements, notes thereto and selected supplemental consolidated financial data.
All statements, trend analyses and other information contained in this
report and elsewhere (such as in other filings by Conseco or Green Tree with the
Securities and Exchange Commission, press releases, presentations by Conseco or
Green Tree or its management or oral statements) relative to markets for
Conseco's or Green Tree's products and trends in Conseco's or Green Tree's
operations or financial results, as well as other statements including words
such as "anticipate," "believe," "plan," "estimate," "expect," "intend," and
other similar expressions, constitute forward-looking statements under the
Private Securities Litigation Reform Act of 1995. These forward-looking
statements are subject to known and unknown risks, uncertainties and other
factors that may cause actual results to be materially different from those
contemplated by the forward-looking statements. Such factors include, among
other things: (i) general economic conditions and other factors, including
prevailing interest rate levels, short-term interest rate fluctuations, stock
market performance and health care inflation, which may affect the ability of
Conseco to sell its products, the ability of Green Tree to make loans and access
capital are sources, the market value of Conseco's and Green Tree's investments,
the lapse rate and profitability of Conseco's policies; and the level of
defaults and prepayments of loans made by Green Tree; (ii) Conseco's ability to
achieve anticipated levels of operational efficiencies at recently acquired
companies, as well as through other cost-saving initiatives; (iii) customer
response to new products, distribution channels and marketing initiatives; (iv)
mortality, morbidity, usage of health care services and other factors that may
affect the profitability of Conseco's insurance products; (v) changes in the
federal income tax laws and regulations that may affect the relative tax
advantages of some of Conseco's products; (vi) increasing competition in the
sale of insurance and annuities and in the consumer finance business; (vii)
regulatory changes or actions, including those relating to regulation of
financial services affecting (among other things) bank sales and underwriting of
insurance products, regulation of the sale, underwriting and pricing of
insurance products, and health care regulation affecting Conseco's supplemental
health insurance products; (viii) the availability and terms of future
acquisitions; and (ix) the risk factors or uncertainties listed in Conseco's or
Green Tree's other filings with the Securities and Exchange Commission. In
addition to the above, these statements are subject to uncertainties related to
the synergies, charges and expenses associated with the Green Tree Merger.
Consolidated results and analysis
Our 1997 operating earnings were $874.0 million, or $2.58 per diluted
share, up 87 percent and 47 percent, respectively, over 1996. Operating earnings
increased as a result of our recent acquisitions: the LPG Merger (completed
effective July 1, 1996), the ALH Stock Purchase (September 30, 1996), the ATC
Merger (December 31, 1996), the THI Merger (December 31, 1996), the BLH Merger
(December 31, 1996), the CAF Merger (January 1, 1997), the PFS Merger (April 1,
1997), the Colonial Penn Purchase (September 30, 1997) and the WNIC Merger
(December 1, 1997). In addition, operating earnings increased as a result of the
increased business in force of the recently acquired companies and companies
previously owned and increased finance receivable originations and sales by
Green Tree. The percentage increase in operating earnings was greater than the
percentage increase in operating earnings per diluted share primarily because of
the 27 percent increase in weighted average diluted common shares or equivalents
outstanding during 1997. The increase in weighted average diluted shares
resulted from shares issued in certain 1997 and 1996 acquisitions (the LPG
Merger, the ATC Merger, the THI Merger, the BLH Merger, the CAF Merger and the
PFS Merger), partially offset by repurchases of common stock.
Our 1996 operating earnings were $467.5 million, or $1.75 per diluted
share, up 22 percent and 7 percent, respectively, over 1995. Operating earnings
increased as a result of the LPG Merger, the ALH Stock Purchase, the effect of
increased ownership of BLH as a result of purchases of BLH common stock during
1995 and 1996, and profit improvements in each of our segments. Such increases
were partially offset by decreased earnings of Green Tree resulting primarily
from a writedown of interest-only securities. Operating earnings for 1996 were
not affected by the ATC Merger, the THI Merger or the BLH Merger, all of which
were recorded as of December 31, 1996. The percentage increase in operating
earnings was greater than the increase in operating earnings per diluted share
primarily because of the additional common shares or equivalents outstanding in
1996 resulting from: (i) the LPG Merger; and (ii) the Company's January 1996
offering of Preferred Redeemable Increased Dividend Equity Securities, 7% PRIDES
Convertible Preferred Stock ("PRIDES"), which are mandatorily convertible into
shares of Conseco common stock.
Net income of $866.4 million in 1997, or $2.52 per diluted share,
included: (i) net investment gains of our life insurance and corporate segments
(net of related costs, amortization and taxes) of $44.1 million, or 13 cents per
diluted share; (ii) an extraordinary charge of $6.9 million, or 2 cents per
share, related to early retirement of debt; (iii) a charge of 4 cents per share
related to the induced conversion of preferred stock (treated as a preferred
stock dividend); and (iv) nonrecurring charges totaling $44.8 million, or 13
cents
4
per share. Nonrecurring charges include: (i) $40.5 million related to our
Medicare supplement business in Massachusetts; and (ii) $4.3 million related to
the death of an executive officer. Regulators in Massachusetts have not allowed
premium increases for Medicare supplement products necessary to avoid losses on
the business. We are currently seeking rate increases. We are no longer writing
new Medicare supplement business in Massachusetts. We have written off the cost
of policies purchased and produced and accrued additional claim reserves related
to our in-force Massachusetts Medicare supplement business due to the estimated
premium deficiencies.
Net income of $452.2 million in 1996, or $1.69 per diluted share,
included: (i) net investment gains of our life insurance and corporate segments
(net of related costs, amortization and taxes) of $11.2 million, or 4 cents per
diluted share; and (ii) an extraordinary charge of $26.5 million, or 10 cents
per share, related to early retirement of debt. Net income of $470.9 million in
1995, or $2.03 per diluted share, included: (i) net investment gains (net of
related costs, amortization and taxes) of $16.3 million, or 7 cents per share;
(ii) restructuring income of $74.9 million, or 32 cents per share, arising from
the release of deferred income taxes previously accrued on income related to CCP
and BLH (such deferred tax was no longer required when Conseco's ownership of
these companies exceeded 80 percent); and (iii) an extraordinary charge of $2.1
million, or nil per share, related to early retirement of debt.
Total revenues include net investment gains of our life insurance and
corporate segments of $266.5 million in 1997, $60.8 million in 1996 and $204.1
million in 1995. Excluding net investment gains, total revenues were $6.4
billion in 1997, up 71 percent from $3.7 billion in 1996. Total revenues in 1997
include a full year of activity for acquisitions completed in 1996 and the
revenues of CAF, PFS, Colonial Penn and WNIC in the periods subsequent to their
acquisitions. Total revenues in 1996 include LPG revenues after July 1, 1996.
Total revenues, excluding net investment gains of our life insurance and
corporate segments, were up 11.0 percent in 1996 from $3.4 billion in 1995.
5
Results of operations by segment for the three years ended December 31,
1997:
The following tables and narratives summarize the results of our
operations by business segment. All amounts reported in these summaries relate
solely to periods after the companies were included in our consolidated
financial statements.
1997 1996 1995
---- ---- ----
(Dollars in millions)
Income before income taxes, minority interest and extraordinary charge:
Consumer and commercial finance:
Operating income...........................................................$ 482.6 $ 322.2 $ 404.2
-------- ------- -------
Supplemental health:
Operating income........................................................... 408.0 136.6 96.0
Net investment gains, net of related costs................................. 26.3 .1 1.1
Nonrecurring charges....................................................... (62.4) - -
-------- ------- -------
Income before income taxes, minority interest and extraordinary charge. 371.9 136.7 97.1
-------- ------- -------
Annuities:
Operating income .......................................................... 305.1 255.0 244.1
Net investment gains (losses), net of related costs and amortization ...... 53.2 (.7) 72.0
-------- ------- -----
Income before income taxes, minority interest and extraordinary charge. 358.3 254.3 316.1
-------- ------- -------
Life insurance:
Operating income........................................................... 304.7 126.8 74.8
Net investment gains (losses), net of related costs and amortization....... 2.4 (2.0) (4.6)
-------- ------- -------
Income before income taxes, minority interest and extraordinary charge. 307.1 124.8 70.2
-------- ------- -------
Individual and group major medical:
Operating income........................................................... 40.2 32.1 35.1
Net investment gains, net of related costs................................. .1 - .1
-------- ------- -------
Income before income taxes, minority interest and extraordinary charge. 40.3 32.1 35.2
-------- ------- -------
Other:
Operating income........................................................... 58.3 30.7 31.5
Net investment gains (losses), net of related costs........................ 3.3 27.4 (6.3)
-------- ------- -------
Income before income taxes, minority interest and extraordinary charge. 61.6 58.1 25.2
-------- ------- -------
Corporate:
Interest and other corporate expenses...................................... (126.8) (112.4) (140.5)
Nonrecurring charges....................................................... (9.3) - -
Net investment gains, net of related costs................................. - - 15.2
-------- ------- -------
Net corporate expenses................................................. (136.1) (112.4) (125.3)
-------- ------- -------
Consolidated:
Operating income........................................................... 1,472.1 791.0 745.2
Net investment gains, net of related costs and amortization ............... 85.3 24.8 77.5
Nonrecurring charges....................................................... (71.7) - -
-------- ------- -------
Income before income taxes, minority interest and extraordinary charge. 1,485.7 815.8 822.7
Income tax expense.............................................................. 560.1 302.2 240.7
-------- ------- -------
Income before minority interest and extraordinary charge............... 925.6 513.6 582.0
Minority interest in consolidated subsidiaries:
Distributions on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts............................................ 49.0 3.6 -
Dividends on preferred stock of subsidiaries................................. 3.3 8.9 11.9
Equity in earnings of subsidiaries........................................... - 22.4 97.1
-------- ------- -----
Income before extraordinary charge..................................... 873.3 478.7 473.0
Extraordinary charge on extinguishment of debt, net of taxes and
minority interest............................................................ 6.9 26.5 2.1
-------- ------- -------
Net income.............................................................$ 866.4 $ 452.2 $ 470.9
======== ======= =======
6
Consumer and Commercial Financing:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Contract originations:
Manufactured housing.............................................. $ 5,479.3 $ 4,882.0 $ 4,159.8
Home equity/home improvement...................................... 3,476.2 1,493.7 627.0
Consumer/retail credit............................................ 1,510.9 835.6 361.4
Commercial/equipment.............................................. 5,181.4 3,343.0 1,742.7
--------- --------- ---------
Total........................................................... $15,647.8 $10,554.3 $ 6,890.9
========= ========= =========
Sales of receivables:
Manufactured housing.............................................. $ 5,370.0 $ 5,033.0 $ 4,020.0
Home equity/home improvement...................................... 3,020.0 1,324.0 579.0
Consumer/equipment................................................ 1,627.0 1,556.0 -
Commercial and revolving credit................................... 224.0 500.0 428.0
Lease and other................................................... 508.0 - 308.0
--------- --------- ---------
Total........................................................... $10,749.0 $ 8,413.0 $ 5,335.0
========= ========== =========
Managed receivables (at period end):
Fixed contracts................................................... $26,036.0 $18,965.0 $13,314.0
Revolving credit.................................................. 1,921.0 1,108.0 574.0
--------- --------- ---------
Total........................................................... $27,957.0 $20,073.0 $13,888.0
========= ========= =========
Gain on sale of receivables.......................................... $ 569.1 $ 388.1 $ 443.3
Net investment income:
Finance receivables............................................... 214.5 138.1 124.7
Interest-only securities.......................................... 130.3 77.2 51.3
Fee revenue and other income......................................... 174.1 119.1 86.6
--------- --------- ---------
Total revenues.................................................. 1,088.0 722.5 705.9
--------- --------- ---------
Consumer and commercial finance interest expense..................... 160.9 70.1 57.3
Amortization of servicing rights and goodwill........................ 15.4 - -
Other operating costs and expenses................................... 429.1 330.2 244.4
--------- --------- ---------
Total expenses.................................................. 605.4 400.3 301.7
--------- --------- ---------
Income before income taxes, minority interest
and extraordinary charge...................................... $ 482.6 $ 322.2 $ 404.2
========= ========= =========
General: This segment provides financing for manufactured housing, home
equity, home improvements, consumer products and equipment and provides consumer
and commercial revolving credit. The segment's financing products include both
fixed term and revolving loans and leases. The segment also markets physical
damage and term mortgage life insurance and other credit protection relating to
the customers contracts it services.
Contract originations in 1997 were $15,647.8 million, up 48 percent over
1996. Contract originations in 1996 were $10,554.3 million, up 53 percent over
1995.
Manufactured housing contract originations increased $597.3 million, or 12
percent, during 1997 over 1996. The number of contracts originated during the
1997 period increased as well as the average contract size reflecting an
increase in land-and-home contracts and slight price increases by the
manufactured housing manufacturers.
Home equity/home improvement contract originations increased $1,982.5
million, or 133 percent, during 1997 over 1996, and increased $866.7 million, or
138 percent, during 1996 over 1995. The increase is primarily the result of the
segment's continued expansion of the home equity retail origination network.
7
Consumer and retail credit originations increased $675.3 million, or 81
percent, during 1997 over 1996, and increased $474.2 million, or 131 percent,
during 1996 over 1995. The increase reflects several credit card portfolio
purchases and overall growth in the consumer products sector.
Commercial and equipment originations increased $1,838.4 million, or 55
percent, during 1997 over 1996, and increased $1,600.3 million, or 92 percent,
during 1996 over 1995. The increase reflects higher production in all areas of
commercial financing.
Sales of receivables occur when the segment sells finance receivables it
originates in secondary markets through securitizations. The total receivables
sold in a particular period is dependent on many factors including: (i) the
volume of recent originations; (ii) market conditions; and (iii) the
availability and cost of alternative financing. Total finance receivables sold
in 1997 were up 28 percent over 1996. Total finance receivables sold in 1996
were up 58 percent over 1995.
Managed finance receivables include finance receivables sold through
securitizations upon which we continue to receive servicing fees as well as
finance receivables. The total portfolio serviced by the segment increased to
$28.0 billion at December 31, 1997, a 39 percent increase over 1996. The total
portfolio increased to $20.1 billion at December 31, 1996, a 45 percent increase
over 1995.
Gain on sale of finance receivables represents the difference between the
proceeds from the sale, net of related transaction costs, and the allocated
carrying amount of the receivables sold. The allocated carrying amount is
determined by allocating the original amount of the receivables between the
portion sold and any retained interests (interest-only securities and servicing
rights), based on their relative fair values at the time of sale. Assumptions
used in calculating the estimated fair value of interest-only securities and
servicing rights are subject to volatility that could materially affect
operating results. Prepayments from competition, obligor mobility, general and
regional economic conditions and prevailing interest rates, as well as actual
losses incurred, may vary from the performance projected, which may result in an
increase or decrease to the value of the interest-only securities and servicing
rights we retain.
Gain on sale of receivables increased 47 percent, to $569.1 million, in
1997 and decreased 12 percent, to $388.1 million, in 1996. Such gain fluctuates
when changes occur in: (i) the amount of loans sold; (ii) market conditions;
(iii) the amount and type of interest retained in the receivables sold; and (iv)
changes in assumptions used to calculate the gain. Recent experience has
indicated that prepayment rates have exceeded expectations for loans sold in
prior periods. As a result, writedowns of interest-only securities of $190.0
million and $200.0 million were recognized as a reduction to the gain during
1997 and 1996. The 1997 writedown of interest-only securities was generally the
result of adverse prepayment experience. The 1996 writedown was the result of
adjustments necessary to consider the effects of partial prepayments on
projected future interest collections.
Prior to giving effect to the writedowns, the gain on sale of finance
receivables increased 29 percent and 33 percent in 1997 and 1996, respectively.
These increases resulted primarily from the increased finance receivables
originated during these years. The increase in sales during 1996 was partially
offset by a higher concentration of shorter term consumer loans originated and
sold compared to the longer term manufactured housing and home equity and home
improvement loans.
Net investment income on finance receivables consists of interest earned on
the segment's unsold finance receivables and interest income on short-term and
other investments. Such income increased 55 percent, to $214.5 million in 1997,
and increased 11 percent, to $138.1 million in 1996. The increases are
consistent with the increases in the average finance receivables during these
years.
Net investment income on interest-only securities represents the accretion
recognized on the interest-only securities retained when finance receivables are
sold. Such income increased 69 percent, to $130.3 million in 1997, and increased
50 percent to $77.2 million in 1996. The increases are consistent with the
increase in the average interest-only securities held during these years.
Fee revenue and other income includes servicing income, commissions earned
on new insurance policies written and renewals on existing policies, as well as
other income from late fees. Such income increased 46 percent, to $174.1
million, in 1997 and increased 38 percent, to $119.1 million, in 1996. The
increase reflects: (i) the growth in the segment's managed receivable portfolio
on which servicing income is earned; and (ii) the increase in net written
insurance premiums consistent with the growth of the segment's managed
receivables.
Consumer and commercial finance interest expense increased 130 percent, to
$160.9 million, in 1997 and increased 22 percent, to $70.1 million, in 1996. The
increase primarily reflects increased borrowings to fund loan originations,
commercial revolving credit and lease portfolio financings.
Other operating costs and expenses include the costs associated with
servicing the segment's managed receivables and costs of originating new loans.
Such expense increased 30 percent, to $429.1 million, in 1997 and increased 35
percent, to $330.2 million, in 1996. The increase reflects: (i) the growth in
the segment's servicing portfolio; and (ii) the increased volume of contracts
originated.
8
Supplemental health:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Premiums collected:
Medicare supplement (first-year)............................. $ 101.9 $ 72.5 $ 81.1
Medicare supplement (renewal)................................ 694.5 545.4 515.6
--------- ------- -------
Subtotal - Medicare supplement........................... 796.4 617.9 596.7
--------- ------- -------
Long-term care (first-year).................................. 143.4 51.6 44.4
Long-term care (renewal)..................................... 520.5 141.3 97.7
--------- ------- -------
Subtotal - long-term care................................ 663.9 192.9 142.1
--------- ------- -------
Specified-disease (first-year)............................... 44.7 - -
Specified-disease (renewal).................................. 338.7 - -
--------- ------- --------
Subtotal - specified-disease............................. 383.4 - -
--------- ------- -------
Total supplemental health premiums collected............. $1,843.7 $ 810.8 $738.8
======== ======= ======
Insurance policy income......................................... $1,858.1 $ 805.9 $756.9
Net investment income........................................... 273.8 66.6 66.9
-------- ------- -------
Total revenues (a)......................................... 2,131.9 872.5 823.8
--------- ------- -------
Insurance policy benefits and change in future policy benefits.. 1,217.5 531.8 525.6
Amortization related to operations.............................. 232.1 87.8 81.6
Interest expense on investment borrowings....................... 6.3 1.1 1.4
Other operating costs and expenses.............................. 268.0 115.2 119.2
--------- ------- -------
Total benefits and expenses................................ 1,723.9 735.9 727.8
--------- ------- -------
Operating income before income taxes,
minority interest and extraordinary
charge................................................... 408.0 136.6 96.0
Net investment gains, net of related costs...................... 26.3 .1 1.1
Nonrecurring charges............................................ (62.4) - -
--------- ------- -------
Income before income taxes, minority
interest and extraordinary charge...................... $ 371.9 $136.7 $97.1
========= ====== =====
Loss ratios:
Medicare supplement products................................. 69.1% 68.2% 71.7%
Long-term care products...................................... 63.6 58.7 60.5
Specified-disease products................................... 61.6 - -
<FN>
(a) Revenues exclude net investment gains.
</FN>
General: This segment includes Medicare supplement and long-term care
insurance products, primarily sold to senior citizens, and effective January 1,
1997 (as a result of the acquisitions of CAF and THI), specified-disease
products. Through December 31, 1996, the supplemental health operations consist
solely of Bankers Life's Medicare supplement and long-term care products,
distributed through a career agency force. The segment's 1997 results of
operations are significantly affected by recent acquisitions (ATC, THI and CAF,
effective January 1, 1997; PFS, effective April 1, 1997; and Colonial Penn,
effective September 30, 1997). The supplemental health products of THI, CAF,
ATC, PFS and Colonial Penn are all distributed through professional independent
producers. The profitability of this segment largely depends on the overall
level of sales, persistency of in-force business, claim experience and expense
management.
9
Premiums collected by this segment in 1997 were $1,843.7 million, up 127
percent from 1996. Premiums collected in 1996 increased to $810.8 million, up
9.7 percent.
Medicare supplement policies accounted for 43 percent of this segment's
collected premiums in 1997, compared with more than 75 percent of this segment's
collected premiums in 1996 and 1995. The change in the mix of premiums collected
reflects the more diverse supplemental health lines sold by Conseco as a result
of the recent acquisitions. Collected premiums on Medicare supplement policies
increased 29 percent in 1997, to $796.4 million, and increased 3.6 percent in
1996, to $617.9 million. Such increases primarily reflect the recent
acquisitions and a larger base of premiums due to rate increases. The sales of
Medicare supplement policies have been affected by: (i) steps taken to improve
profitability by increasing premium rates and changing both the commission
structure and the underwriting criteria for these policies; and (ii) increased
competition from alternative providers, including HMOs.
Premiums collected on long-term care policies increased 244 percent in
1997, to $663.9 million, and 36 percent in 1996, to $192.9 million. First-year
collected premiums in 1997, 1996 and 1995 were $143.4 million, $51.6 million and
$44.4 million, respectively. The increase in long-term care premiums collected
primarily reflects the acquisition of recently acquired companies.
Premiums collected on specified-disease policies were $383.4 million in
1997, substantially all of which were collected by recently acquired companies.
Insurance policy income comprises premiums earned on the segment's
policies and has increased over the last three years consistent with the
explanations provided above for premiums collected.
Net investment income increased 311 percent in 1997, to $273.8 million,
and did not change materially in 1996 compared with 1995. Such investment income
fluctuates when changes occur in: (i) the amount of average invested assets
supporting insurance liabilities; and (ii) the yield earned on invested assets.
During 1997, the segment's average invested assets increased approximately 278
percent, to $3.4 billion, and the net yield on invested assets increased to 8.0
percent from 7.6 percent. During 1996, the segment's average invested assets
increased approximately 5.0 percent, to $.9 billion, and the net yield on
invested assets decreased from 8.0 percent to 7.6 percent. Invested assets grew
as a result of the growth in insurance liabilities related to the segment's
business.
Insurance policy benefits and change in future policy benefits increased
in 1997, reflecting recent acquisitions, the larger amount of business in force
on which benefits are incurred, and a higher incidence of claims. This account
increased in 1996 as a result of the larger amount of business in force on which
benefits are incurred, net of the lower incidence of claims. In 1997, the ratio
of policy benefits to insurance policy income for the Medicare supplement
policies increased to 69.1 percent from 68.2 percent, reflecting the different
characteristics of such policies in recently acquired companies as well as
fluctuations in claim experience. In 1996, the ratio of policy benefits to
insurance policy income for Medicare supplement policies fell 3.5 percentage
points to 68.2 percent, reflecting the premium rate increases implemented in
1996 and 1995.
Changes in the ratio of policy benefits to insurance policy income for
long-term care policies reflect different characteristics of such policies in
recently acquired companies as well as fluctuations in claim experience and
reserve development. In 1997, the long-term care loss ratio increased by 4.9
percentage points, to 63.6 percent. In 1996, the long-term care loss ratio fell
by 1.8 percentage points, to 58.7 percent.
The ratio of policy benefits to insurance policy income for
specified-disease policies was 61.6 percent in 1997. Such products were not sold
by Conseco prior to the acquisitions of THI and CAF.
Amortization related to operations includes amortization of: (i) the cost
of policies produced; (ii) the cost of policies purchased; and (iii) goodwill
related to this segment's business. The amount of amortization increased
primarily because of the increase in balances subject to amortization as a
result of recent acquisitions.
Interest expense on investment borrowings was affected by changes in
investment borrowing activities during the last three years and the changes in
interest rates paid on such borrowings.
Other operating costs and expenses increased in 1997 from the increased
business of recently acquired companies. Such expenses did not change materially
in 1996 compared with 1995.
10
Net investment gains, net of related costs, often fluctuate from period
to period.
Nonrecurring charges for 1997 represent an increase to claim reserves of
$41.5 million and the write-off of cost of policies produced and cost of
policies purchased of $20.9 million related to Medicare supplement business in
the state of Massachusetts. Regulators in that state have not allowed premium
increases for Medicare supplement products necessary to avoid losses on the
business. We are currently seeking rate increases. We are no longer writing new
Medicare supplement business in Massachusetts.
11
Annuities:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Annuity premiums collected:
Traditional fixed (first-year)................................ $ 857.8 $1,148.6 $1,536.4
Traditional fixed (renewal)................................... 79.4 92.7 62.8
--------- -------- --------
Subtotal - traditional fixed.............................. 937.2 1,241.3 1,599.2
--------- -------- --------
Market value - adjusted (first-year).......................... 165.7 237.2 27.7
Market value - adjusted (renewal)............................. 13.8 20.5 3.1
--------- -------- --------
Subtotal - market value - adjusted........................ 179.5 257.7 30.8
--------- -------- --------
Equity-indexed (all first-year)............................... 387.7 80.4 -
--------- -------- --------
Variable annuities (first-year)............................... 127.4 37.9 17.2
Variable annuities (renewal).................................. 57.8 53.0 46.7
--------- -------- --------
Subtotal - variable annuities............................. 185.2 90.9 63.9
--------- -------- --------
Total annuity premiums collected.......................... $1,689.6 $1,670.3 $1,693.9
======== ======== ========
Insurance policy income.......................................... $ 96.8 $ 77.6 $ 68.4
Net investment income:
General account invested assets............................... 960.9 891.2 851.5
Change in fair value of S&P 500 Call Options.................. 39.4 - -
Separate account assets....................................... 70.3 48.4 28.8
--------- -------- --------
Total revenues (a)...................................... 1,167.4 1,017.2 948.7
--------- -------- --------
Insurance policy benefits and change in future policy benefits... 74.1 67.3 61.8
Amounts added to policyholder account balances:
Annuity products other than those listed below................ 542.2 523.2 505.0
Equity-indexed products based on S&P 500 Index................ 39.3 - -
Variable annuity products..................................... 70.3 48.4 28.8
Amortization related to operations............................... 84.8 76.9 64.9
Interest expense on investment borrowings........................ 23.2 14.3 16.9
Other operating costs and expenses............................... 28.4 32.1 27.2
--------- -------- --------
Total benefits and expenses (a)......................... 862.3 762.2 704.6
--------- -------- --------
Operating income before income taxes, minority
interest and extraordinary charge..................... 305.1 255.0 244.1
Net investment gains (losses), net of related costs and
amortization.................................................. 53.2 (.7) 72.0
--------- -------- --------
Income before income taxes, minority interest
and extraordinary charge.............................. $ 358.3 $ 254.3 $ 316.1
========= ========= ========
Weighted average gross interest spread on annuity products (b)... 2.8% 2.9% 3.1%
=== === ===
Total traditional fixed and market value-adjusted annuity
product insurance liabilities at end of period................ $13,007.4 $11,998.6 $10,169.1
========= ========= =========
Total annuity product insurance liabilities at end of period..... $14,150.8 $12,421.8 $10,396.1
========= ========= =========
<FN>
(a) Revenues exclude net investment gains (losses); benefits and expenses
exclude amortization related to net investment gains (losses).
(b) Excludes variable annuity products where the credited amount is based on
investment income from segregated investments.
</FN>
General: This segment includes traditional fixed rate annuity products
(SPDAs, FPDAs and SPIAs), market value-adjusted annuity products, equity-indexed
annuity products and variable annuities sold through both career agents and
professional independent producers. The profitability of this segment largely
depends on the investment spread earned (i.e., the excess of investment earnings
12
over interest credited on annuity deposits), the persistency of in-force
business, and expense management. In addition, comparability between periods is
affected by: (i) the LPG Merger, effective July 1, 1996; and (ii) the ALH Stock
Purchase, effective September 30, 1996.
Premiums collected by this segment in 1997 were $1,689.6 million, up 1.2
percent over 1996. Premiums collected in 1996 were $1,670.3 million, down 1.4
percent from 1995. Increased competition from products such as mutual funds,
traditional bank investments, variable annuities and other investment and
retirement funding alternatives was a significant factor in the modest increase
in annuity premiums collected, despite the full-year impact of the former LPG
subsidiaries.
Traditional fixed rate annuity products include SPDAs, FPDAs and SPIAs,
which are credited with a guaranteed rate. SPDA and FPDA policies (which make up
78 percent, 84 percent and 90 percent of traditional fixed rate annuity premiums
collected in 1997, 1996 and 1995, respectively) 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. The demand for traditional fixed rate annuity contracts has
decreased in recent years, as relatively low interest rates have made other
investment products more attractive. Annuity premiums on these products
decreased 24 percent in 1997, to $937.2 million, and decreased 22 percent in
1996, to $1,241.3 million.
We offer deferred annuity products with a "market value adjustment"
feature designed to provide additional protection from early terminations during
a period of rising interest rates by reducing the surrender value payable upon a
full surrender of the policy in excess of the allowable penalty-free withdrawal
amount. Conversely, during a period of declining interest rates, the market
value adjustment feature would increase the surrender value payable to the
policyholder. Annuity premiums collected with this feature represent 11 percent
and 16 percent of total annuity premiums collected during 1997 and 1996,
respectively.
In response to consumers' desire for alternative investment products with
returns linked to equities, we introduced an equity- indexed annuity product in
June 1996. The accumulation value of these annuities is credited with interest
at an annual minimum guaranteed rate of 3 percent, but the annuities provide for
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
potential increases to policyholder benefits resulting from increases in the S&P
500 Index to which the product's return is linked. Total collected premiums for
this product were $387.7 million in 1997 compared with $80.4 million in 1996.
Variable annuities offer contract holders a rate of return based on the
specific investment portfolios into which premiums may be directed. The
popularity of such annuities has increased recently as a result of the desire of
investors to invest in common stocks. In addition, in 1996, we began to offer
more investment options for variable annuity deposits, and we expanded our
marketing efforts, which resulted in increased collected premiums. Profits on
variable annuities are derived from the fees charged to contract holders rather
than from the investment spread. Variable annuity collected premiums increased
104 percent in 1997, to $185.2 million, and increased 42 percent in 1996, to
$90.9 million.
Insurance policy income includes: (i) premiums received on SPIA policies
that incorporate significant mortality features; (ii) cost of insurance and
expenses charged to annuity policies; and (iii) surrender charges earned on
annuity policy withdrawals. In accordance with GAAP, premiums on annuity
contracts without mortality features are not reported as revenues, but rather
are reported as deposits to insurance liabilities. Insurance policy income
increased in 1997 and 1996 primarily because of increased surrender charges
collected (changes in premiums received on policies with mortality features and
cost of insurance and expenses charged to annuity policies were not
significant). Surrender charges were $64.0 million in 1997, $41.2 million in
1996 and $28.6 million in 1995. Annuity policy withdrawals were $1.8 billion in
1997, compared with $1.7 billion in 1996 and $1.5 billion in 1995. The increase
in policy withdrawals and surrender charges generally corresponds to the aging
and the growth of our annuity business in force. In addition, policyholders are
using the systematic withdrawal features available in several of our annuity
policies, and more policyholders are surrendering in order to invest in
alternative investments. Total withdrawals and surrenders were 15 percent, 16
percent and 16 percent of insurance liabilities related to surrenderable
policies in 1997, 1996 and 1995, respectively.
Net investment income on general account invested assets (excluding
income on separate account assets related to variable annuities and the change
in the fair value of S&P 500 Call Options related to equity-indexed products)
increased 7.8 percent in 1997, to $960.9 million, and increased 4.7 percent in
1996, to $891.2 million. These increases primarily reflect the increase in
general account invested assets acquired in conjunction with the recent
acquisitions. The segment's average invested assets increased 11 percent to
$12.8 billion in 1997, compared with 1996, and the annualized yield earned on
average invested assets decreased from 7.9 percent to 7.5 percent in 1997. The
segment's average invested assets increased 10 percent to $11.2 billion in 1996,
and the annualized yield earned on average invested assets decreased from 8.4
percent to 7.9 percent in 1996. Cash flows received during 1997 and 1996
(including cash flows from the sales of investments) were invested in lower
yielding securities due to a general decline in interest rates.
13
Net investment income from the change in fair value of S&P 500 Call
Options is substantially offset by a corresponding charge to amounts added to
policyholder account balances for equity-indexed products. Such income and
related charge fluctuate based on the performance of the S&P 500 Index to which
the returns on such products are linked.
Net investment income on separate account assets is offset by a
corresponding charge to amounts added to policyholder account balances for
variable annuity products. Such income and related charge fluctuate in
relationship to total separate account assets and the return earned on such
assets.
Insurance policy benefits and change in future policy benefits relate
solely to annuity policies that incorporate significant mortality features. The
increase corresponds to the increase in the in-force block of such policies.
Amounts added to policyholder account balances for interest expense on
annuity products increased 3.6 percent in 1997 and 3.6 percent in 1996,
primarily due to a larger block of annuity business in force in 1997, partially
offset by a reduction in crediting rates. The weighted average crediting rates
for these annuity liabilities were 4.8 percent in 1997, 5.0 percent in 1996 and
5.3 percent in 1995.
Amortization related to operations increased 10 percent in 1997 and 18
percent in 1996. Amortization related to operations includes amortization of:
(i) the cost of policies produced; (ii) the cost of policies purchased; and
(iii) goodwill related to this segment's business. The amount of amortization
increased primarily because of the increase in balances subject to amortization
as a result of recent acquisitions.
Interest expense on investment borrowings is affected by changes in
investment borrowing activities during the last three years and the changes in
interest rates paid on such borrowings.
Other operating costs and expenses decreased 12 percent in 1997 and
increased 18 percent in 1996. Other operating costs and expenses were favorably
affected in 1997 by the consolidation of all annuity operations in Conseco's
Carmel, Indiana facilities. The increase in 1996 corresponds to the increases in
the total business in force primarily related to acquisition transactions
described above under "General."
Net investment gains (losses), net of related costs and amortization,
often fluctuate from period to period. Selling securities at a gain and
reinvesting the proceeds at lower yields may, absent other management action,
tend to decrease future investment yields. We believe, however, that the
following factors mitigate the adverse effect of such decreases on net income:
(i) we recognized additional amortization of cost of policies purchased and cost
of policies produced in order to reflect reduced future yields (thereby reducing
such amortization in future periods); (ii) we can reduce interest rates credited
to some products, thereby diminishing the effect of the yield decrease on the
investment spread; and (iii) the investment portfolio grows as a result of
reinvesting the realized gains. As a result of the sales of fixed maturity
investments, the amortization of the cost of policies produced and the cost of
policies purchased increased $132.0 million in 1997, $31.6 million in 1996 and
$117.3 million in 1995.
14
Life insurance:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Premiums collected:
Universal life (first-year).......................................$ 96.6 $ 62.2 $ 15.7
Universal life (renewal).......................................... 354.3 208.9 97.4
---------- ------- ---------
Subtotal - universal life..................................... 450.9 271.1 113.1
---------- ------- ---------
Traditional life (first-year)..................................... 49.0 17.0 16.1
Traditional life (renewal)........................................ 209.1 115.5 124.4
---------- ------- ---------
Subtotal - traditional life................................... 258.1 132.5 140.5
---------- ------- ---------
Total life premiums collected.............................$ 709.0 $ 403.6 $ 253.6
========== ======= =========
Insurance policy income:
Premiums earned on traditional life products......................$ 258.6 $ 141.1 $ 143.5
Mortality charges and administrative fees......................... 357.8 211.2 73.8
Surrender charges................................................. 14.1 8.2 5.1
---------- ------- ---------
Total insurance policy income................................... 630.5 360.5 222.4
Net investment income................................................ 448.2 279.7 176.9
---------- ------- ---------
Total revenues (a)........................................ 1,078.7 640.2 399.3
---------- ------- ---------
Insurance policy benefits and change in future policy benefits....... 456.9 270.5 182.5
Interest added to financial product policyholder account balances.... 154.9 97.0 51.6
Amortization related to operations................................... 61.3 48.1 33.4
Interest expense on investment borrowings............................ 11.6 6.3 3.5
Other operating costs and expenses................................... 89.3 91.5 53.5
---------- ------- ---------
Total benefits and expenses (a)........................... 774.0 513.4 324.5
---------- ------- ---------
Operating income before income taxes,
minority interest and extraordinary
charge................................................. 304.7 126.8 74.8
Net investment gains (losses), net of related costs
and amortization.................................................. 2.4 (2.0) (4.6)
---------- ------- ---------
Income before income taxes, minority
interest and extraordinary charge......................$ 307.1 $ 124.8 $ 70.2
========== ======= =========
Total life product insurance liabilities.............................$ 7,075.0 $4,992.7 $ 2,102.2
========== ======== =========
Life insurance in force..............................................$104,144.5 $80,149.5 $33,783.2
========== ========= =========
<FN>
(a) Revenues exclude net investment gains (losses); benefits and expenses
exclude amortization related to net investment gains (losses).
</FN>
General: This segment includes traditional life and universal life
products sold through career agents, professional independent producers and
direct response distribution channels. This segment's operations were
significantly affected by recent acquisitions (LPG effective July 1, 1996; PFS
effective April 1, 1997; Colonial Penn effective September 30, 1997; and WNIC
effective December 1, 1997). The profitability of this segment largely depends
on the investment spread earned (for universal life), the persistency of
in-force business, claim experience and expense management.
15
Premiums collected by this segment were up 76 percent in 1997, to $709.0
million. Premiums collected in 1996 were up 59 percent in 1996, to $403.6
million. Such increases relate primarily to premiums collected by recently
acquired companies in periods after their acquisition.
Universal life product collected premiums increased 66 percent in 1997,
to $450.9 million, and increased 140 percent in 1996, to $271.1 million.
Traditional life product collected premiums increased 95 percent in 1997,
to $258.1 million, and decreased 5.7 percent in 1996, to $132.5 million.
Insurance policy income includes: (i) premiums received on traditional
life products; (ii) the mortality charges and administrative fees earned on
universal life insurance; and (iii) surrender charges on terminated universal
life insurance policies. In accordance with GAAP, premiums on universal life
products are accounted for as deposits to insurance liabilities. Revenues are
earned over time in the form of investment income on policyholder account
balances, surrender charges, and mortality and other charges deducted from
policyholders' account balances.
All three components of insurance policy income have increased over the
last three years primarily as a result of the acquisition transactions described
above under "General."
Net investment income increased 60 percent in 1997, to $448.2 million,
and 58 percent in 1996, to $279.7 million. Investment income fluctuates with
changes in: (i) the amount of average invested assets supporting insurance
liabilities; and (ii) the yield earned on invested assets. During 1997, the
segment's average invested assets increased 71 percent, to $6.0 billion, and the
net yield on invested assets decreased from 7.9 percent to 7.5 percent. During
1996, the segment's average invested assets increased 66 percent, to $3.5
billion, and the net yield on invested assets decreased from 8.4 percent to 7.9
percent. Invested assets grew primarily as a result of the growth in insurance
liabilities from the acquisition transactions described above under "General."
Insurance policy benefits and change in future policy benefits increased
in 1997 and 1996, reflecting the larger amount of business in force on which
benefits are incurred as a result of the acquisition transactions described
above under "General." There were no unusual fluctuations in claim experience
during the periods.
Interest added to financial product policyholder account balances
increased 60 percent in 1997, to $154.9 million, and 88 percent in 1996, to
$97.0 million. Such expense fluctuates with changes in: (i) the amount of
insurance liabilities for universal life products; and (ii) the interest rate
credited to such products. During 1997, such average liabilities increased 66
percent, to $3.3 billion, and the rate credited decreased from 5.0 percent to
4.8 percent. During 1996, such average liabilities increased 98 percent, to $2.0
billion, and the rate credited decreased from 5.2 percent to 5.0 percent.
Universal life product liabilities increased primarily as a result of the
acquisition transactions described above under "General."
Amortization related to operations increased 27 percent in 1997, to $61.3
million, and 44 percent in 1996, to $48.1 million. Amortization related to
operations includes amortization of: (i) the cost of policies produced; (ii) the
cost of policies purchased; and (iii) goodwill related to this segment's
business. The amount of amortization was primarily affected by the increases in
balances subject to amortization as a result of the recent acquisitions, net of
the effect of reductions in the balances of the cost of policies purchased and
cost of policies produced resulting from net investment gains recognized during
1997 and 1996 (see "Net investment gains (losses)" below).
Interest expense on investment borrowings is affected by changes in
investment borrowing activities during the last three years and the changes in
interest rates paid on such borrowings.
Other operating costs and expenses decreased 2.4 percent in 1997, to
$89.3 million, and increased 71 percent in 1996, to $91.5 million. The
fluctuations correspond to the increases in this segment's business as a result
of recent acquisitions, offset in 1997 by expense reductions realized as a
result of the consolidation of certain operations.
Net investment gains (losses), net of related costs and amortization,
often fluctuate from period to period. Net investment gains (losses) affect the
timing of the amortization of costs of policies purchased and the cost of
policies produced. As a result of net investment gains (losses) from the sales
of fixed maturity investments, amortization of cost of policies purchased and
cost of policies produced increased $49.2 million in 1997, $4.4 million in 1996
and $9.3 million in 1995.
16
Individual and group major medical:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Premiums collected:
Individual (first-year)...............................................$ 70.3 $ 6.0 $ 8.4
Individual (renewal).................................................. 147.4 44.9 56.1
------- -------- --------
Subtotal - individual............................................. 217.7 50.9 64.5
------- -------- --------
Group (first-year).................................................... 63.6 - -
Group (renewal)....................................................... 462.9 290.1 289.1
------- -------- --------
Subtotal - group.................................................. 526.5 290.1 289.1
------- -------- --------
Total individual and group major medical premiums collected.......$ 744.2 $ 341.0 $ 353.6
======= ======== ========
Insurance policy income..................................................$ 758.1 $ 357.0 $ 352.0
Net investment income.................................................... 17.3 8.8 9.5
------- -------- --------
Total revenues (a)................................................ 775.4 365.8 361.5
------- -------- --------
Insurance policy benefits and changes in future policy benefits.......... 579.5 300.3 300.8
Amortization related to operations....................................... 21.2 16.0 13.6
Interest expense on investment borrowings................................ .6 .1 .2
Other operating costs and expenses....................................... 133.9 17.3 11.8
------- -------- --------
Total benefits and expenses....................................... 735.2 333.7 326.4
------- -------- --------
Operating income before income taxes, minority interest and
extraordinary charge............................................ 40.2 32.1 35.1
Net investment gains, net of related costs............................... .1 - .1
------- -------- --------
Income before income taxes, minority interest and extraordinary
charge..........................................................$ 40.3 $ 32.1 $ 35.2
======= ======== ========
Benefit ratio ........................................................... 78.0% 85.7% 85.4%
<FN>
(a) Revenues exclude net investment gains.
</FN>
General: This segment includes individual and group major medical health
insurance products. The segment's operations were significantly affected by the
PFS Merger, effective April 1, 1997, and to a lesser extent, by the LPG Merger,
effective July 1, 1996. The profitability of this business depends largely on
the overall persistency of the business in force, as well as claim experience
and expense management.
Premiums collected by this segment increased 118 percent in 1997, to
$744.2 million, and decreased 3.6 percent in 1996, to $341.0 million. Individual
health premiums increased 328 percent in 1997, to $217.7 million, and decreased
21 percent in 1996, to $50.9 million. Group premiums increased 81 percent in
1997, to $526.5 million, and did not change materially between 1995 and 1996.
The recently acquired companies accounted for all of the 1997 increases.
Insurance policy income comprises premiums earned on the segment's
policies and fee income earned for group medical risk management services.
Fluctuations in premiums earned have been consistent with the fluctuations in
premiums collected described above. Fee income (which is earned by a subsidiary
acquired in the LPG Merger) was $15.0 million in 1997 and $7.0 million in 1996.
Net investment income increased 97 percent in 1997, to $17.3 million, and
decreased 7.4 percent in 1996, to $8.8 million. Investment income fluctuates
when changes occur in: (i) the amount of average invested assets supporting
insurance liabilities; and (ii) the yield earned on invested assets. During
1997, the segment's average invested assets increased approximately 111 percent,
to $244.0 million, and the net yield on invested assets decreased from 7.6
percent to 7.1 percent. During 1996, the segment's average
17
invested assets did not change significantly and the net yield on invested
assets decreased from 7.9 percent to 7.6 percent. Average invested assets
increased in 1997 as a result of the PFS Merger.
Insurance policy benefits and change in future policy benefits increased
in 1997, primarily as a result of the larger amount of segment business in
force. In 1997, the ratio of policy benefits to insurance policy income
decreased 7.7 percentage points, to 78.0 percent. In 1996, the ratio of policy
benefits to insurance policy income increased from 85.4 percent to 85.7 percent.
The lower benefit ratio in 1997 reflects: (i) the lower incidence of claims
experienced on business written by the acquired companies compared with the
business of other Conseco subsidiaries; and (ii) favorable claim developments.
Amortization related to operations includes amortization of: (i) the cost
of policies produced; (ii) the cost of policies purchased; and (iii) goodwill
related to this segment's business. Amortization expense increased 33 percent in
1997, to $21.2 million, and 18 percent in 1996, to $16.0 million. The amount of
amortization was primarily affected by the increase in balances subject to
amortization as a result of the recent acquisitions.
Interest expense on investment borrowings is affected by changes in
investment borrowing activities during the last three years and the changes in
interest rates paid on such borrowings.
Other operating costs and expenses increased 674 percent in 1997, to
$133.9 million, and 47 percent in 1996, to $17.3 million. Such increases
correspond to the increases in the total business in force related primarily to
the recently acquired companies.
Net investment gains, net of related costs, realized by this segment were
not material in 1997, 1996 or 1995.
18
Other:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Premiums collected:
Other (first-year)................................................ $ 3.9 $ 2.2 $ 2.6
Other (renewal)................................................... 65.3 52.3 64.0
-------- -------- ---------
Total other premiums collected................................ $ 69.2 $ 54.5 $ 66.6
======== ======== =========
Insurance policy income.............................................. $ 67.3 $ 53.2 $ 65.3
Net investment income................................................ 15.4 7.8 9.0
Fee revenue and other income......................................... 65.8 49.8 43.6
-------- -------- ---------
Total revenues (a)............................................ 148.5 110.8 117.9
-------- -------- ---------
Insurance policy benefits and changes in future policy benefits...... 40.3 25.1 36.8
Amortization related to operations................................... 9.4 11.2 10.1
Interest expense on investment borrowings............................ .3 .2 .2
Other operating costs and expenses................................... 40.2 43.6 39.3
-------- -------- ---------
Total benefits and expenses .................................. 90.2 80.1 86.4
-------- -------- ---------
Operating income before income taxes,
minority interest and extraordinary
charge...................................................... 58.3 30.7 31.5
Net investment gains (losses), net of related costs.................. 3.3 27.4 (6.3)
-------- -------- --------
Income before income taxes, minority
interest and extraordinary charge........................... $ 61.6 $ 58.1 $ 25.2
======== ======== =========
<FN>
(a) Revenues exclude net investment gains (losses).
</FN>
General: This segment includes: (i) various other health insurance
products that are not currently being actively marketed; and (ii) beginning
December 1, 1997, the specialty health insurance products of WNIC marketed to
educators through career agents. The segment's operations were significantly
affected by recent acquisitions (THI, effective January 1, 1997, and WNIC,
effective December 1, 1997). The profitability of this business depends largely
on the overall persistency of the business in force, claim experience and
expense management.
This segment also includes the fee revenue generated by our non-life
subsidiaries, including the investment advisory fees earned by CCM and
commissions earned for insurance and investment product marketing and
distribution. Such amounts exclude the fees and commissions we charge to our
consolidated subsidiaries. The profitability of the fee-based business depends
on the total fees generated and on expense management.
Premiums collected by this segment increased 27 percent in 1997, to $69.2
million, and decreased 18 percent in 1996, to $54.5 million. The increase in
premiums collected in 1997 primarily relates to recent acquisitions.
We do not emphasize the sale of many of the products in this segment,
andcollected premiums are expected to decrease in future years. However, the
in-force business continues to be profitable.
Insurance policy income comprises premiums earned on the segment's
policies, and has fluctuated over the last three years consistent with the
explanations provided above for premiums collected.
Net investment income increased 97 percent in 1997, to $15.4 million, and
decreased 13 percent in 1996, to $7.8 million. Such investment income fluctuated
primarily in relationship to the amount of average invested assets supporting
this segment's insurance liabilities. During 1997, the segment's average
invested assets increased 96 percent, to $199.5 million, and the net yield on
invested assets did not change materially. During 1996, the segment's average
invested assets decreased approximately 8.6 percent, to $101.6 million, and the
net yield on invested assets decreased from 8.1 percent to 7.7 percent.
19
Fee revenue and other income includes: (i) fees for investment management
and for mortgage origination and servicing; and (ii) commissions earned for
insurance and investment product marketing and distribution. Such amounts
exclude the fees and commissions we charge our consolidated subsidiaries. Fee
revenue and other income increased 32 percent in 1997, to $65.8 million,
primarily due to increased investment management fees. Fee revenue and other
income increased 14 percent in 1996, to $49.8 million, primarily as a result of
the acquisition of certain property and casualty insurance brokerage businesses.
Insurance policy benefits and change in future policy benefits fluctuate
in relationship to the amount of segment business in force and the incidence of
claims.
Amortization related to operations decreased 16 percent in 1997, to $9.4
million, and increased 11 percent in 1996, to $11.2 million. Amortization
related to operations includes amortization of: (i) the cost of policies
produced; (ii) the cost of policies purchased; and (iii) goodwill related to
this segment's business. The decrease in amortization in 1997 is consistent with
the declining balance of cost of policies purchased and cost of policies
produced associated with the business included in this segment. The increase in
1996 was primarily due to the increases in such balances as a result of our
purchase of additional shares of BLH common stock in 1995 and 1996. The
acquisitions of THI and WNIC did not materially increase the balance of goodwill
and cost of policies purchased of this segment (valuations of the acquired
blocks indicated that such amounts were insignificant).
Other components of income before income taxes, minority interest and
extraordinary charge:
In addition to the income of the five operating segments, income before
income taxes, minority interest and extraordinary charge is affected by interest
and other corporate expenses, nonrecurring charges and net investment gains not
attributable to the operating segments.
Interest and other corporate expenses were $126.8 million in 1997, $112.4
million in 1996, and $140.5 million in 1995. Interest expense included therein
was $109.4 million in 1997, $108.1 million in 1996, and $119.4 million in 1995.
Such expense fluctuates in relationship to the average debt outstanding during
each period and the interest rate thereon.
Nonrecurring charges of $9.3 million in 1997 represent expenses incurred
related to the death of an executive officer.
Net investment gains, net of related costs, of $15.2 million in 1995
primarily arose from the gain realized on the sale of Conseco's investment in
Eagle Credit (a finance subsidiary of Harley-Davidson).
LIFE INSURANCE SEGMENT SALES
In accordance with GAAP, insurance policy income shown in our
consolidated statement of operations consists of premiums received 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 rather are reported as deposits to insurance liabilities. Revenues
for these products are recognized over time in the form of investment income and
surrender or other charges assessed to the policy.
20
Total premiums collected by our business segments during the last three
years were as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Supplemental health:
First-year....................................................................... $ 290.0 $ 124.1 $ 125.5
Renewal.......................................................................... 1,553.7 686.7 613.3
--------- --------- ---------
Total supplemental health.................................................... 1,843.7 810.8 738.8
--------- --------- ---------
Annuities:
First-year ...................................................................... 1,538.6 1,504.1 1,581.3
Renewal.......................................................................... 151.0 166.2 112.6
--------- --------- ---------
Total annuities.............................................................. 1,689.6 1,670.3 1,693.9
--------- --------- ---------
Life insurance:
First-year....................................................................... 145.6 79.2 31.8
Renewal.......................................................................... 563.4 324.4 221.8
--------- --------- ---------
Total life insurance......................................................... 709.0 403.6 253.6
--------- --------- ---------
Individual and group major medical:
First-year....................................................................... 133.9 6.0 8.4
Renewal.......................................................................... 610.3 335.0 345.2
--------- --------- ---------
Total individual and group major medical..................................... 744.2 341.0 353.6
--------- --------- ---------
Other:
First-year....................................................................... 3.9 2.2 2.6
Renewal.......................................................................... 65.3 52.3 64.0
--------- --------- ---------
Total other.................................................................. 69.2 54.5 66.6
--------- --------- ---------
Total:
First-year....................................................................... 2,112.0 1,715.6 1,749.6
Renewal.......................................................................... 2,943.7 1,564.6 1,356.9
--------- --------- ---------
Total collected premiums...................................................... $ 5,055.7 $ 3,280.2 $ 3,106.5
========= ========= =========
21
Fluctuations in premiums collected are discussed above under "Results of
operations by segment for the three years ended December 31, 1997." Our recent
acquisitions will have a significant effect on future premiums collected. Total
premiums collected for all currently consolidated companies (except subsidiaries
of WNIC, which were acquired on December 1, 1997) for all periods (including
periods prior to ownership by Conseco) are provided below:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Supplemental health:
First-year....................................................................... $ 303.7 $ 306.0 $ 296.6
Renewal.......................................................................... 1,631.7 1,521.1 1,417.3
--------- --------- ---------
Total supplemental health.................................................... 1,935.4 1,827.1 1,713.9
--------- --------- ---------
Annuities:
First-year....................................................................... 1,540.9 1,549.1 1,613.1
Renewal.......................................................................... 138.8 182.9 177.3
--------- --------- ---------
Total annuities.............................................................. 1,679.7 1,732.0 1,790.4
--------- --------- ---------
Life insurance:
First-year....................................................................... 165.1 185.9 136.0
Renewal.......................................................................... 647.3 620.9 681.5
--------- --------- ---------
Total life insurance......................................................... 812.4 806.8 817.5
--------- --------- ---------
Individual and group major medical:
First-year....................................................................... 172.4 145.6 137.0
Renewal.......................................................................... 691.4 630.8 652.3
--------- --------- ---------
Total individual and group major medical..................................... 863.8 776.4 789.3
--------- --------- ---------
Other:
First-year....................................................................... 1.7 2.3 2.6
Renewal.......................................................................... 89.9 112.5 144.1
--------- --------- ---------
Total other.................................................................. 91.6 114.8 146.7
--------- --------- ---------
Total:
First-year....................................................................... 2,183.8 2,188.9 2,185.3
Renewal.......................................................................... 3,199.1 3,068.2 3,072.5
--------- --------- ---------
Total collected premiums..................................................... $ 5,382.9 $ 5,257.1 $ 5,257.8
========= ========= =========
INVESTMENTS HELD BY OUR LIFE INSURANCE SUBSIDIARIES
Our investment strategy is to: (i) maintain a predominately
investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet
the cash flow requirements of policyholders and other obligations; and (iii)
maximize current income and total investment return through active investment
management. Consistent with this strategy, investments in fixed maturity
securities, mortgage loans, credit-tenant loans, policy loans, separate accounts
and short-term investments made up 97 percent of our $27.0 billion investment
portfolio at December 31, 1997. The remainder of the invested assets were equity
securities and other invested assets.
Our insurance subsidiaries are regulated by insurance statutes and
regulations as to the type of investments that they are permitted to make and
the amount of funds that may be used for any one type of investment. In light of
these statutes and regulations and our business and investment strategy, Conseco
generally seeks to invest in United States government and government-agency
securities and corporate securities rated investment grade by established
nationally recognized rating organizations or, if not rated, in securities of
comparable investment quality.
22
The following table summarizes investment yields earned over the past
three years, excluding the investments and investment income of the consumer and
commercial finance segment.
1997 1996 1995
---- ---- ----
(Dollars in millions)
Weighted average invested assets:
As reported ................................................................. $23,288.8 $16,356.3 $13,769.3
Excluding unrealized appreciation (depreciation) (a)......................... 23,177.7 16,278.8 13,690.6
Net investment income............................................................... 1,825.3 1,302.5 1,142.6
Yields earned:
As reported.................................................................. 7.8% 8.0% 8.3%
Excluding unrealized appreciation (depreciation) (a) ........................ 7.9% 8.0% 8.3%
<FN>
(a) Excludes the effect of reporting fixed maturities at fair value as
described in note 1 to the consolidated financial statements.
</FN>
Although investment income is a significant component of total revenues,
the profitability of a portion of our insurance products is determined primarily
by spreads between interest rates earned and rates credited or accruing to our
insurance liabilities. At December 31, 1997, the average yield, computed on the
cost basis of our investment portfolio, was 7.5 percent, and the average
interest rate credited or accruing to our total insurance liabilities was 5.2
percent, excluding interest bonuses guaranteed only for the first year of the
contract.
Actively managed fixed maturities
Our actively managed fixed maturity portfolio at December 31, 1997,
included primarily debt securities of the United States government, public
utilities and other corporations, and mortgage-backed securities.
Mortgage-backed securities included collateralized mortgage obligations ("CMOs")
and mortgage-backed pass-through securities.
At December 31, 1997, our fixed maturity portfolio had net unrealized
gains of $484.4 million (equal to approximately 2.1 percent of the portfolio's
carrying value), consisting of $611.5 million of unrealized gains and $127.1
million of unrealized losses. Estimated fair values for fixed maturity
investments were determined based on: (i) estimates from nationally recognized
pricing services (82 percent of the portfolio); (ii) broker-dealer market makers
(8 percent of the portfolio); and (iii) internally developed methods (10 percent
of the portfolio).
As discussed in the notes to the consolidated financial statements, when
we adjust carrying values of actively managed fixed maturity securities for
changes in fair value, we also adjust the cost of policies purchased, cost of
policies produced and liabilities. These adjustments are made in order to
reflect the change in amortization and liability accruals that would be needed
if those fixed maturity investments had actually been sold at their fair values
and the proceeds reinvested at current interest rates.
At December 31, 1997, approximately 5.5 percent of our invested assets
and 6.6 percent of fixed maturity investments were rated below-investment grade
by nationally recognized statistical rating organizations (or, if not rated by
such firms, with ratings below Class 2 assigned by the NAIC). We plan to
maintain approximately the present level of below-investment-grade fixed
maturities. These securities generally have greater risks than other corporate
debt investments, including risk of loss upon default by the borrower, and are
often unsecured and subordinated to other creditors. Below-investment-grade
issuers usually have high levels of indebtedness and are more sensitive to
adverse economic conditions, such as recession or increasing interest rates,
than are investment grade issuers. We are aware of these risks and monitor our
below-investment-grade securities closely. At December 31, 1997, our below-
investment-grade fixed maturity investments had an amortized cost of $1,525.1
million and an estimated fair value of $1,496.2 million.
We periodically evaluate the creditworthiness of each issuer whose
securities the Company holds. Special attention is paid to those securities
whose market values have declined materially for reasons other than changes in
interest rates or other general market conditions. We consider available
information to evaluate the realizable value of the investment, the specific
condition of the issuer and the issuer's ability to comply with the material
terms of the security. Information reviewed may include the recent operational
results and financial position of the issuer, information about its industry,
recent press releases and other information. Conseco employs a staff of
experienced securities analysts in a variety of specialty areas. Among its other
responsibilities, this staff is charged with compiling and reviewing such
information. If evidence does not exist to support a realizable value equal to
or greater than the carrying value of the investment, and such decline in market
value is determined to be other than temporary, we reduce the carrying amount to
its net realizable value, which becomes the new cost basis; the amount of the
reduction is reported as a realized loss. We recognize any recovery of such
reductions in the cost basis of an investment only upon the sale, repayment or
other disposition of the investment. We recorded writedowns of fixed maturity
investments and other invested assets totaling $1.2 million
23
in 1997, primarily as a result of: (i) changes in the financial condition of a
private company in which we had an indirect equity investment; and (ii) changes
in the value of the underlying collateral associated with certain notes. These
changes caused us to conclude that the decline in fair value of such investments
was other than temporary. Our investment portfolio is subject to the risks of
further declines in realizable value. However, we attempt to mitigate this risk
through the diversification and active management of our portfolio.
As of December 31, 1997, fixed maturity investments in substantive
default (i.e., in default due to nonpayment of interest or principal) had an
amortized cost and carrying value of $2.1 million and $1.2 million,
respectively. Fixed maturity investments in technical (but not substantive)
default (i.e., in default, but not as to the payment of interest or principal)
had an amortized cost and carrying value of $.3 million. There were no other
fixed maturity investments about which we had serious doubts as to the ability
of the issuer to comply on a timely basis with the material terms of the
instruments.
Our policy is to discontinue the accrual of interest and eliminate all
previous interest accruals for defaulted securities, if it is determined that
such amounts will not be ultimately realized in full. Investment income forgone
due to defaulted securities was $.2 million in 1997, $3.8 million in 1996 and
$1.6 million in 1995.
At December 31, 1997, fixed maturity investments included $6.9 billion of
mortgage-backed securities (or 30 percent of all fixed maturity securities). The
yield characteristics of mortgage-backed securities differ from those of
traditional fixed-income securities. Interest and principal payments occur more
frequently, often monthly. Mortgage-backed securities are subject to risks
associated with variable prepayments. Prepayment rates are influenced by a
number of factors that cannot be predicted with certainty, including: the
relative sensitivity of the underlying mortgages backing the assets to changes
in interest rates; a variety of economic, geographic and other factors; and the
repayment priority of the securities in the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the
securities backed by these loans, increase when the level of prevailing interest
rates declines significantly relative to the interest rates on such loans.
Mortgage-backed securities purchased at a discount to par will experience an
increase in yield when the underlying mortgages prepay faster than expected.
These securities purchased at a premium that prepay faster than expected will
incur a reduction in yield. When interest rates decline, the proceeds from the
prepayment of mortgage-backed securities are likely to be reinvested at lower
rates than we were earning on the prepaid securities. When interest rates
increase, prepayments on mortgage-backed securities decrease, because fewer
underlying mortgages are refinanced. When this occurs, the average maturity and
duration of the mortgage-backed securities increase, which decreases the yield
on mortgage-backed securities purchased at a discount, because the discount is
realized as income at a slower rate and increases the yield on those purchased
at a premium as a result of a decrease in annual amortization of the premium.
CMOs are securities backed by pools of pass-through securities and/or
mortgages that are segregated into sections or "tranches" that provide for
sequential retirement of principal, rather than the pro rata share of principal
return that occurs through regular monthly principal payments on pass-through
securities.
All mortgage-backed securities are subject to risks associated with
variable prepayments. As a result, these securities may have a different actual
maturity than planned at the time of purchase. When securities having a cost
greater than par are backed by mortgages that prepay faster than expected, we
record a charge to investment income. When securities having a cost less than
par prepay faster than expected, we record investment income.
The degree to which a mortgage-backed security is susceptible to income
fluctuations is influenced by: (i) the difference between its cost and par; (ii)
the relative sensitivity of the underlying mortgages backing the security to
prepayment in a changing interest rate environment; and (iii) the repayment
priority of the security in the overall securitization structure. The Company
seeks to limit the extent of these risks by: (i) purchasing securities that are
backed by collateral with lower prepayment sensitivity (such as mortgages priced
at a discount to par value and mortgages that are extremely seasoned); (ii)
avoiding securities whose values are heavily influenced by changes in
prepayments (such as interest-only and principal-only securities); (iii)
investing in securities structured to reduce prepayment risk (such as planned
amortization class ("PAC") and targeted amortization class ("TAC") CMOs); and
(iv) actively managing the entire portfolio of mortgage-backed securities to
dispose of those which are deemed more likely to be prepaid. PAC and TAC
instruments represented approximately 24 percent of our mortgage-backed
securities at December 31, 1997. The call-adjusted modified duration of our
mortgage-backed securities at December 31, 1997, was 5.2 years.
24
The following table sets forth the par value, amortized cost and
estimated fair value of mortgage-backed securities at December 31, 1997,
summarized by interest rates on the underlying collateral:
Par Amortized Estimated
value cost fair value
----- ---- ----------
(Dollars in millions)
Below 7 percent............................................................ $2,025.5 $1,980.4 $2,014.7
7 percent - 8 percent...................................................... 3,568.0 3,546.5 3,638.2
8 percent - 9 percent...................................................... 712.9 716.1 730.5
9 percent and above........................................................ 445.1 455.5 467.0
-------- -------- --------
Total mortgage-backed securities............................... $6,751.5 $6,698.5 $6,850.4
======== ======== ========
The amortized cost and estimated fair value of mortgage-backed securities
at December 31, 1997, summarized by type of security, were as follows:
Estimated fair value
--------------------
% of
Amortized fixed
Type cost Amount maturities
- ---- ---- ------ ----------
(Dollars in millions)
Pass-throughs and sequential and targeted amortization classes............ $4,599.7 $4,697.5 21%
Planned amortization classes and accretion-directed bonds.................. 1,515.9 1,547.6 7
Support classes............................................................ 36.0 36.9 -
Accrual (Z tranche) bonds.................................................. 27.9 28.8 -
Subordinated classes....................................................... 519.0 539.6 2
-------- -------- --
$6,698.5 $6,850.4 30%
======== ======== ==
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 and provide the best
price/performance ratio in a highly volatile interest rate environment. This
type of security is also frequently used as collateral in the dollar-roll
market. Sequential classes pay in a strict sequence; all principal payments
received by the CMO are paid to the sequential tranches in order of priority.
Targeted amortization classes provide a modest amount of prepayment protection
when prepayments on the underlying collateral increase from those assumed at
pricing. Thus, they offer slightly better call protection than sequential
classes and pass-throughs.
Planned amortization classes and accretion-directed bonds are some of the
most stable and liquid instruments in the mortgage-backed securities market.
Planned amortization class bonds adhere to a fixed schedule of principal
payments as long as the underlying mortgage collateral experiences prepayments
within a certain range. Changes in prepayment rates are first absorbed by
support classes. This insulates the planned amortization classes from the
consequences of both faster prepayments (average life shortening) and slower
prepayments (average life extension).
Support classes absorb the prepayment risk from which planned
amortization and targeted amortization classes are protected. As such, they are
usually extremely sensitive to prepayments. Most of our support classes are
higher-average-life instruments that generally will not lengthen if interest
rates rise further, and will have a tendency to shorten if interest rates
decline. However, since these bonds have costs below their par values, higher
prepayments will have the effect of increasing yields.
Accrual bonds are CMOs structured such that the payment of coupon
interest is deferred until principal payments begin. On each accrual date, the
principal balance is increased by the amount of the interest (based on the
stated coupon rate) that otherwise would have been payable. As such, these
securities act much the same as zero-coupon bonds until cash payments begin.
Cash payments typically do not commence until earlier classes in the CMO
structure have been retired, which can be significantly influenced by the
prepayment experience of the underlying mortgage loan collateral in the CMO
structure. Because of the zero-coupon element of these securities and the
potential uncertainty as to the timing of cash payments, their market values and
yields are more sensitive to changing interest rates than are other CMOs,
pass-through securities and coupon bonds.
Subordinated CMO classes have both prepayment and credit risk. The
subordinated classes are used to enhance the credit quality of the senior
securities, and as such, rating agencies require that this support not
deteriorate due to the prepayment of the subordinated securities. The credit
risk of subordinated classes is derived from the negative leverage of owning a
small percentage of the underlying mortgage loan collateral while bearing a
majority of the risk of loss due to homeowner defaults.
25
If we determine that an investment held in the actively managed fixed
maturity category will be sold, we will either sell the security or transfer it
to the trading account at its fair value and recognize the gain or loss
immediately. There were no material transfers in 1997. During 1997, we sold
actively managed fixed maturity securities with a $17.8 billion book value,
resulting in $342.6 million of investment gains and $41.4 million of investment
losses (both before related expenses, amortization and taxes). Such securities
were sold in response to changes in the investment environment, which created
opportunities to enhance the total return of the investment portfolio without
adversely affecting the quality of the portfolio or the matching of expected
maturities of assets and liabilities. The realization of gains and losses
affects the timing of the amortization of the cost of policies produced and the
cost of policies purchased, as explained in note 10 to the consolidated
financial statements.
Other investments of our life insurance subsidiaries
Credit-tenant loans are loans on commercial properties where the lease of
the principal tenant is assigned to the lender. The principal tenant, or any
guarantor of such tenant's obligations, must have a credit rating at the time of
origination of the loan of at least BBB- or its equivalent. The underwriting
guidelines consider such factors as: (i) the lease term of the property; (ii)
the mortgagee's management ability, including business experience, property
management capabilities and financial soundness; and (iii) economic, demographic
or other factors that may affect the income generated by the property or its
value. The underwriting guidelines also generally require a loan-to-value ratio
of 75 percent or less. Credit-tenant loans are carried at amortized cost and
totaled $558.6 million at December 31, 1997, or 2.1 percent of total invested
assets. The total estimated fair value of credit-tenant loans was $587.2 million
at December 31, 1997.
At December 31, 1997, we held mortgage loan investments with a carrying
value of $516.2 million (or 1.9 percent of total invested assets) and a fair
value of $551.0 million. The balance of mortgage loans included 96 percent
commercial loans, 2 percent residential loans and 2 percent residual interests
in CMOs. The residual interests in CMOs entitle the Company to the excess cash
flows arising from the difference between: (i) the cash flows required to make
principal and interest payments on the related senior interests in the CMOs; and
(ii) the actual cash flows received on the mortgage loan assets included in the
CMO portfolios. If prepayments vary from projections on the mortgage loan assets
included in such CMO portfolios, the total cash flows to the Company from such
junior and residual interests could change from projected cash flows, resulting
in a gain or loss.
Noncurrent mortgage loans were insignificant at December 31, 1997. We
recognized realized losses of $.8 million on mortgage loans for the year ended
December 31, 1997. At December 31, 1997, we had a loan loss reserve of $9.0
million. Approximately 20 percent of the mortgage loans were on properties
located in California, 11 percent in Texas and 9 percent in Florida. No other
state accounted for more than 7 percent of the mortgage loan balance.
At December 31, 1997, we held $64.8 million of trading securities that
are included in other invested assets. Trading securities are investments that
are held with the intent to be traded prior to their maturity, or are believed
likely to be disposed of in the foreseeable future as a result of market or
issuer developments. Trading securities are carried at estimated fair value,
with the changes in fair value reflected in the statement of operations.
Other invested assets include: (i) trading securities; (ii) S&P 500 Call
Options; and (iii) certain nontraditional investments, including investments in
venture capital funds, limited partnerships, mineral rights and promissory
notes.
Short-term investments totaled $990.5 million, or 3.7 percent of invested
assets at December 31, 1997, and consisted primarily of commercial paper and
repurchase agreements relating to government securities.
As part of our investment strategy, we enter into reverse repurchase
agreements and dollar-roll transactions to increase our return on investments
and improve our liquidity. Reverse repurchase agreements involve a sale of
securities and an agreement to repurchase the same securities at a later date at
an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements
except that the repurchase involves securities that are only substantially the
same as the securities sold. We enhance our investment yield by investing the
proceeds from the sales in short-term securities pending the contractual
repurchase of the securities at discounted prices in the forward market. We are
able to engage in such transactions due to the market demand for mortgage-backed
securities to form CMOs. Such investment borrowings averaged $719.3 million
during 1997 and were collateralized by investment securities with fair values
approximately equal to the loan value. The weighted average interest rate on
short-term collateralized borrowings was 5.8 percent in 1997. The primary risk
associated with short-term collateralized borrowings is that the counterparty
will be unable to perform under the terms of the contract. Our exposure is
limited to the excess of the net replacement cost of the securities over the
value of the short-term investments (which was not material at December 31,
1997). We believe that the counterparties to our reverse repurchase and
dollar-roll agreements are financially responsible and that the counterparty
risk is minimal.
26
INVESTMENTS, FINANCE RECEIVABLES AND SERVICING RIGHTS OF FINANCE
SUBSIDIARIES
We pool and securitize substantially all of the finance receivables we
originate, retaining: (i) investments in interest-only securities that are
subordinated to the rights of other investors; (ii) servicing on the contracts;
and (iii) investment in senior securities made by our insurance subsidiaries
(classified as fixed maturity securities). In a typical securitization, we sell
finance receivables to a special purpose entity, established for the limited
purpose of purchasing the finance receivables and selling securities
representing interests in the receivables. The special purpose entity issues
interest-bearing securities that are collateralized by the underlying pool of
finance receivables. We receive the proceeds from the sale of the securities in
exchange for the finance receivables. The securities are typically sold at the
same amount as the principal balance of the receivables sold. We retain a
residual interest representing the right to receive, over the life of the pool
of finance receivables, the excess of the cash flows received on the receivables
transferred to the trust over the return paid to the holders of other interests
in the securitization and servicing fees.
We recognize a gain on the sale of finance receivables equal to the
difference between the proceeds from the sale, net of related transaction costs,
and the allocated carrying amount of the receivables sold. We allocate the
carrying amount of finance receivables between the assets sold and retained
based on their relative fair values at the date of sale. The estimated fair
value of interest-only securities and servicing rights is determined by
discounting the projected cash flows over the expected life of the finance
receivables sold using prepayment, default, loss, servicing cost and discount
rate assumptions.
On a quarterly basis, we determine the estimated fair value of our
interest-only securities based on discounted projected future cash flows using
current assumptions. Differences between the estimated fair value and carrying
value of interest-only securities considered temporary declines are recognized
as reductions to shareholders' equity, while differences that are considered
other than temporary declines in value are recognized as a reduction to
earnings. Other than temporary declines in value are deemed to occur when the
present value of estimated future cash flows discounted at a risk free rate
using appropriate assumptions is less than the carrying value of the
interest-only securities. If other than temporary impairment occurs, the
carrying value is reduced to estimated fair value and a loss is recognized in
the statement of operations.
27
A summary of the principal balance of finance receivables sold, the gain on
sale recognized and writedowns of interest-only securities is as follows:
For the year ended
December 31,
-------------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
(Dollars in millions)
Manufactured housing............................. $ 5,370 $5,033 $4,020 $3,226 $2,303
Home improvement/home equity..................... 3,020 1,324 579 544 43
Consumer/equipment............................... 1,627 1,556 - - -
Commercial and revolving credit.................. 224 500 428 - -
Lease and other.................................. 508 - 308 600 -
-------- ------ ------ ------ ------
Total....................................... $10,749 $8,413 $5,335 $4,370 $2,346
======= ====== ====== ====== ======
Gain on sale of finance receivables
before writedowns............................. $ 759.1 $588.1 $443.3 $318.6 $201.5
Writedowns of interest-only securities........... (190.0) (200.0) - - -
------- ------ ------ ------ ------
Net gain on sale............................ $ 569.1 $388.1 $443.3 $318.6 $201.5
======= ====== ====== ====== ======
We service all of the finance receivables we originate or purchase from
other originators, (i) collecting loan payments, taxes and insurance payments,
where applicable, and other payments from borrowers; and (ii) remitting
principal and interest payments to holders of securities backed by the finance
receivables we have sold.
The following summarizes the composition of our managed finance
receivables:
December 31,
-------------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
(Dollars in millions)
Fixed term....................................... $26,036 $18,965 $13,314 $9,653 $7,194
Revolving credit................................. 1,921 1,108 574 168 -
--------- ------- ------- -------- ------
Total....................................... $27,957 $20,073 $13,888 $9,821 $7,194
======= ======= ======= ====== ======
Number of fixed term contracts serviced.......... 1,076,000 827,000 657,000 512,000 406,000
========= ======= ======= ======= =======
Number of revolving credit accounts serviced..... 700,000 180,000 23,000 8,000 -
======== ======== ======= ===== =======
The following summarizes information with respect to the 60-days-and-over
contractual dollar delinquencies, loss experience and repossessed collateral
experience of our managed finance receivables:
1997 1996 1995
---- ---- ----
60-days-and-over delinquencies as a percentage
of managed finance receivables at period end........... 1.08% 1.08% .93%
==== ==== ===
Net credit losses as a percentage of average managed
receivables during the year............................ 1.04% .74% .56%
==== === ===
Repossessed collateral during the year as a percentage of
managed receivables at year end........................ .95% .85% .58%
=== === ===
28
The following summarizes the finance receivables we originated:
Year ended
December 31,
------------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
(Dollars in millions)
Manufactured housing............................. $ 5,479.3 $ 4,882.0 $4,159.8 $3,201.5 $2,449.1
Home improvement/home equity..................... 3,476.2 1,493.7 627.0 465.5 169.5
Consumer/retail credit........................... 1,510.9 835.6 361.4 96.1 47.3
Commercial....................................... 5,181.4 3,343.0 1,742.7 302.4 .1
--------- --------- -------- -------- --------
Total....................................... $15,647.8 $10,554.3 $6,890.9 $4,065.5 $2,666.0
========= ========= ======== ======== ========
At December 31, 1997, no single state accounted for more than 10 percent of
the contracts we serviced. In addition, no single contractor, dealer or vendor
accounted for more than 5 percent of the total contracts we originated.
Activity in the interest-only securities account during 1997 is as follows
(dollars in millions):
Balance at January 1, 1997............................................... $1,014.3
Transfer to servicing rights in conjunction with implementation
of SFAS 125......................................................... (30.8)
Additions resulting from securitizations during the period............ 674.7
Investment income..................................................... 130.3
Principal and interest received....................................... (270.5)
Realized loss......................................................... (190.0)
Change in unrealized appreciation..................................... 35.2
--------
Balance at December 31, 1997............................................. $1,363.2
========
In 1995 and previous years, we sold a substantial portion of our
interest-only securities related to manufactured housing securitization
transactions between 1978 and 1995 in the form of securitized net interest
margin certificates. We retained a subordinated interest in the cash flow of the
interest-only securities sold. These interests are included in interest-only
securities and total $77.0 million at December 31, 1997.
Generally, interest-only securities relate to the sale of closed end
manufactured housing, home equity, home improvement, consumer and equipment
finance receivables. Interest-only securities are subject to a substantial
amount of credit loss and prepayment risk related to the receivables sold. In
connection with the valuation of interest-only securities, the Company has
provided for approximately $900.0 million of credit losses as of December 31,
1997. On a nondiscounted basis, the amount of credit losses provided for in
connection with the valuation of the interest-only securities is approximately
$1.3 billion. These estimated losses, if realized, would reduce the amount of
cash flows available to the interest-only securities and are considered in the
determination of the estimated fair value of such securities.
The following summarizes assumptions used to determine the estimated fair
value of interest-only securities as of December 31, 1997.
Manufactured Home equity/ Consumer/
housing home improvement equipment Total
------- ---------------- --------- -----
(Dollars in millions)
Interest-only securities............................ $857.4 $335.1 $170.7 $1,363.2
Principal balance of sold managed finance
receivables...................................... 17,558.2 4,251.6 2,467.5 24,277.3
Weighted average customer interest rate on sold
managed finance receivables...................... 10.49% 11.82% 11.33%
Expected weighted average constant prepayment
rate as a percentage of principal balance of
sold managed finance receivables (1)............. 9.5% 24.0% 22.0%
Expected nondiscounted credit losses as a
percentage of principal balance of sold managed
finance receivables (1).......................... 6.2% 4.3% 2.1%
29
- -------------------
<FN>
(1) The valuation of interest-only securities is affected not only by the
projected level of prepayments of principal and net credit losses, as shown
above, but also by the projected timing of such prepayments and net credit
losses. Should the timing of projected prepayments of principal or net
credit losses differ materially from the timing projected by the Company,
such timing could have a material effect on the valuation of the
interest-only securities.
</FN>
The weighted average interest rate we use to discount expected future
cash flows of the interest-only securities is 11.47 percent at December 31,
1997.
CONSOLIDATED FINANCIAL CONDITION
Changes in the consolidated balance sheet of 1997 compared with 1996
Our consolidated balance sheet at December 31, 1997, compared with 1996,
reflects growth through operations, changes in the fair value of actively
managed fixed maturity securities, and the following capital and financing
transactions described in the notes to the consolidated financial statements:
(i) the CAF Merger; (ii) the issuance of $800 million of Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts; (iii) the
repurchase of senior subordinated notes and senior notes with a par value of
$130.1 million; (iv) the conversion of convertible debentures acquired in the
ATC Merger into Conseco common stock; (v) the conversion of PRIDES into Conseco
common stock; (vi) the repurchase of mandatorily redeemable preferred stock of a
subsidiary; (vii) the PFS Merger; (viii) the Colonial Penn Purchase; (ix) the
WNIC Merger; (x) common stock repurchases; and (xi) the issuance of commercial
paper and notes payable.
Our total capital (excluding the notes payable of the consumer and
corporate finance segment used to fund finance receivables) at December 31, 1997
and 1996, was as follows:
1997 1996
---- ----
(Dollars in millions)
Notes payable...................................................... $1,906.7 $1,094.9
Commercial paper................................................... 448.2 -
Minority interest:
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts............................. 1,383.9 600.0
Mandatorily redeemable preferred stock of subsidiary........... - 97.0
Common stock of subsidiary..................................... .7 .7
Shareholders' equity:
Preferred stock................................................ 115.8 267.1
Common stock and additional paid-in capital.................... 2,619.8 2,350.7
Accumulated other comprehensive income......................... 200.6 36.6
Retained earnings.............................................. 2,277.7 1,562.4
--------- ----------
Total shareholders' equity.................................. 5,213.9 4,216.8
--------- ---------
Total capital of Conseco.................................... $8,953.4 $6,009.4
======== ========
Notes payable increased during 1997 primarily as a result of: (i) debt
issued or assumed in connection with the acquisitions of CAF, PFS, Colonial Penn
and WNIC; (ii) debt used to finance common stock repurchases; and (iii) the
redemption of mandatorily redeemable preferred stock of a subsidiary of ALH. The
increase in notes payable was partially offset by the repayment of debt using
the proceeds from the issuance of Company-obligated mandatorily redeemable
preferred securities.
We instituted a commercial paper program in April 1997 to lower our
borrowing costs and improve our liquidity. Borrowings under our commercial paper
program averaged approximately $525.9 million during the period of April 24,
1997 through December 31, 1997. The weighted average interest rate on such
borrowings was 5.8 percent during 1997.
Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts are classified as minority interest in accordance with GAAP.
During 1997, we issued $300 million of Capital Securities and $500 million of
FELINE PRIDES. See note 8 to the consolidated financial statements for a
description of these securities.
30
Minority interest, excluding the Company-obligated mandatorily redeemable
preferred securities, at December 31, 1997, included a $.7 million interest in
common stock of a subsidiary of ALH. At December 31, 1996, minority interest
included: (i) $97.0 million of mandatorily redeemable preferred stock of a
subsidiary of ALH; and (ii) $.7 million interest in the common stock of a
subsidiary of ALH.
During 1997, we repurchased all of the mandatorily redeemable preferred
stock of a subsidiary of ALH formerly held by minority interests. As a result,
gains of $3.7 million were realized from the sale of securities having an
amortized cost of $47.7 million; such securities had been held in a segregated
account to ensure the redemption of such preferred stock.
Shareholders' equity increased by $997.1 million in 1997, to $5.2
billion. Significant components of the increase included: (i) Conseco common
stock issued in the CAF Merger with a value of $117.4 million; (ii) Conseco
common stock issued in the PFS Merger with a value of $354.1 million; (iii) net
income of $866.4 million; (iv) the conversion of convertible debentures into
Conseco common stock with a value of $150.0 million; (v) the issuance of common
stock related to stock options and employee benefit plans (including the tax
benefit thereon) of $338.1 million; and (vi) the increase in net unrealized
appreciation of $164.9 million. These increases were partially offset by: (i)
repurchases of common stock for $857.0 million; and (ii) common and preferred
stock dividends totaling $125.0 million.
Book value per common share outstanding increased to $16.45 at December
31, 1997, from $13.47 at December 31, 1996. Such increase was primarily
attributable to the factors discussed in the previous paragraph. Excluding
unrealized appreciation of fixed maturity securities in accordance with SFAS
115, book value per common share outstanding was $15.88 at December 31, 1997,
compared with $13.33 at December 31, 1996.
Total assets increased by $11.9 billion in 1997, to $40.6 billion,
primarily due to the assets acquired in the CAF Merger, the PFS Merger, the
Colonial Penn Purchase and the WNIC Merger.
In accordance with SFAS 115, Conseco records its actively managed fixed
maturity investments at estimated fair value. At December 31, 1997 and 1996,
such investments were increased by $484.4 million and $103.8 million,
respectively, as a result of the SFAS 115 adjustment.
Financial ratios
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
Ratio of earnings to fixed charges:
As reported........................................................ 2.45X 1.93X 2.04X 3.24X 2.45X
Excluding interest on annuities and financial products(a).......... 5.55X 4.85X 4.94X 5.80X 7.15X
Ratio of earnings to fixed charges and preferred dividends:
As reported........................................................ 2.36X 1.81X 1.94X 2.84X 2.30X
Excluding interest on annuities and financial products(a).......... 4.94X 3.81X 4.14X 4.48X 5.58X
Ratio of earnings to fixed charges, preferred dividends and
distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts:
As reported..................................................... 2.20X 1.80X 1.94X 2.84X 2.30X
Excluding interest on annuities and financial products(a)....... 4.10X 3.74X 4.14X 4.48X 5.58X
Ratio of corporate debt to total capital: (b)
As reported........................................................ .26X .18X .30X .12X .20X
Excluding unrealized appreciation (depreciation)(c)................ .27X .18X .31X .11X .20X
Ratio of corporate debt and Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts to total capital:(b) (d)
As reported..................................................... .42X .28X .30X .12X .20X
Excluding unrealized appreciation (depreciation) (c)............ .43X .28X .31X .11X .20X
Rating agency ratios: (c) (e) (f) (g)
Debt to total capital.............................................. .22X .12X .25X .00X .14X
Debt and preferred stock to total capital (h)...................... .38X .23X .25X .00X .14X
31
- --------------------
<FN>
(a) These ratios are included to assist the reader in analyzing the impact
of interest on annuities and financial products (which is not generally
required to be paid in cash in the period in which it is recognized).
Such ratios are not intended to, and do not, represent the following
ratios prepared in accordance with GAAP: the ratio of earnings to fixed
charges; the ratio of earnings to fixed charges and preferred dividends;
and the ratio of earnings to fixed charges, preferred dividends and
distributions on Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts.
(b) For periods prior to 1996, debt includes obligations for which Conseco
was not directly liable. Excludes debt of consumer and corporate finance
segment used to fund finance receivables.
(c) Excludes the effect of reporting fixed maturities at fair value.
(d) Represents the ratio of debt and the Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts to the sum of
shareholders' equity, debt, minority interest and the Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts.
(e) Consistent with our discussions with rating agencies, the Company has
targeted: (i) the ratio of corporate debt to total capital to be at or
below 35 percent; and (ii) the ratio of corporate debt and preferred
stock to total capital to be at or below 49 percent. These ratios are
calculated in a manner discussed with rating agencies.
(f) Corporate debt is reduced by cash and investments held by non-life
companies and excludes, for periods prior to 1996, obligations for which
Conseco was not directly liable.
(g) Assumes conversion of all convertible debentures.
(h) Assumes purchase of common shares under purchase contracts.
Liquidity for insurance operations
</FN>
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 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.
Of our total insurance liabilities at December 31, 1997, approximately 17
percent could be surrendered by the policyholder without a penalty.
Approximately 59 percent could be surrendered by the policyholder subject to
penalty or the release of an insurance liability in excess of surrender benefits
paid. The remaining 24 percent are not subject to surrender. Payment
characteristics of the insurance liabilities at December 31, 1997, were as
follows (dollars in millions):
Payments under contracts containing fixed payment dates:
Due in one year or less.............................................. $ 339.6
Due after one year through five years................................ 819.0
Due after five years through ten years............................... 415.9
Due after ten years.................................................. 852.4
---------
Total gross payments whose payment dates are fixed by contract.. 2,426.9
Less amounts representing future interest on such contracts.......... 879.0
---------
Insurance liabilities whose payment dates are fixed by contract. 1,547.9
Insurance liabilities whose payment dates are not fixed by contract........ 24,352.2
---------
Total insurance liabilities..................................... $25,900.1
=========
Of the above insurance liabilities under contracts containing fixed
payment dates, approximately 59 percent relate to payments that will be made for
the lifetime of the contract holder. We consider expected mortality in
determining the amount of this liability. The remaining insurance liabilities
having fixed payment dates are payable regardless of the contract holder's
survival.
Approximately 30 percent of insurance liabilities were contracts subject
to a fixed interest rate for the life of the contract. The remaining liabilities
generally were subject to interest rates that could be reset annually.
32
The following summarizes insurance liabilities for investment contracts
by credited rate (excluding interest rate bonuses for the first policy year
only) at December 31, 1997 (dollars in millions):
Below 4.75 percent......................................................... $ 2,627.0
4.75 percent - 5.00 percent................................................ 2,533.0
5.00 percent - 5.25 percent................................................ 3,588.0
5.25 percent - 5.50 percent................................................ 1,703.0
5.50 percent - 5.75 percent................................................ 676.0
5.75 percent and above..................................................... 1,597.0
---------
Total insurance liabilities on investment contracts.................. $12,724.0
=========
We believe that the diversity of the investment portfolio of our life
insurance subsidiaries and the concentration of investments in high quality
liquid securities provide sufficient liquidity to meet foreseeable cash
requirements. The investment portfolio of our life insurance subsidiaries at
December 31, 1997, included $1.0 billion of short-term investments and $19.2
billion of publicly traded investment grade bonds, including $.6 billion of
United States government and agency securities. Although there is no present
need or intent to dispose of such investments, our life insurance subsidiaries
could readily liquidate portions of their investments, if such a need arose. In
addition, investments could be used to facilitate borrowings under reverse
repurchase agreements or dollar-roll transactions. Such borrowings have been
used by the life companies from time to time to increase their return on
investments and to improve liquidity. At December 31, 1997, our portfolio of
bonds and redeemable preferred stocks had an aggregate unrealized gain of $484.4
million.
Liquidity for finance operations
Our consumer and commercial finance segment requires continued access to
the capital markets for the warehousing and sale of finance receivables. To
satisfy these needs, a variety of capital resources are utilized.
Historically, the most important liquidity source for our finance segment
has been our ability to sell finance receivables in the secondary markets
through loan securitizations. Under certain securitized sales structures, we
have provided a variety of credit enhancements, which generally take the form of
corporate guarantees, but have also included bank letters of credit, surety
bonds, cash deposits or other equivalent collateral. We analyze the cash flows
unique to each transaction, as well as the marketability and projected economic
value of such transactions when choosing the appropriate structure for a
securitized loan sale. The structure of each securitized sale depends, to a
great extent, on conditions of the fixed income markets at the time of sale as
well as cost considerations and availability and effectiveness of the various
enhancement methods. During 1997, we used a senior/subordinated structure for
the eight manufactured home loan sales and enhanced a portion of the
subordinated certificates sold with a corporate guarantee. During 1997, our home
equity and home improvement loan sales included two separate but
cross-collateralized loan pools, both of which employed a senior/subordinated
structure with a limited guarantee on a portion of the subordinate certificates.
Our sale of consumer products and equipment finance loans during the
first quarter of 1997 employed a multi-class credit tranched owner trust
structure with floating rate senior notes and limited corporate guarantee on the
subordinate fixed rate certificates. In the second and third quarters of 1997,
our sale of consumer product, equipment finance, certain home equity and non
lien home improvement loans utilized a multi-class credit tranched grantor trust
structure issuing fixed rate certificates with a limited corporate guarantee on
the most subordinate class. Also during the third quarter, we sold approximately
$150.0 million of private-label credit card receivables and $74.4 million of
floorplan receivables through two separate revolving trusts. In addition, in the
fourth quarter of 1997, we completed a sale of consumer product, equipment
finance, certain home equity and non lien home improvement loans which employed
a multi-class credit tranched owner trust structure with fixed and floating rate
senior certificates and a limited corporate guarantee on the most subordinate
fixed rate certificates. We also sold approximately $551 million of fixed rate
notes backed by lease receivables in the fourth quarter of 1997.
Another liquidity source for our finance segment has been sales of a
portion of our interest-only securities in the form of securitized NIM
Certificates. During 1995, we sold $308.0 million of NIM Certificates. These
certificates represent approximately 75 percent of the estimated interest-only
cash flows from our sale of certain manufactured housing contracts in 1995 and
1994. Net proceeds from these sales were used to reduce short-term borrowings
supporting ongoing loan originations.
Interest on finance receivables increased during 1997 and 1996 primarily
as a result of the increase in the average finance receivables that had not yet
been securitized. Servicing fees and interest income on our interest-only
securities have also increased during 1997 and 1996 primarily as a result of the
increase in our total managed finance receivables and interest-only securities.
33
As of December 31, 1997, the finance segment had a $1.5 billion unsecured
bank credit agreement. This credit facility included a $750.0 million three-year
committed revolving line of credit which was scheduled to expire on April 28,
2000 and a $750.0 million 364-day committed revolving line of credit which was
scheduled to expire on April 28, 1998. In addition, the finance segment had $2.8
billion in master repurchase agreements, subject to the availability of eligible
collateral, with various investment banking firms for the purpose of financing
contract and commercial finance loan production. At December 31, 1997, the
finance segment had $35.0 million of borrowings outstanding under the unsecured
bank credit agreement and no borrowings outstanding under the repurchase
agreements. The master repurchase agreements generally provide for annual terms
that are extended each quarter by mutual agreement of the parties for an
additional annual term based upon receipt of updated quarterly financial
information.
At December 31, 1997, the finance segment had a commercial paper program
through which we were authorized to issue up to $2 billion in notes of varying
terms (not to exceed 270 days) to meet our liquidity needs. This program was
backed by the bank credit agreement and master repurchase agreements referred to
above. As of December 31, 1997, we had issued and outstanding, net of interest
discount, $1.3 billion in notes under this program.
During the fourth quarter of 1997 and the first quarter of 1998, our
finance subsidiary's senior unsecured debt ratings and short-term debt ratings
were lowered by each of the credit rating agencies which provide ratings on our
subsidiary's debt. As a result of these ratings actions, we curtailed our
issuance of commercial paper in favor of master repurchase agreements.
In addition, effective February 10, 1998, we substantially restructured
our unsecured bank credit agreements reducing the aggregate commitment to $750.0
million and renegotiating significant terms and covenants in lieu of a waiver of
certain representations required of our subsidiary for purposes of utilizing the
credit line.
Certain of our master repurchase agreements have been amended in 1998
primarily to include financing for a broader range of receivables originated.
Additionally, aggregate master repurchase lines have been increased to $3.8
billion.
In addition, on February 13, 1998, we closed on a $500 million line of
credit secured by our interest-only securities. This line of credit matures on
February 12, 2000, with an option to extend for an additional one year term.
Subsequent to the completion of the Green Tree Merger in the third and
fourth quarters of 1998, we contributed over $1.0 billion of additional capital
to the consumer and commercial segment which was used to reduce outstanding debt
and to fund new finance receivables.
Liquidity of Conseco (parent company)
The parent company is a legal entity, separate and distinct from its
subsidiaries, and has no business operations. The parent company needs cash for:
(i) principal and interest on debt; (ii) dividends on preferred and common
stock; (iii) distributions on the Company-obligated mandatorily redeemable
preferred stock of subsidiary trusts; (iv) holding company administrative
expenses; (v) income taxes; and (vi) investments in subsidiaries. The primary
sources of cash to meet these obligations include statutorily permitted payments
from our life insurance subsidiaries, including: (i) dividend payments; (ii)
surplus debenture interest and principal payments; (iii) tax sharing payments;
and (iv) fees for services provided. The parent company may also obtain cash by:
(i) issuing debt or equity securities; (ii) borrowing additional amounts under
its revolving credit agreement, as described in note 7 to the consolidated
financial statements; or (iii) selling all or a portion of its subsidiaries.
These sources have historically provided adequate cash flow to fund: (i) the
needs of the parent company's normal operations; (ii) internal expansion,
acquisitions and investment opportunities; and (iii) the retirement of debt and
equity. In 1997, we also issued new shares of Conseco common stock for a portion
of the cost to acquire CAF and the entire cost to acquire PFS.
34
The following table shows the cash flow activity of the parent company
and its wholly owned non-life and non-finance subsidiaries:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Items relating to operations:
Dividends and surplus debenture interest payments from life subsidiaries...... $ 166.1 $ 109.9 $ 80.6
Tax sharing payments from life subsidiaries................................... 9.3 4.6 2.7
Fees from life subsidiaries................................................... 89.1 74.8 34.7
Fees from unaffiliated companies.............................................. 35.2 39.3 39.0
Parent and non-life subsidiary costs.......................................... (74.1) (39.8) (64.5)
Interest on debt of Conseco, including direct and indirect obligations........ (117.4) (71.3) (41.6)
Interest on amounts due to life subsidiaries.................................. (26.5) (7.3) (8.8)
Income taxes.................................................................. (2.3) 2.2 (7.7)
Payments from finance subsidiaries (a)........................................ 184.6 29.9 79.4
Other........................................................................ 8.9 (4.7) -
--------- ---------- -------
Total items relating to operations......................................... 272.9 137.6 113.8
--------- ----------- -------
Items relating to investing:
Purchase of investments....................................................... (140.7) (71.1) (70.8)
Sales and maturities of investments........................................... 70.2 45.3 125.6
Cash held by non-life subsidiaries prior to acquisition....................... 4.1 40.9 17.0
Investment in consolidated subsidiaries....................................... (939.7) (226.1) (552.3)
Surplus debenture principal payments.......................................... 73.9 36.5 -
Expense incurred in terminated merger......................................... - - (5.5)
--------- --------- --------
Total items relating to investing.......................................... (932.2) (174.5) (486.0)
--------- --------- --------
Items relating to financing:
Proceeds from issuance of Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts, net of issuance costs........... 780.4 587.7 -
Proceeds from the issuance of equity securities............................... 57.4 26.7 4.1
Proceeds from the issuance of debt, net of issuance costs..................... 2,578.8 856.0 827.2
Commercial paper, net......................................................... 448.2 - -
Common and preferred dividends................................................ (121.2) (70.3) (52.4)
Dividends on stock held by subsidiaries....................................... (53.8) (38.1) (38.7)
Distributions on Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts....................................................... (65.7) (2.9) -
Payments on debt, including prepayments and acquired debt..................... (2,218.8) (1,467.2) (330.0)
Payments to retire redeemable preferred stock of a non-life subsidiary........ (72.4) (.3) -
Repurchases of common stock .................................................. (738.6) (21.5) (146.3)
Proceeds from the issuance of convertible preferred stock, net of issuance
cost....................................................................... - 257.7 -
--------- --------- ------
Total items relating to financing.......................................... 594.3 127.8 263.9
--------- --------- ------
Change in short-term investments of parent
and its non-life subsidiaries......................................... (65.0) 90.9 (108.3)
Short-term investments, beginning of year.................................. 115.1 24.2 132.5
--------- --------- -------
Short-term investments, end of year........................................ $ 50.1 $ 115.1 $ 24.2
========= ========= ======
<FN>
(a) Represents amounts transferred from the consumer and commercial
subsidiaries in periods prior to the consummation of the Green Tree Merger
for the payment of Green Tree dividends and for the purchase of Green Tree
treasury stock, net of proceeds from the issuance of Green Tree common
stock.
</FN>
At December 31, 1997, the parent company and its non-life subsidiaries
had short-term investments of $50.1 million, of which $28.7 million was expended
in January 1998 for accrued interest and dividends. The parent company and its
non-life subsidiaries had additional investments in fixed maturities, equity
securities and other invested assets of $155.0 million at December 31, 1997,
which, if needed, could be liquidated or contributed to the insurance
subsidiaries.
35
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid for any 12 month period in amounts equal to the greater of
(or in a few states, the lesser of): (i) net gain from operations for the prior
year; or (ii) 10 percent of surplus as of the end of the preceding year. Any
dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department. The amount of
dividends that our insurance subsidiaries could pay to non-life parent companies
in 1998 without prior approval is approximately $165.1 million.
Statutory operating results and statutory surplus are determined
according to accounting practices prescribed or permitted by each state in which
the subsidiaries do business. Statutory surplus bears no direct relationship to
equity as determined under GAAP. With respect to new business, statutory
accounting practices require acquisition costs and reserves for future
guaranteed benefit payments and interest in excess of statutory rates to be
expensed as the new business is written. These items cause a statutory loss
("surplus strain") on many insurance policies in the year in which they are
issued. We manage the effect of such statutory surplus strain by designing our
products to minimize such first-year losses, and by controlling the amount of
new premiums written.
Note 13 to the consolidated financial statements shows the difference
between pretax income reported using statutory accounting practices and GAAP.
Insurance departments in the states where our life insurance subsidiaries
are domiciled or do business require insurance companies to make annual and
quarterly filings. The interest maintenance reserve ("IMR") and the asset
valuation reserve ("AVR") are required to be appropriated and reported as
liabilities. The IMR captures all investment gains and losses resulting from
changes in interest rates and provides for such amounts to be amortized into
statutory net income on a basis reflecting the remaining lives of the assets
sold. The AVR captures investment gains and losses related to changes in
creditworthiness; it is also adjusted each year based on a formula related to
the quality and loss experience of the Company's investment portfolio. These
reserves affect the ability of our insurance subsidiaries to reflect investment
gains and losses in statutory earnings and surplus.
Our debt agreements require the Company to maintain minimum working
capital and RBC ratios and limit the Company's ability to incur additional
indebtedness. They also restrict the amount of retained earnings that is
available for dividends and require Conseco to maintain certain minimum ratings
at its insurance subsidiaries.
INFLATION
Inflation does not have a significant effect on Conseco's balance sheet;
we have minimal investments in property, equipment or inventories.
Medical cost inflation has had a significant impact on our supplemental
health operations. Generally, these costs have increased more rapidly than the
Consumer Price Index. Medical costs will likely continue to rise. The impact of
medical cost inflation on our operations depends on our ability to increase
premium rates. Such increases are subject to approval by state insurance
departments. Before Medicare supplement plans were standardized, approximately
two-thirds of the states permitted rate plans with automatic escalation clauses.
This permitted Conseco, in periods following initial approval, to adjust premium
rates for changes in Medicare deductibles and increases in medical cost
inflation without refiling with the regulators. Currently, rate changes for all
Medicare supplement plans must be individually approved by each state. We seek
to price our new standardized supplement plans to reflect the impact of these
filings and the lengthening of the period required to implement rate increases.
YEAR 2000 CONVERSION COSTS
We have initiated a corporate-wide program designed to ensure that our
computer systems will function properly in the year 2000. For some of our
operations, the most effective solution will be to ensure timely completion of
the previously planned conversions of their older systems to more modern, year
2000 - compliant systems used in other areas of the Company. In some cases, our
most effective solution will be to purchase new, more modern systems; these
costs will be capitalized as assets and amortized over their expected useful
lives. In other cases, we will modify existing systems, thereby incurring costs
that will be charged to operating expense. To date, we have incurred $12.6
million in costs related to year 2000 projects. We expect to spend approximately
an additional $45 million on these projects over the next two years. We began to
incur expenses related to this program several years ago. We expect our year
2000 program to be completed on a timely basis.
36
MARKET-SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Insurance subsidiaries
We seek to invest our available funds in a manner that will maximize
shareholder value and fund future obligations to policyholders and debtors,
subject to appropriate risk considerations. We seek to meet this objective
through investments that: (i) have similar characteristics to the liabilities
they support; (ii) are diversified among industries, issuers and geographic
locations; and (iii) make up a predominantly investment-grade fixed maturity
securities portfolio. Many of our insurance products incorporate surrender
charges, market interest rate adjustments or other features to encourage
persistency. Approximately 59 percent of our total insurance liabilities at
December 31, 1997, had surrender penalties or other restrictions and
approximately 24 percent are not subject to surrender.
We seek to maximize the total return on our investments through active
investment management. Accordingly, we have determined that our entire portfolio
of fixed maturity securities is available to be sold in response to: (i) changes
in market interest rates; (ii) changes in relative values of individual
securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in
credit quality outlook for certain securities; (v) liquidity needs; and (vi)
other factors. From time to time, we invest in securities for trading purposes,
although such investments account for a relatively small portion of our total
portfolio.
Profitability of many of our insurance products is significantly affected
by the spreads between interest yields on investments and rates credited on
insurance liabilities. Although substantially all credited rates on our annuity
products may be changed annually (subject to minimum guaranteed rates), changes
in competition and other factors, including the impact of the level of
surrenders and withdrawals, may limit our ability to adjust or to maintain
crediting rates at levels necessary to avoid narrowing of spreads under certain
market conditions. As of December 31, 1997, the average yield, computed on the
cost basis of our investment portfolio, was 7.5 percent, and the average
interest rate credited or accruing to our total insurance liabilities was 5.2
percent, excluding interest bonuses guaranteed for the first year of the annuity
contract only.
We use computer models to perform simulations of the cash flows generated
from our existing insurance business under various interest rate scenarios.
These simulations enable us to measure the potential gain or loss in fair value
of our interest rate-sensitive financial instruments. With such estimates, we
seek to closely match the duration of our assets to the 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, 1997, the adjusted modified duration of the fixed maturity
securities and short-term investments held by our insurance subsidiaries was
approximately 5.8 years and the duration of our insurance liabilities was
approximately 6.7 years.
If interest rates were to increase by 10 percent from their December 31,
1997 levels, the fixed maturity securities and short-term investments held by
our insurance subsidiaries (net of corresponding changes in the value of cost of
policies purchased, cost of policies produced and insurance liabilities) would
decline in fair value by approximately $545 million. 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, actual losses could
be less than those estimated above.
Finance subsidiary
Our finance receivables are funded primarily with floating-rate debt.
Interest rate risk is substantially eliminated through the sale of such
receivables through securitizations. The finance receivables sold and the
asset-backed securities purchased by investors generally both have fixed rates.
Principal payments on the assets are passed through to investors in the
securities as received, thereby eliminating interest rate exposure that might
otherwise arise from maturities of debt instruments not matching maturities of
assets.
We retain interests in the finance receivables sold through investments in
interest-only securities that are subordinated to the rights of other investors.
Interest-only securities do not have a stated maturity or amortization period.
The expected amount of the cash flow as well as the timing is dependent on the
performance of the underlying collateral supporting each securitization. The
actual cash flow of these instruments could vary substantially if performance is
different from our assumptions. We develop assumptions to value these
investments by analyzing past portfolio performance, current loan
characteristics, current market conditions and the expected effect of our
actions to mitigate adverse performance. Assumptions used as of December 31,
1997, are summarized in note 4 to the supplemental consolidated financial
statements.
37
The expected cash flows from interest-only securities as of December 31,
1997 were as follows (dollars in millions):
1998....................................... $ 456.9
1999....................................... 321.3
2000....................................... 235.3
2001....................................... 188.1
2002....................................... 156.3
Thereafter................................. 1,266.0
--------
Total expected cash flow.............. $2,623.9
========
Estimated fair value.................. $1,363.2
========
We use computer models to perform simulations of the cash flows generated
from our interest-only securities under various interest rate scenarios. These
simulations enable us to measure the potential gain or loss in fair value of
these financial instruments. If interest rates were to decrease by 10 percent
from their December 31, 1997 levels, our interest-only securities would decline
in fair value by approximately $46 million. 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 interest-only securities in reaction to such change.
Consequently, potential changes in value of our interest-only securities
indicated by the simulations will likely be different from the actual changes
experienced under given interest rate scenarios, and the differences may be
material.
Corporate
We manage the composition of our borrowed capital by considering factors
such as the ratio of borrowed capital to total capital, the portion of our
outstanding capital subject to fixed and variable rates, the current interest
rate environment and other market conditions. Our borrowed capital at December
31, 1997, includes commercial paper, notes payable and Company-obligated
mandatorily redeemable preferred securities of subsidiary trusts totaling $3.7
billion ($1.8 billion of which is at floating rates and $1.9 billion of which is
at fixed rates). Based on the interest rate exposure and prevalent rates at
December 31, 1997, a relative 10 percent decrease in interest rates would
increase the fair value of our fixed-rate borrowed capital by approximately $75
million. Our interest expense on floating-rate debt will fluctuate as prevailing
interest rates change.
We periodically use options and interest rate swaps to hedge interest rate
risk associated with our investments and borrowed capital. Although we had no
such agreements outstanding at December 31, 1997, we entered into four interest
rate swap agreements in March 1998. The Company entered into such agreements to
create a hedge that effectively converts a portion of its fixed-rate borrowed
capital into floating-rate instruments for the period during which the
agreements are outstanding. Such interest rate swap agreements have an aggregate
notional principal amount of $1.0 billion, mature in various years through 2008,
and have an average remaining life of seven years. If the counterparties of
these interest rate swaps do not meet their obligations, Conseco could have a
loss. Conseco limits its exposure to such a loss by diversifying among several
counterparties believed to be financially sound and creditworthy. At March 13,
1998, all of the counterparties were rated "A" or higher by Standard & Poor's
Corporation. These swap agreements, if in existence when the assumed 10 percent
decrease in interest rates occurred (see preceding paragraph), would cause the
increase in the fair value of our borrowed capital to be $55.0 million, or $20.0
million less than indicated in the preceding paragraph.
38
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
and Shareholders
Conseco, Inc.
We have audited the accompanying supplemental consolidated balance sheet
of Conseco, Inc. and Subsidiaries as of December 31, 1997 and 1996, and the
related supplemental consolidated statements of operations, shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 1997. The supplemental consolidated financial statements give retroactive
effect to the merger of Conseco, Inc. and Green Tree Financial Corporation on
June 30, 1998, which has been accounted for as a pooling of interests as
described in note 1 to the supplemental consolidated financial statements. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits. We did not audit the consolidated financial statements of Green Tree
Financial Corporation and subsidiaries which statements reflect total assets of
12 percent and 11 percent as of December 31, 1997 and 1996, respectively, and
total revenues of 16 percent, 13 percent and 20 percent for the years ended
December 31, 1997, 1996 and 1995, respectively, of the related consolidated
financial statement totals. Those statements were audited by other auditors
whose report has been furnished to us, and our opinion, insofar as it relates to
data included for Green Tree Financial Corporation, is based solely on the
report of the other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.
Generally accepted accounting principles prohibit giving effect to a
consummated business combination accounted for by the pooling of interests
methods in financial statements that do not include the date of consummation.
These financial statements do not extend through the date of consummation;
however, they will become the historical consolidated financial statements of
Conseco, Inc. and Subsidiaries after financial statements covering the date of
consummation of the business combination are issued.
In our opinion, based on our audits and the report of other auditors, the
supplemental consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Conseco, Inc.
and Subsidiaries as of December 31, 1997 and 1996, and the consolidated results
of their operations and their cash flows for each of the three years in the
period ended December 31, 1997, after giving retroactive effect to the merger of
Conseco, Inc. and Green Tree Financial Corporation described in note 1 to the
supplemental financial statements, all in conformity with generally accepted
accounting principles applicable after financial statements are issued for a
period which includes the date of consummation of the business combination.
/S/ PRICEWATERHOUSECOOPERS LLP
------------------------------
PRICEWATERHOUSECOOPERS LLP
Indianapolis, Indiana
July 7, 1998
39
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED BALANCE SHEET
December 31, 1997 and 1996
(Dollars in millions)
ASSETS
1997 1996
---- ----
Investments:
Actively managed fixed maturities at fair value (amortized cost:
1997 - $22,289.3; 1996 - $17,203.3)............................................. $22,773.7 $17,307.1
Interest-only securities........................................................... 1,363.2 1,014.3
Equity securities at fair value (cost: 1997 - $227.6; 1996 - $97.6)................ 228.9 99.7
Mortgage loans..................................................................... 516.2 356.0
Credit-tenant loans................................................................ 558.6 447.1
Policy loans....................................................................... 692.4 542.4
Other invested assets ............................................................. 530.7 262.3
Short-term investments............................................................. 1,179.1 377.4
Assets held in separate accounts................................................... 682.8 337.6
--------- ----------
Total investments............................................................ 28,525.6 20,743.9
Accrued investment income.............................................................. 379.3 296.9
Finance receivables.................................................................... 1,971.0 1,220.0
Servicing rights....................................................................... 96.3 -
Cost of policies purchased............................................................. 2,466.4 2,015.0
Cost of policies produced.............................................................. 915.2 544.3
Reinsurance receivables................................................................ 795.8 504.2
Goodwill (net of accumulated amortization: 1997 - $170.9; 1996 - $83.4)............... 3,693.4 2,259.8
Property and equipment (net of accumulated depreciation: 1997 - $153.9; 1996 -
$113.7).............................................................................. 284.0 188.3
Cash held in segregated accounts for investors......................................... 552.8 346.3
Cash deposits, restricted under pooling and servicing agreements....................... 247.2 171.5
Other assets........................................................................... 702.9 402.5
--------- ----------
Total assets................................................................. $40,629.9 $28,692.7
========= =========
(continued on next page)
The accompanying notes are an integral
part of the consolidated financial
statements.
40
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED BALANCE SHEET (Continued)
December 31, 1997 and 1996
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
1997 1996
---- ----
Liabilities:
Insurance liabilities:
Interest sensitive products..................................................... $17,357.6 $14,795.5
Traditional products............................................................ 5,784.8 3,251.5
Claims payable and other policyholder funds..................................... 1,615.5 984.9
Unearned premiums............................................................... 406.1 272.4
Liabilities related to separate accounts ....................................... 682.8 337.6
Investor payables.................................................................. 552.8 346.3
Other liabilities.................................................................. 1,488.3 1,088.0
Income tax liabilities............................................................. 532.8 461.2
Investment borrowings.............................................................. 1,389.5 383.4
Notes payable and commercial paper:
Corporate....................................................................... 2,354.9 1,094.9
Consumer and commercial finance................................................. 1,866.3 762.5
--------- ---------
Total liabilities.......................................................... 34,031.4 23,778.2
--------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts............................................................ 1,383.9 600.0
Mandatorily redeemable preferred stock of subsidiary............................... - 97.0
Common stock of subsidiary......................................................... .7 .7
Shareholders' equity:
Preferred stock.................................................................... 115.8 267.1
Common stock and additional paid-in capital (no par value, 1,000,000,000 shares
authorized, shares issued and outstanding: 1997 - 310,011,669;
1996 - 293,359,337)............................................................. 2,619.8 2,350.7
Accumulated other comprehensive income:
Unrealized appreciation of fixed maturity securities (net of applicable
deferred income taxes: 1997 - $95.5; 1996 - $21.5).......................... 177.2 39.8
Unrealized appreciation (depreciation) of interest-only securities and
other investments (net of applicable deferred income taxes:
1997 - $16.0; 1996 - $(.5)).................................................. 26.6 (.9)
Minimum pension liability adjustment............................................ (3.2) (2.3)
Retained earnings.................................................................. 2,277.7 1,562.4
--------- ---------
Total shareholders' equity................................................. 5,213.9 4,216.8
--------- ---------
Total liabilities and shareholders' equity................................. $40,629.9 $28,692.7
========= =========
The accompanying notes are an integral
part of the consolidated financial
statements.
41
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED STATEMENT OF OPERATIONS
for the years ended December 31, 1997, 1996 and 1995
(Dollars in millions, except per share data)
1997 1996 1995
---- ---- ----
Revenues:
Insurance policy income:
Traditional products............................................... $2,954.1 $1,384.3 $1,355.6
Interest sensitive products........................................ 456.7 269.9 109.4
Net investment income:
Assets held by insurance subsidiaries.............................. 1,825.3 1,302.5 1,142.6
Finance receivables................................................ 214.5 138.1 124.7
Interest-only securities........................................... 130.3 77.2 51.3
Gain on loan securitizations......................................... 569.1 388.1 443.3
Net investment gains................................................. 266.5 60.8 204.1
Fee revenue and other income......................................... 239.9 168.9 130.2
-------- -------- --------
Total revenues................................................... 6,656.4 3,789.8 3,561.2
-------- -------- --------
Benefits and expenses:
Insurance policy benefits............................................ 2,368.3 1,195.0 1,107.5
Amounts added to annuity and financial product policyholder
account balances:
Interest......................................................... 697.1 620.2 556.6
Other amounts added to variable and equity-indexed
annuity products............................................... 109.6 48.4 28.8
Interest expense:
Corporate.......................................................... 109.4 108.1 119.4
Finance and investment borrowings.................................. 202.9 92.1 79.5
Amortization......................................................... 605.4 276.0 330.2
Nonrecurring charges................................................. 71.7 - -
Other operating costs and expenses................................... 1,006.3 634.2 516.5
-------- -------- --------
Total benefits and expenses...................................... 5,170.7 2,974.0 2,738.5
-------- -------- --------
Income before income taxes, minority interest
and extraordinary charge ...................................... 1,485.7 815.8 822.7
Income tax expense...................................................... 560.1 302.2 240.7
-------- -------- --------
Income before minority interest and extraordinary charge ........ 925.6 513.6 582.0
Minority interest:
Distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts, net of income taxes..... 49.0 3.6 -
Dividends on preferred stock of subsidiaries......................... 3.3 8.9 11.9
Equity in earnings of subsidiaries................................... - 22.4 97.1
-------- -------- --------
Income before extraordinary charge .............................. 873.3 478.7 473.0
Extraordinary charge on extinguishment of
debt, net of taxes and minority interest............................. 6.9 26.5 2.1
-------- -------- --------
Net income....................................................... 866.4 452.2 470.9
Less amounts applicable to preferred stock:
Charge related to induced conversions................................ 13.2 - -
Preferred stock dividends............................................ 8.7 27.4 18.4
-------- -------- --------
Net income applicable to common stock............................ $ 844.5 $ 424.8 $ 452.5
======== ======== ========
(continued on next page)
The accompanying notes are an integral
part of the consolidated financial
statements.
42
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED STATEMENT OF OPERATIONS (continued)
for the years ended December 31, 1997, 1996 and 1995
(Dollars in millions, except per share data)
1997 1996 1995
---- ---- ----
Earnings per common share:
Basic:
Weighted average shares outstanding............................ 311,050,000 230,141,000 206,639,000
Net income before extraordinary charge ........................ $2.74 $1.97 $2.20
Extraordinary charge .......................................... .02 .12 .01
------- ------- -------
Net income................................................ $2.72 $1.85 $2.19
===== ===== =====
Diluted:
Weighted average shares outstanding............................ 338,722,000 267,685,000 232,273,000
Net income before extraordinary charge ........................ $2.54 $1.79 $2.04
Extraordinary charge........................................... .02 .10 .01
------- -------- -------
Net income................................................ $2.52 $1.69 $2.03
===== ===== =====
The accompanying notes are an integral
part of the consolidated financial
statements.
43
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
for the years ended December 31, 1997, 1996 and 1995
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income earnings
----- ----- --------------- ------ --------
Balance, January 1, 1995.................................. $ 1,471.4 $ 283.5 $ 463.9 $(139.7) $ 863.7
Comprehensive income, net of tax:
Net income........................................... 470.9 - - - 470.9
Change in unrealized appreciation (depreciation) of
securities (net of applicable income taxes of
$132.8 million).................................... 252.4 - - 252.4 -
---------
Total comprehensive income....................... 723.3
Issuance of shares for stock options and employee
benefit plans........................................ 32.8 - 32.8 - -
Tax benefit related to issuance of shares under stock
option plans......................................... .4 - .4 - -
Cost of shares acquired................................ (146.3) - (68.9) - (77.4)
Dividends on preferred stock........................... (18.4) - - - (18.4)
Dividends on common stock.............................. (31.5) - - - (31.5)
--------- --------- ---------- --------- ---------
Balance, December 31, 1995................................ 2,031.7 283.5 428.2 112.7 1,207.3
Comprehensive income, net of tax:
Net income........................................... 452.2 - - - 452.2
Change in minimum pension liability adjustment....... (2.3) - - (2.3) -
Change in unrealized appreciation (depreciation) of
securities (net of applicable income tax benefit of
$45.9 million)..................................... (73.8) - - (73.8) -
---------
Total comprehensive income....................... 376.1
Issuance of convertible preferred stock................ 267.1 267.1 - - -
Conversion of preferred stock into common shares....... - (283.2) 283.2 - -
Redemption of preferred stock for cash................. (.3) (.3) - - -
Issuance of shares in merger transactions.............. 1,568.6 - 1,568.6 - -
Issuance of shares for stock options and employee
benefit plans........................................ 79.6 - 79.6 - -
Tax benefit related to issuance of shares under stock
option plans......................................... 15.9 - 15.9 - -
Cost of issuance of preferred stock.................... (21.7) - (21.7) - -
Cost of shares acquired................................ (26.0) - (3.1) - (22.9)
Dividends on preferred stock........................... (27.4) - - - (27.4)
Dividends on common stock.............................. (46.8) - - - (46.8)
--------- ------- --------- ------- ---------
Balance, December 31, 1996................................ 4,216.8 267.1 2,350.7 36.6 1,562.4
(continued on following page)
The accompanying notes are an integral
part of the consolidated financial
statements.
44
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (continued)
for the years ended December 31, 1997, 1996 and 1995
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income earnings
----- ----- --------------- ------ --------
Balance, December 31, 1996 (carried forward from
prior page)............................................$4,216.8 $ 267.1 $2,350.7 $ 36.6 $1,562.4
Comprehensive income, net of tax:
Net income........................................... 866.4 - - - 866.4
Change in minimum pension liability adjustment....... (.9) - - (.9) -
Change in unrealized appreciation (depreciation) of
securities (net of applicable income taxes of
$90.5 million)..................................... 164.9 - - 164.9 -
--------
Total comprehensive income....................... 1,030.4
Conversion of preferred stock into common shares....... - (151.3) 151.3 - -
Issuance of shares in merger transactions.............. 471.5 - 471.5 - -
Issuance of shares for stock options and agent and
employee benefit plans............................... 252.9 - 252.9 - -
Tax benefit related to issuance of shares under stock
option plans......................................... 85.2 - 85.2 - -
Conversion of convertible debentures into common
shares............................................... 150.0 - 150.0 - -
Cost of shares acquired................................ (857.0) - (830.9) - (26.1)
Value of stock purchase contracts, a component of the
FELINE PRIDES........................................ (3.4) - (3.4) - -
Other.................................................. (7.5) - (7.5) - -
Amounts applicable to preferred stock:
Charge related to induced conversion of convertible
preferred stock.................................... (13.2) - - - (13.2)
Dividends on preferred stock......................... (8.7) - - - (8.7)
Dividends on common stock.............................. (103.1) - - - (103.1)
-------- --------- -------- ------- --------
Balance, December 31, 1997................................$5,213.9 $ 115.8 $2,619.8 $ 200.6 $2,277.7
======== ========= ======== ======= ========
The accompanying notes are an integral
part of the consolidated financial
statements.
45
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED STATEMENT OF CASH FLOWS
for the years ended December 31, 1997, 1996 and 1995
(Dollars in millions)
1997 1996 1995
---- ---- ----
Cash flows from operating activities:
Net income....................................................... $ 866.4 $ 452.2 $ 470.9
Adjustments to reconcile net income to net
cash provided by operating activities:
Gain on sale of finance receivables........................ (759.1) (588.1) (443.3)
Valuation adjustments of interest-only securities.......... 190.0 200.0 -
Net increase in cash deposits.............................. (75.8) (19.7) (13.3)
Amortization and depreciation.............................. 651.6 328.1 338.2
Income taxes............................................... 333.9 92.5 83.5
Insurance liabilities...................................... (344.4) (123.8) (3.0)
Amounts added to annuity and financial product policyholder
account balances......................................... 806.7 668.6 585.4
Fees charged to insurance liabilities...................... (456.7) (269.9) (109.4)
Accrual and amortization of investment income.............. 69.8 25.9 (40.9)
Deferral of cost of policies produced...................... (602.6) (308.4) (282.1)
Nonrecurring charges....................................... 71.7 - -
Minority interest.......................................... 75.4 26.8 91.9
Extraordinary charge on extinguishment of debt............. 10.6 36.9 3.7
Net investment gains....................................... (266.5) (60.8) (204.1)
Other...................................................... 19.2 20.5 66.1
----------- ----------- -----------
Net cash provided by operating activities................ 590.2 480.8 543.6
----------- ----------- -----------
Cash flows from investing activities:
Sales of investments............................................. 18,446.0 8,402.1 7,901.9
Maturities and redemptions....................................... 750.7 614.3 417.1
Purchases of investments......................................... (20,043.8) (9,409.7) (9,112.3)
Cash received from sales of finance receivables,
net of expenses................................................ 10,541.0 8,312.2 5,252.2
Principal payments received on finance receivables............... 4,373.3 2,434.6 1,308.4
Finance receivables originated................................... (15,695.6) (10,433.2) (6,790.2)
Acquisition of subsidiaries, net of cash held at the date of the
mergers....................................................... (759.7) (642.3) (586.3)
Short-term investments held by CCP Insurance, Inc. before
consolidation at January 1, 1995.............................. - - 123.0
Repurchase of equity securities by CCP Insurance, Inc............ - - (44.5)
Cash paid in reinsurance transactions............................ - - (71.1)
Other............................................................ (61.4) (31.9) (34.7)
----------- ----------- -----------
Net cash used by investing activities..................... (2,449.5) (753.9) (1,636.5)
----------- ---------- ----------
(continued on next page)
The accompanying notes are an integral
part of the consolidated financial
statements.
46
CONSECO, INC. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATED STATEMENT OF CASH FLOWS (Continued)
for the years ended December 31, 1997, 1996 and 1995
(Dollars in millions)
1997 1996 1995
---- ---- ----
Cash flows from financing activities:
Issuance of notes payable and commercial paper:
Corporate...................................................... $ 3,027.0 $ 1,315.4 $ 1,028.6
Consumer and commercial finance................................ 10,577.8 7,514.4 4,633.2
Issuance of Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts...................... 780.4 587.7 -
Investment borrowings............................................ 962.5 30.6 298.1
Payments on notes payable and commercial paper:
Corporate...................................................... (2,273.3) (2,134.3) (599.0)
Consumer and commercial finance................................ (9,474.0) (7,128.4) (4,559.8)
Purchase of preferred stock of a subsidiary...................... (98.4) (12.6) -
Deposits to insurance liabilities................................ 2,099.4 1,881.3 1,757.5
Withdrawals from insurance liabilities........................... (2,072.3) (1,842.5) (1,622.6)
Issuance of shares for employee benefit plans.................... 57.4 26.7 4.1
Issuance of convertible preferred stock.......................... - 257.7 -
Issuance of equity interests in subsidiaries, net................ - 2.2 16.8
Payments to repurchase equity securities......................... (738.6) (21.5) (146.3)
Payments related to the induced conversion of convertible
preferred stock................................................ (13.2) - -
Redemption of preferred stock.................................... - (.3) -
Distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts...................... (65.7) (2.9) -
Dividends paid................................................... (108.0) (70.3) (52.4)
---------- --------- -----------
Net cash provided by financing activities................ 2,661.0 403.2 758.2
---------- --------- -----------
Net increase (decrease) in short-term investments........ 801.7 130.1 (334.7)
Short-term investments, beginning of year............................ 377.4 247.3 582.0
---------- --------- -----------
Short-term investments, end of year.................................. $ 1,179.1 $ 377.4 $ 247.3
========== ========= ===========
The accompanying notes are an integral
part of the consolidated financial
statements.
47
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
1. SIGNIFICANT ACCOUNTING POLICIES:
Basis of Presentation
The following summary explains the accounting policies we use to arrive
at the more significant numbers in our financial statements. We have restated
all share and per-share amounts for the two-for-one stock splits distributed
February 11, 1997 and April 1, 1996. We prepare our financial statements in
accordance with generally accepted accounting principles ("GAAP"). We follow the
accounting standards established by the Financial Accounting Standards Board,
the American Institute of Certified Public Accountants and the Securities and
Exchange Commission.
Conseco, Inc. (We, "Conseco" or the "Company" ) is a financial services
holding company. The Company's life insurance subsidiaries develop, market and
administer supplemental health insurance, annuity, individual life insurance,
individual and group major medical insurance and other insurance products. The
Company's finance subsidiaries originate, purchase, sell and service consumer
and commercial finance loans throughout the United States. Conseco's operating
strategy is to grow its businesses by focusing its resources on the development
and expansion of profitable products and strong distribution channels. Conseco
has supplemented such growth by acquiring companies that have profitable niche
products and strong distribution systems. Once a company is acquired, our
operating strategy has been to consolidate and streamline management and
administrative functions where appropriate, to realize superior investment
returns through active asset management, to eliminate unprofitable products and
distribution channels and to expand and develop the profitable distribution
channels and products.
Consolidation issues. The supplemental consolidated financial statements
have been prepared to give retroactive effect to the merger (the "Green Tree
Merger") with Green Tree Financial Corporation ("Green Tree") accounted for as a
pooling of interests (see note 2, "Acquisitions/Dispositions"). GAAP prohibits
giving effect to a consummated business combination accounted for by the pooling
of interests method in financial statements that do not include the date of
consummation. These financial statements do not extend through the date of
consummation; however, they will become the historical consolidated financial
statements of Conseco after financial statements covering the date of
consummation of the Merger are issued. The pooling of interests method of
accounting requires the restatement of all periods presented as if Conseco and
Green Tree had always been combined. The consolidated statement of shareholders'
equity reflects the accounts of the Company as if additional shares of Conseco
common stock had been issued during all periods presented. Intercompany
transactions prior to the merger have been eliminated, and certain
reclassifications were made to Green Tree's financial statements to conform to
Conseco's presentations. No material adjustments were recorded to conform Green
Tree's accounting policies. See note 2 for additional discussion of the Green
Tree Merger.
Conseco Capital Partners, L.P. ("Partnership I"), an investment
partnership formed by Conseco with other investors, was the Company's vehicle
for acquiring four insurance companies: Great American Reserve Insurance Company
("Great American Reserve") in June 1990, Jefferson National Life Insurance
Company in November 1990 (it was merged with Great American Reserve in 1994),
Beneficial Standard Life Insurance Company ("Beneficial Standard") in March 1991
and Bankers Life and Casualty Company ("Bankers Life") in November 1992. CCP
Insurance, Inc. ("CCP"), a newly organized holding company for Partnership I's
first three acquisitions, completed an initial public offering ("IPO") in July
1992. In August 1995, we completed the purchase of all the shares of CCP common
stock we did not previously own in a transaction pursuant to which CCP was
merged with Conseco, with Conseco being the surviving corporation (the merger
and related transactions are referred to herein as the "CCP Merger"). As a
result, CCP's subsidiaries (Great American Reserve and Beneficial Standard)
became wholly owned subsidiaries of the Company. The accounts of CCP are
consolidated with Conseco's for all periods in the accompanying financial
statements.
We were required to use step-basis accounting when we acquired the shares
of CCP common stock in various transactions. As a result, the assets and
liabilities of CCP included in our consolidated balance sheet represent the
following combination of values: (i) the portion of CCP's net assets acquired by
Conseco in the initial acquisitions of CCP's subsidiaries made by Partnership I
is valued as of those respective acquisition dates; and (ii) the portion of
CCP's net assets acquired in the CCP Merger is valued as of August 31, 1995.
Bankers Life Holding Corporation ("BLH"), a company formed by Partnership
I to acquire Bankers Life, completed an IPO in March 1993. As a result of the
IPO and the acquisition of additional BLH common shares in September 1993, we
owned 56 percent of BLH at January 1, 1995. In June 1995, we purchased
additional common shares of BLH, increasing the Company's ownership of BLH to 85
percent. Conseco's ownership of BLH increased to 88 percent at December 31,
1995, and 90.5 percent at March 5, 1996, as a result of share repurchases by
BLH. On December 31, 1996, we completed the purchase of all of the shares of
48
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
BLH common stock we did not already own in a transaction pursuant to which BLH
merged with a wholly owned subsidiary of Conseco (the "BLH Merger"). The
accounts of BLH are consolidated with Conseco's accounts for all periods in the
accompanying consolidated financial statements.
We were required to use step-basis accounting when we acquired the BLH
common shares at the various acquisition dates. The assets and liabilities of
BLH included in our consolidated balance sheet represent the following
combination of values: (i) the portion of BLH's net assets acquired by Conseco
in the November 1992 acquisition made by Partnership I is valued as of that
acquisition date; (ii) the portion of BLH's net assets acquired in 1993, 1995
and the first quarter of 1996 is valued as of the dates of their purchase; and
(iii) the portion of BLH's net assets acquired in the BLH Merger is valued as of
December 31, 1996.
Conseco Capital Partners II, L.P. ("Partnership II"), Conseco's second
investment partnership, acquired American Life Holdings, Inc. ("ALH" and the
parent of American Life and Casualty Insurance Company) on September 29, 1994.
Because Conseco was the sole general partner of Partnership II, Conseco
controlled Partnership II and ALH even though our ownership interest was less
than 50 percent. Because of this control, Conseco's consolidated financial
statements were required to include the accounts of ALH.
On January 1, 1995, Conseco had a 27 percent ownership interest in ALH.
On November 30, 1995, ALH issued 2,142,857 shares of its common stock for $30.0
million (including $13.2 million paid by Conseco and its subsidiaries) in a
private placement transaction. Conseco's ownership interest in ALH increased to
36 percent at December 31, 1995, as a result of this transaction and changes in
our ownership of affiliated companies with ownership interests in ALH.
On September 30, 1996, we purchased all of the common shares of ALH we
did not previously own from Partnership II for $166.0 million in cash (the "ALH
Stock Purchase") and Partnership II was terminated. We were required to use
step-basis accounting when we acquired the shares of ALH common stock in the ALH
Stock Purchase and for our previous acquisitions. As a result, the assets and
liabilities of ALH included in the December 31, 1996, consolidated balance sheet
represent the following combination of values: (i) the portion of ALH's net
assets acquired by Conseco in the initial acquisition of ALH made by Partnership
II is valued as of September 29, 1994; (ii) the portion of ALH's net assets
acquired on November 30, 1995 is valued as of that date; and (iii) the portion
of ALH's net assets acquired in the ALH Stock Purchase is valued as of September
30, 1996.
On August 2, 1996, we completed the acquisition (the "LPG Merger") of
Life Partners Group, Inc. ("LPG") and LPG became a wholly owned subsidiary of
Conseco. On December 17, 1996, we completed the acquisition (the "ATC Merger")
of American Travellers Corporation ("ATC") and ATC was merged with and into
Conseco, with Conseco being the surviving corporation. On December 23, 1996, we
completed the acquisition (the "THI Merger") of Transport Holdings Inc. ("THI")
and THI was merged with and into Conseco, with Conseco being the surviving
corporation. On March 4, 1997, we completed the acquisition (the "CAF Merger")
of Capitol American Financial Corporation ("CAF") and CAF became a wholly owned
subsidiary of Conseco. On May 30, 1997, we completed the acquisition (the "PFS
Merger") of Pioneer Financial Services, Inc. ("PFS") and PFS became a wholly
owned subsidiary of Conseco. On September 30, 1997, we completed the acquisition
(the "Colonial Penn Purchase") of Colonial Penn Life Insurance Company and
Providential Life Insurance Company and certain other assets (collectively
referred to as "Colonial Penn"). Colonial Penn became a wholly owned subsidiary
of Conseco. On December 1, 1996, we completed the purchase (the "FINOVA
Purchase") of the net assets of FINOVA Acquisition, Inc. ("FINOVA"). On December
5, 1997, we completed the acquisition (the "WNIC Merger") of Washington National
Corporation ("WNIC") and WNIC became a wholly owned subsidiary of Conseco. The
accounts of LPG are consolidated with Conseco effective July 1, 1996; the
accounts of ATC and THI are consolidated effective December 31, 1996; the
accounts of CAF are consolidated effective January 1, 1997; the accounts of PFS
are consolidated effective April 1, 1997; the accounts of Colonial Penn are
consolidated effective September 30, 1997; and the accounts of WNIC are
consolidated effective December 1, 1997.
Neither "consolidation" nor "non-consolidation" methods of accounting for
partially owned subsidiaries affect our reported net income or shareholders'
equity. Our consolidated financial statements do not include the results of
material transactions between us and our consolidated affiliates, or among our
consolidated affiliates. We reclassified some amounts in our 1996 and 1995
consolidated financial statements and notes to conform with the 1997
presentation.
49
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Investments
Fixed maturities are securities primarily held by our life insurance
subsidiaries that mature more than one year after issuance. They include bonds,
notes receivable and preferred stocks with mandatory redemption features and are
classified as follows:
Actively managed - fixed maturity securities that we may sell prior
to maturity in response to changes in interest rates, issuer credit
quality or our liquidity requirements. We carry actively managed
securities at estimated fair value. We record any unrealized gain
or loss, net of tax and the related adjustments described below, as
a component of shareholders' equity.
Trading - fixed maturity securities that we buy principally for the
purpose of selling in the near term. We carry trading securities at
estimated fair value. We include any unrealized gain or loss in net
investment gains (losses). We held $64.8 million of trading
securities at December 31, 1997, which are included in other
invested assets. We did not hold any trading securities at December
31, 1996 or 1995.
Held to maturity - fixed maturity securities that we have the
ability and positive intent to hold to maturity. When we own such
securities, we carry them at amortized cost. We may dispose of
these securities if the credit quality of the issuer deteriorates,
if regulatory requirements change or under other unforeseen
circumstances. We have not held any held to maturity securities
since implementing SFAS 115 in 1993.
We consider the anticipated returns from investing policyholder balances,
including investment gains and losses, in determining the amortization of the
cost of policies purchased and the cost of policies produced. When we state
actively managed fixed maturities at fair value, we also adjust the cost of
policies purchased and the cost of policies produced to reflect the change in
cumulative amortization that we would have recorded if we had sold these
securities at their fair value and reinvested the proceeds at current yields. If
future yields on such securities decline, it may be necessary to increase
certain of our insurance liabilities. We are required to adjust such liabilities
when their balances and future net cash flows (including investment income) are
insufficient to cover future benefits and expenses.
The unrealized gains and losses and the related adjustments described
above have no effect on our earnings. We record them, net of tax and other
adjustments, to shareholders' equity. The following table summarizes the effect
of these adjustments on the related balance sheet accounts as of December 31,
1997:
Effect of fair value
adjustment to
actively managed
Cost fixed maturity Reported
basis securities amount
----- ---------- ------
(Dollars in millions)
Actively managed fixed maturity securities.................... $22,289.3 $ 484.4 $22,773.7
Other balance sheet items:
Cost of policies purchased................................. 2,639.0 (172.6) 2,466.4
Cost of policies produced.................................. 949.9 (34.7) 915.2
Other .................................................... - (4.4) (4.4)
Income tax liabilities..................................... (437.3) (95.5) (532.8)
-------
Unrealized appreciation of fixed maturity securities,
net................................................. $ 177.2
=======
When there are changes in conditions that cause us to transfer a fixed
maturity investment to a different category (i.e., actively managed, trading or
held to maturity), we transfer it at its fair value on that date. We account for
the security's unrealized gain or loss (such amounts were immaterial in 1997) as
follows:
For a transfer to the trading category - we recognize the unrealized
gain or loss immediately in earnings.
For a transfer from the trading category - we do not reverse the
unrealized gain or loss already recognized in earnings.
50
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
For a transfer to actively managed from held to maturity - we
recognize the unrealized gain or loss immediately in shareholders'
equity.
For a transfer to held to maturity from actively managed - we continue
to report the unrealized gain or loss at the date of transfer in
shareholders' equity, but we amortize the gain or loss over the
remaining life of the security as an adjustment of yield.
Interest-only securities represent the right to receive certain cash
flows which exceed the amount of cash flows sold in our securitized receivable
sales. Such cash flows generally are equal to the value of the interest to be
collected on the underlying financial contracts of each securitization in excess
of the sum of the interest to be paid on the securities sold, contractual
servicing fees and credit losses. We carry interest-only securities at estimated
fair value. We determine fair value by discounting the projected cash flows over
the expected life of the receivables sold using current prepayment, default,
loss and interest rate assumptions. We record any unrealized gain or loss
determined to be temporary, net of tax, as a component of shareholders' equity.
See note 4 for additional discussion of gain on sale of receivables and
interest-only securities.
Equity securities include investments in common stocks and non-redeemable
preferred stock. We treat them like actively managed fixed maturities (as
described above).
Credit-tenant loans ("CTLs") are loans for commercial properties. When we
make these loans: (i) the lease of the principal tenant must be assigned to
Conseco; (ii) the lease must produce adequate cash flow to fund substantially
all the requirements of the loan; and (iii) the principal tenant or the
guarantor of such tenant's obligations must have an investment-grade credit
rating when the loan is made. These loans also must be collateralized by the
value of the related property. Our underwriting guidelines take into account
such factors as: (i) the lease term of the property; (ii) the borrower's
management ability, including business experience, property management
capabilities and financial soundness; and (iii) such economic, demographic or
other factors that may affect the income generated by the property, or its
value. The underwriting guidelines generally require a loan-to-value ratio of 75
percent or less. We carry both CTLs and traditional mortgage loans at amortized
cost.
As part of our investment strategy, we may enter into reverse repurchase
agreements and dollar-roll transactions to increase our investment return or to
improve our liquidity. We account for these transactions as collateral
borrowings, where the amount borrowed is equal to the sales price of the
underlying securities.
Policy loans are stated at their current unpaid principal balances.
Other invested assets include: (i) trading securities; (ii) Standard &
Poor's 500 Call Options ("S&P 500 Call Options"); and (iii) certain
non-traditional investments. Trading securities are carried at estimated fair
value as described above. The S&P 500 Call Options are also carried at estimated
fair value and are further described below under "Financial Instruments."
Non-traditional investments include investments in venture capital funds,
limited partnerships, mineral rights and promissory notes and are accounted for
using either the cost method, or for investments in partnerships over whose
operations the Company exercises significant influence, the equity method.
Short-term investments include commercial paper, invested cash and other
investments purchased with maturities of less than three months. We carry them
at amortized cost, which approximates their estimated fair value. We consider
all short-term investments to be cash equivalents.
We defer any fees received or costs incurred when we originate
investments--principally CTLs and mortgages. We amortize fees, costs, discounts
and premiums as yield adjustments over the contractual lives of the investments.
We consider anticipated prepayments on mortgage-backed securities in determining
estimated future yields on such securities.
When we sell a security (other than a trading security), we report the
difference between our sale proceeds and its amortized cost as an investment
gain or loss.
We regularly evaluate all of our investments 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, we treat it as a realized
51
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
loss and we reduce our cost basis of the security to its estimated fair value.
See note 4 for a discussion of other than temporary declines in realizable value
of interest-only securities.
Separate Accounts
Separate accounts are funds on which investment income and gains or
losses accrue directly to certain policyholders. The assets of these accounts
are legally segregated. They are not subject to the claims that may arise out of
any other business of Conseco. We report separate account assets at market
value; the underlying investment risks are assumed by the contract holders. We
record the related liabilities at amounts equal to the underlying assets; the
fair value of these liabilities equals their carrying amount.
Finance Receivables
Finance receivables consist of lease, commercial finance and revolving
credit receivables and loans held for securitization (which include recently
originated manufactured housing, home equity, home improvement, consumer and
equipment loans which will be sold in the near future). We carry finance
receivables held for securitization at the lower of cost or market. We carry our
lease receivables (which are direct financing leases as defined in Statement of
Financial Accounting Standards No. 13 "Accounting for Leases") at the present
value of the future minimum lease payments and related residual values. We carry
commercial finance receivables (which include dealer floor plan, asset-based
financing arrangements with dealers, manufacturers and other commercial entities
and commercial real estate loans) and revolving credit receivables (which
include retail credit card arrangements with merchants and dealers and their
customers) at amortized cost. Finance receivables are net of allowance for
expected losses.
We defer fees received or costs incurred when we originate finance
receivables. We amortize fees, costs, discounts and premiums over the
contractual lives of the receivables, with consideration to anticipated
prepayments. Such deferred fees or costs are included in the cost of finance
receivables sold when receivables are sold. See note 4 for a discussion of the
sale of finance receivables.
Servicing Rights
We generally retain the right to service loans we originate or purchase
and subsequently sell through securitizations. Fees for servicing loans are
based on a stipulated percentage of the unpaid principal balance of the loans.
We recognize a servicing asset when we sell our loans, equal to the present
value of the expected future net servicing revenue using prepayment, default,
loss and interest rate assumptions. We amortize servicing rights in proportion
to total projected net servicing income. We periodically assess our servicing
rights for impairment based on the fair value of such rights. If an impairment
exists, it is recognized in the statement of operations during the period in
which the impairment occurs as an adjustment to the corresponding valuation
allowance. See note 4 for a discussion of the sale of receivables.
Cost of Policies Purchased
When we acquire an insurance company, we assign a portion of its cost to
the right to receive future cash flows from insurance contracts existing at the
date of the acquisition. This cost of policies purchased represents the
actuarially determined present value of the projected future cash flows from the
acquired policies. To determine this value, we use a method that is consistent
with methods commonly used to value blocks of insurance business and with the
basic methodology generally used to value assets. It can be summarized as
follows:
- Identify the expected future cash flows from the blocks of business.
- Identify the risks to realizing those cash flows (i.e., assess the
probability that the cash flows will be realized).
- Identify the rate of return that we must earn in order to accept these
risks, based on consideration of the factors summarized below.
- Determine the value of the policies purchased by discounting the
expected future cash flows by the discount rate we need to earn.
52
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The expected future cash flows we use in determining such value are based
on actuarially determined projections of future premium collections, mortality,
surrenders, operating expenses, changes in insurance liabilities, investment
yields on the assets held to back the policy liabilities and other factors.
These projections take into account all factors known or expected at the
valuation date, based on the collective judgment of Conseco's management. Our
actual experience on purchased business may vary from projections due to
differences in renewal premiums collected, investment spread, investment gains
or losses, mortality and morbidity costs and other factors.
The discount rate we use to determine the value of the cost of policies
purchased is the rate of return we need to earn in order to invest in the
business being acquired. In determining this required rate of return, we
consider the following factors:
- The magnitude of the risks associated with each of the actuarial
assumptions used in determining expected future cash flows (as
described above).
- The cost of our capital required to fund the acquisition.
- The likelihood of changes in projected future cash flows that might
occur if there are changes in insurance regulations and tax laws.
- The acquired company's compatibility with other Conseco activities that
may favorably affect future cash flows.
- The complexity of the acquired company.
- Recent prices (i.e., discount rates used in determining valuations)
paid by others to acquire similar blocks of business.
After we determine the cost of policies purchased, we amortize that
amount and evaluate recoverability in the same manner as cost of policies
produced as described below.
The cost of policies purchased related to acquisitions completed prior to
November 19, 1992 (representing 8 percent of the balance of cost of policies
purchased at December 31, 1997) is amortized under a slightly different method
than that described above. However, the effect of the different method on 1997
net income was insignificant.
Cost of Policies Produced
The costs that vary with and are primarily related to producing new
business are referred to as cost of policies produced. They consist primarily of
commissions, first-year bonus interest and certain costs of policy issuance and
underwriting, net of fees charged to the policy in excess of ultimate fees
charged. To the extent that they are recoverable from future profits, we defer
these costs and amortize them, using the interest rate credited to the
underlying policies, as follows:
- For universal life-type contracts and investment-type contracts, in
relation to the present value of expected gross profits from the
contracts.
- For immediate annuities with mortality risks, in relation to the
present value of benefits to be paid.
- For traditional life and accident and health products, in relation to
future anticipated premium revenue, using the same assumptions that
are used in calculating the insurance liabilities.
Each year, we evaluate the recoverability of the unamortized balance of
the cost of policies produced. For universal life-type contracts and
investment-type contracts, we increase or decrease the accumulated amortization
whenever there is a material change in the estimated gross profits expected over
the life of a block of business. We do this in order to maintain a constant
relationship between the cumulative amortization and the present value
(discounted at the rate of interest that accrues to the policies) of expected
gross profits. For most other contracts, we reduce the unamortized asset balance
(by a charge to income) only when the present value of future cash flows, net of
the policy liabilities, is insufficient to recover the asset balance.
53
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Goodwill
Goodwill is the excess of the amount we paid to acquire a company over
the fair value of its net assets. We amortize goodwill on the straight-line
basis generally over a 40-year period. We continually monitor the value of our
goodwill based on our estimates of future earnings. We determine whether
goodwill is fully recoverable from projected undiscounted net cash flows from
earnings of the subsidiaries over the remaining amortization period. If we were
to determine that changes in such projected cash flows no longer supported the
recoverability of goodwill over the remaining amortization period, we would
reduce its carrying value with a corresponding charge to expense or shorten the
amortization period (no such changes have occurred). Cash flows considered in
such an analysis are those of the business acquired, if separately identifiable,
or the business segment that acquired the business if such earnings are not
separately identifiable.
Property and Equipment
We carry property and equipment at depreciated cost. We depreciate
property and equipment on a straight-line basis over the estimated useful lives
of the assets, which average approximately 11 years. Our depreciation expense
was $46.1 million in 1997, $29.8 million in 1996 and $20.3 million in 1995.
Insurance Liabilities, Recognition of Insurance Policy Income and Related
Benefits and Expenses
Our reserves for universal life-type and investment-type contracts are
based either on the contract account balance (if future benefit payments in
excess of the account balance are not guaranteed) or on the present value of
future benefit payments (if such payments are guaranteed). We make additions to
insurance liabilities if we determine that future cash flows (including
investment income) are insufficient to cover future benefits and expenses.
For investment contracts without mortality risk (such as deferred
annuities and immediate annuities with benefits paid for a period certain) and
for contracts that permit either Conseco or the insured to make changes in the
contract terms (such as single- premium whole life and universal life), we are
required to record premium deposits and benefit payments as increases or
decreases in a liability account, rather than as revenue and expense. We record
as revenue any amounts charged against the liability account for the cost of
insurance, policy administration and surrender penalties. We record as expense
any interest credited to the liability account and any benefit payments that
exceed the contract liability account balance.
We calculate our reserves for traditional and limited-payment life
contracts generally using the net-level-premium method, based on assumptions as
to investment yields, mortality, withdrawals and dividends. We make these
assumptions at the time we issue the contract or, in the case of contracts
acquired by purchase, at the purchase date. We base these assumptions on
projections from past experience, modified as necessary to reflect anticipated
trends and making allowance for possible unfavorable deviation.
For traditional life insurance contracts, we recognize premiums as income
when due or, for short-duration contracts, over the period to which the premiums
relate. We recognize benefits and expenses as a level percentage of earned
premiums. We accomplish this by providing for future policy benefits and by
amortizing deferred policy acquisition costs.
For contracts with mortality risk, but with premiums paid for only a
limited period (such as single-premium immediate annuities with benefits paid
for the life of the annuitant), we use an accounting treatment similar to that
used for traditional contracts. An exception is that we defer the excess of the
gross premium over the net premium and recognize it in relation to the present
value of expected future benefit payments (when accounting for annuity
contracts) or in relation to insurance in force (when accounting for life
insurance contracts).
We establish reserves for the estimated present value of the remaining
net cost of all reported and unreported claims. We base our estimates on past
experience and on published tables for disabled lives. We believe that the
reserves we have established are adequate. Final claim payments, however, may
differ from the established reserves, particularly when those payments may not
occur for several years. Any adjustments we make to reserves are reflected in
the results for the year during which the adjustments are made.
The liability for future policy benefits for accident and health policies
consists of active life reserves and the estimated present value of the
remaining ultimate net cost of incurred claims. Active life reserves include
unearned premiums and additional reserves. The additional reserves are computed
on the net level premium method using assumptions for future investment yield,
mortality and
54
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
morbidity experience. Our assumptions are based on projections of past
experience and include provisions for possible adverse deviation.
For participating policies, we determine annually the amount of dividends
to be paid. We include as an insurance liability the portion of the earnings
allocated to participating policyholders.
Reinsurance
In the normal course of business, Conseco seeks to limit its exposure to
loss on any single insured and to recover a portion of the benefits paid over
such limits. We do this by ceding reinsurance to other insurance enterprises or
reinsurers under excess coverage and coinsurance contracts. We limit how much
risk per policy we will retain. We currently retain no more than $.8 million of
risk on any one policy.
We report assets and liabilities related to insurance contracts before
the effects of reinsurance. We report reinsurance receivables and prepaid
reinsurance premiums (including amounts related to insurance liabilities) as
assets. We recognize estimated reinsurance receivables in a manner consistent
with the liabilities related to the underlying reinsured contracts.
Income Taxes
Our income tax expense includes deferred income taxes arising from
temporary differences between the tax and financial reporting bases of assets
and liabilities. This liability method of accounting for income taxes also
requires us to reflect in income the effect of a tax-rate change on accumulated
deferred income taxes in the period in which the change is enacted.
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 deferred income tax assets depends upon
generating future taxable income during the periods in which temporary
differences become deductible. If future income is not generated as expected,
deferred income tax assets may need to be written off.
Minority Interest
Our consolidated financial statements for 1995 and 1996 include all of
the assets, liabilities, revenues and expenses of BLH and ALH, even though we
did not own all of the common stock of these subsidiaries until December 1996.
We make a charge against consolidated income for: (i) the share of earnings
allocable to minority interests; (ii) dividends on preferred stock of
subsidiaries; and (iii) distributions on the Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts. We show the shareholders'
equity of such entities allocable to the minority interests separately on our
consolidated balance sheet.
We report Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts at their book value under minority interest. We charge the
distributions on these securities against consolidated income.
Earnings Per Share
As of December 31, 1997, we adopted Statement of Financial Accounting
Standards No. 128, "Earnings Per Share"("SFAS 128"). SFAS 128 provides new
accounting and reporting standards for earnings per share. It replaces primary
and fully diluted earnings per share with basic and diluted earnings per share.
Basic earnings per share excludes dilution and is computed by dividing income
available to common shareholders by the weighted average number of common shares
outstanding for the period. Diluted earnings per share represents the potential
dilution that could occur if all convertible securities, warrants and stock
options were exercised and converted into common stock if their effect is
dilutive. The diluted earnings per share calculation assumes that the proceeds
received upon the conversion of all dilutive options and warrants are used to
repurchase the Company's common shares at the average market price of such
shares during the period. Prior period earnings per share amounts have been
restated. We have also restated all share and per-share amounts for the
two-for-one stock splits distributed February 11, 1997 and April 1, 1996.
55
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Comprehensive Income
As of December 31, 1997, we adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130
establishes standards for reporting and presentation of comprehensive income and
its components in a full set of financial statements. Comprehensive income
includes all changes in shareholders' equity (except those arising from
transactions with shareholders) and includes net income, net unrealized gains
(losses) on securities and minimum pension liability adjustments. The new
standard requires only additional disclosures in the consolidated financial
statements; it does not affect our financial position or results of operations.
Comprehensive income excludes net investment gains (losses) included in
net income of: (i) $42.1 million (after income taxes of $22.6 million) in 1997;
(ii) $(2.0) million (after income tax benefit of $1.0 million) in 1996; and
(iii) $48.1 million (net of income taxes of $25.9 million) in 1995.
Use of Estimates
Our financial statements have been prepared in accordance with GAAP. As
such, they include amounts based on our informed estimates and judgment, with
consideration given to materiality. We use many estimates and assumptions
calculating amortized value and recoverability of securities, cost of policies
produced, cost of policies purchased, interest-only securities, servicing
rights, goodwill, insurance liabilities, guaranty fund assessment accruals,
liabilities for litigation, and deferred income taxes. Actual results could
differ from reported results using those estimates.
Financial Instruments
In 1996, we introduced equity-indexed annuity products, which provide a
guaranteed base rate of return with a higher potential return linked to the
performance of a broad-based equity index. 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 the
equity-indexed annuity products. We reflect changes in the values of the S&P 500
Call Options, which fluctuate in relation to changes in policyholder account
balances for these annuities, in net investment income. Premiums paid to
purchase these instruments are deferred and amortized over their term.
During the year ended December 31, 1997, net investment income increased
by $39.4 million as a result of changes in the value of the S&P 500 Call
Options. Such investment income was substantially offset by amounts added to
policyholder account balances for annuities and financial products. The value of
the S&P 500 Call Options was $41.4 million at December 31, 1997. We classify
such instruments as other invested assets.
If the counterparties of the aforementioned financial instruments do not
meet their obligations, Conseco may have to recognize a loss. Conseco limits its
exposure to such a loss by diversifying among several counterparties believed to
be strong and creditworthy. At December 31, 1997, all of the counterparties were
rated "A"or higher by Standard & Poor's Corporation.
In conjunction with its investment in a consumer financing company,
Conseco has guaranteed up to $10.0 million of the financing company's
indebtedness to its primary lender through 1998. In conjunction with certain
finance receivable sales, Conseco has provided guarantees of $1.7 billion and
$1.5 billion as of December 31, 1997 and 1996, respectively. Conseco believes
the likelihood of a significant loss from the guarantee is remote.
Revenue Recognition for Sales of Finance Receivables
Effective January 1, 1997, we account for the sale of finance receivables
in accordance with the new standard, Statement of Financial Accounting Standards
No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities "("SFAS 125"). In applying SFAS 125 to our
securitized finance receivables sales, we are required to recognize a gain,
representing the difference between the proceeds from the sale (net of related
sale costs) and the carrying value of the component of the finance receivable
sold. Such carrying amount is determined by allocating the carrying value of the
finance receivables between the portion we sell and the interests in the finance
receivables we retain (generally interest-only securities and servicing rights),
based on each portion's relative fair value on the date of the sale. See note 4
for additional discussion of finance receivable sales.
56
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Fair Values of Financial Instruments
We use the following methods and assumptions to determine the estimated
fair values of financial instruments:
Investment securities. For fixed maturity securities (including
redeemable preferred stocks) and for equity and trading securities, we
use quotes from independent pricing services, where available. For
investment securities for which such quotes are not available, we use
values obtained from broker-dealer market makers or by discounting
expected future cash flows using a current market rate appropriate for
the yield, credit quality, and for fixed maturity securities, the
maturity of the investment being priced.
Interest-only securities. We determine estimated fair value by
discounting future expected cash flows over the expected life of the
receivables sold using current prepayment, default, loss and interest
rate assumptions.
Short-term investments. We use quoted market prices. The carrying amount
reported on our consolidated balance sheet for these instruments
approximates their estimated fair value.
Mortgage loans, credit-tenant loans and policy loans. We discount future
expected cash flows based on interest rates currently being offered for
similar loans to borrowers with similar credit ratings. We aggregate
loans with similar characteristics in our calculations.
Other invested assets. We use quoted market prices, where available. For
other invested assets, which are not material, we have assumed a market
value equal to carrying value.
Other assets. The portion of other assets in 1996 representing the value
attributable to the U.S. Treasury securities held in escrow for the
future redemption of mandatorily redeemable preferred stock of a
subsidiary of ALH are based on quoted market prices. In 1997, the
redeemable preferred stock was redeemed and the securities held in escrow
were released.
Finance receivables. We estimate the fair value of these loans to be
approximately equal to their carrying value, including adjustments for
deferred fees and costs.
Servicing rights. We determine estimated fair value by discounting future
expected net servicing revenue using prepayment, default, loss and
interest rate assumptions.
Insurance liabilities for investment contracts. We use discounted cash
flow calculations based on interest rates currently being offered for
similar contracts having maturities consistent with the contracts being
valued.
Investment borrowings and notes payable. We use either: (i) discounted
cash flow analyses based on our current incremental borrowing rates for
similar types of borrowing arrangements; or (ii) current market values
for publicly traded debt.
Other liabilities. The portion of other liabilities representing the
value attributable to the conversion features of subordinated convertible
debentures acquired in conjunction with the ATC Merger and the PFS Merger
are valued at estimated fair value.
Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts. We use quoted market prices.
Mandatorily redeemable preferred stock of a subsidiary of ALH (a
component of minority interest). The estimated fair value of redeemable
preferred stock which is publicly-traded is based on quoted market
prices. The estimated fair value of the privately placed redeemable
preferred stock is determined by discounting expected future cash flows
using assumed incremental dividend rates for similar duration securities.
These securities were redeemed in 1997.
57
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Here are the estimated fair values of our financial instruments:
1997 1996
----------------------- ----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
(Dollars in millions)
Financial assets held for purposes other than trading:
Actively managed fixed maturities........................ $22,773.7 $22,773.7 $17,307.1 $17,307.1
Interest-only securities................................. 1,363.2 1,363.2 1,014.3 1,006.5
Equity securities ....................................... 228.9 228.9 99.7 99.7
Mortgage loans........................................... 516.2 551.0 356.0 356.1
Credit-tenant loans...................................... 558.6 587.2 447.1 446.3
Policy loans............................................. 692.4 692.4 542.4 542.4
Other invested assets.................................... 530.7 530.7 262.3 262.3
Short-term investments................................... 1,179.1 1,179.1 377.4 377.4
Finance receivables...................................... 1,971.0 1,971.0 1,220.0 1,220.0
Servicing rights......................................... 96.3 96.3 - -
Other assets............................................. - - 45.6 49.1
Financial liabilities held for purposes other than trading:
Insurance liabilities for investment contracts (1)....... 12,724.0 12,724.0 11,491.6 11,491.6
Investment borrowings.................................... 1,389.5 1,389.5 383.4 383.4
Other liabilities........................................ 72.6 95.1 145.5 145.5
Notes payable and commercial paper:
Corporate.............................................. 2,354.9 2,398.8 1,094.9 1,140.8
Consumer and commercial finance........................ 1,866.3 1,876.0 762.5 803.8
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts.............. 1,383.9 1,491.6 600.0 604.3
Mandatorily redeemable preferred stock of a subsidiary
(a component of minority interest).................... - - 97.0 97.0
<FN>
1) The estimated fair value of the liabilities for investment contracts
was approximately equal to its carrying value at December 31, 1997 and
1996. This was because interest rates credited on the vast majority of
account balances approximate current rates paid on similar investments
and because these rates are not generally guaranteed beyond one year. We
are not required to disclose fair values for insurance liabilities, other
than those for investment contracts. However, we take into consideration
the estimated fair values of all insurance liabilities in our overall
management of interest rate risk. We attempt to minimize exposure to
changing interest rates by matching investment maturities with amounts
due under insurance contracts.
</FN>
Recently Issued Accounting Standards
Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information" ("SFAS 131") establishes new
standards for reporting about operating segments and products and services,
geographic areas and major customers. Under SFAS 131, segments are to be defined
consistent with the basis management uses internally to assess performance and
allocate resources. Implementing SFAS 131 will have no impact on the
consolidated amounts we report, and we do not expect any significant changes to
our segment disclosures. SFAS 131 is effective for our December 31, 1998
financial statements.
58
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Statement of Financial Accounting Standards No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits" ("SFAS 132") was
issued in February 1998 and revises current disclosure requirements for
employers' pensions and other retiree benefits. SFAS 132 will have no effect on
our financial position or results of operations. SFAS 132 is effective for our
December 31, 1998 financial statements.
Statement of Position 97-3, "Accounting by Insurance and Other
Enterprises for Insurance-Related Assessments" ("SOP 97-3") was issued by the
American Institute of Certified Public Accountants in December 1997 and provides
guidance for determining when an insurance company or other enterprise should
recognize a liability for guaranty-fund assessments and guidance for measuring
the liability. The statement is effective for 1999 financial statements with
early adoption permitted. The adoption of this statement is not expected to have
a material effect on our financial position or results of operations.
2. ACQUISITIONS/DISPOSITIONS:
Green Tree
On June 30, 1998, we completed the Green Tree Merger. Each outstanding
share of Green Tree common stock was exchanged for .9165 of a share of Conseco
common stock. We issued 128.7 million shares of Conseco common stock (including
5.0 million common equivalent shares issued in exchange for Green Tree's
outstanding options). The Green Tree Merger constituted a tax-free exchange and
is accounted for under the pooling of interests method. All prior period
consolidated financial statements presented have been restated to include Green
Tree as though it had always been a subsidiary of Conseco. As a result of the
Green Tree Merger, a restructuring charge of $148 was recorded in the second
quarter of 1998. The restructuring charge includes investment banking,
accounting, legal and regulatory fees, severance costs and other costs
associated with the Green Tree Merger.
The results of operations for Conseco and Green Tree, separately and
combined, were as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Revenues:
Conseco............................................................... $5,568.4 $3,067.3 $2,855.3
Green Tree............................................................ 1,091.5 724.1 711.3
Less elimination of intercompany revenues............................. (3.5) (1.6) (5.4)
-------- -------- --------
Combined............................................................ $6,656.4 $3,789.8 $3,561.2
======== ======== ========
Net income:
Conseco............................................................... $567.3 $252.4 $220.4
Green Tree............................................................ 301.4 200.8 254.0
Less elimination of intercompany net income........................... (2.3) (1.0) (3.5)
------ ------ ------
Combined............................................................ $866.4 $452.2 $470.9
====== ====== ======
Washington National Corporation
On December 5, 1997, we completed the WNIC Merger. In the merger, each
share of WNIC common stock was converted into the right to receive $33.25 in
cash. We paid $400.6 million in cash, of which $73.7 million was funded through
a dividend to Conseco from WNIC. The remaining purchase price was funded with
amounts borrowed under our bank credit facilities.
We accounted for the WNIC Merger under the purchase method of accounting
effective December 1, 1997. Under this method, we allocated the cost to acquire
WNIC to the assets and liabilities acquired based on fair values as of the date
of the WNIC Merger, and reported the excess of the total purchase cost over the
fair value of the assets acquired less the fair value of the liabilities assumed
as goodwill.
59
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Colonial Penn
On September 30, 1997, we completed the Colonial Penn Purchase from
Leucadia National Corporation ("Leucadia") for $460.0 million in cash and notes
payable. The Colonial Penn Purchase was funded with: (i) $60.0 million in cash
which was borrowed under our bank credit facility; and (ii) notes payable to
Leucadia (the "Leucadia Notes") totaling $400.0 million.
The Colonial Penn Purchase was accounted for under the purchase method of
accounting effective September 30, 1997. Under this method, we allocated the
cost to acquire Colonial Penn to the assets and liabilities acquired based on
fair values as of the date of the Colonial Penn Purchase, and reported the
excess of the total purchase cost over the fair value of the assets acquired
less the fair value of the liabilities assumed as goodwill.
Pioneer Financial Services, Inc.
On May 30, 1997, we completed the PFS Merger. Each outstanding share of
PFS common stock was exchanged for .7077 of a share of Conseco common stock. We
issued 9.0 million shares of common stock (including .6 million common
equivalent shares issued in exchange for PFS's outstanding options) with a value
of $354.1 million. We also assumed PFS's convertible subordinated notes, which
are convertible into 3.1 million shares of Conseco common stock, with a value of
$130.6 million (of which $86.3 million, representing the principal amount
outstanding, was classified as notes payable and $44.3 million, representing the
additional value attributable to the conversion feature, was classified as other
liabilities). In addition, we assumed a $21.3 million note payable of PFS, which
we repaid on the merger date.
The PFS Merger was accounted for under the purchase method of accounting
effective April 1, 1997. Under this method, we allocated the cost to acquire PFS
to the assets and liabilities acquired based on fair values as of the date of
the PFS Merger, and reported the excess of the total purchase cost over the fair
value of the assets acquired less the fair value of the liabilities assumed as
goodwill. The PFS Merger did not qualify to be accounted for under the pooling
of interests method in accordance with APB No. 16 because an affiliate of PFS
sold a portion of his holdings of PFS common stock after the PFS Merger was
announced.
Capitol American Financial Corporation
On March 4, 1997, we completed the CAF Merger. Each outstanding share of
CAF common stock was exchanged for $30.75 in cash plus 0.1647 of a share of
Conseco common stock. We paid $552.8 million (including acquisition expenses of
$14.2 million) in cash and issued 3.0 million shares of common stock (including
.1 million common equivalent shares issued in exchange for CAF's outstanding
options) with a value of $117.4 million. In addition, we assumed a $31.0 million
note payable of CAF, which we repaid on the merger date.
The CAF Merger was accounted for under the purchase method of accounting
effective January 1, 1997. Under this method, we allocated the cost to acquire
CAF to the assets and liabilities acquired based on fair values as of the date
of the CAF Merger, and reported the excess of the total purchase cost over the
fair value of the assets acquired less the fair value of the liabilities assumed
as goodwill.
Transport Holdings Inc.
On December 23, 1996, we completed the THI Merger. Each outstanding share
of THI common stock was exchanged for 2.8 shares of Conseco common stock. We
issued 4.9 million shares of common stock (including .4 million common
equivalent shares issued in exchange for THI's outstanding options and warrants)
with a value of $121.7 million. In addition, pursuant to an exchange offer, all
of THI's convertible notes were exchanged for 4.2 million shares of Conseco
common stock with a value of $106.2 million plus a cash premium of $11.9
million.
The THI Merger was accounted for under the purchase method of accounting
effective December 31, 1996. Under this method, we allocated the cost to acquire
THI to the assets and liabilities acquired based on fair values as of the date
of the THI Merger. There was no goodwill acquired with the THI Merger. The THI
Merger did not qualify to be accounted for under the pooling of interests method
in accordance with APB No. 16 because THI was a subsidiary of another
corporation within two years of the transaction.
60
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
American Travellers Corporation
On December 17, 1996, we completed the ATC Merger. Each outstanding share
of ATC common stock was exchanged for 1.1672 shares of Conseco common stock. We
issued 21.0 million shares of common stock (including .9 million common
equivalent shares issued in exchange for ATC's outstanding options) with a value
of $630.9 million. We also assumed ATC's convertible subordinated debentures,
which are convertible into 7.9 million shares of Conseco common stock with a
value of $248.3 million (of which $102.8 million, representing the principal
amount outstanding, was classified as notes payable and $145.5 million,
representing the additional value attributable to the conversion feature, was
classified as other liabilities).
The ATC Merger was accounted for under the purchase method of accounting
effective December 31, 1996. Under this method, we allocated the cost to acquire
ATC to the assets and liabilities acquired based on fair values as of the date
of the ATC Merger, and reported the excess of the total purchase cost over the
fair value of the assets acquired less the fair value of the liabilities assumed
as goodwill. The ATC Merger did not qualify to be accounted for under the
pooling of interests method in accordance with APB No. 16 because an affiliate
of ATC sold a portion of the Conseco common stock received in the ATC Merger
shortly after the consummation of the ATC Merger.
FINOVA Acquisition I, Inc.
On December 1, 1996, we completed the purchase of the net assets of
FINOVA, consisting primarily of leases and loans to manufacturers and dealers
and their customers. We paid $620.6 million in cash for such assets.
We accounted for the FINOVA Purchase under the purchase method of
accounting effective December 1, 1996. Under this method, we allocated the cost
to acquire the net assets based on fair values as of the date of the FINOVA
Purchase and reported the excess of the total purchase cost over the fair value
of the net assets acquired as goodwill.
Life Partners Group, Inc.
Effective July 1, 1996, we completed the LPG Merger. Each of the issued
and outstanding shares of LPG common stock was converted into 1.1666 shares of
Conseco common stock. We issued 32.6 million shares of common stock (including
.4 million common equivalent shares issued in exchange for LPG's outstanding
options) with a value of $586.8 million. In connection with the LPG Merger, we
also assumed notes payable of $253.1 million.
The LPG Merger was accounted for under the purchase method of accounting.
Under this method, we allocated the cost to acquire LPG to the assets and
liabilities acquired based on their fair values as of July 1, 1996, and recorded
the excess of the total purchase cost over the fair value of the liabilities we
assumed as goodwill. The LPG Merger did not qualify to be accounted for under
the pooling of interest method in accordance with Accounting Principles Board
Opinion No. 16, Business Combinations ("APB No. 16"), because of Conseco's
significant common stock repurchases.
American Life Holdings, Inc.
At January 1, 1995, we owned 27 percent of ALH through our direct
investment and through our investment in Partnership II. On November 30, 1995,
ALH issued 2,142,857 shares of its common stock for $30.0 million (including
$13.2 million paid by Conseco and its subsidiaries) in a private placement
transaction. Eighty percent of the shares were purchased by Partnership II and
the remainder were purchased by the other holders of ALH common stock. The
proceeds from the sale were used to reduce the amount of ALH's outstanding debt.
In accordance with the Partnership II agreement, Conseco earned fees of $.2
million (net of taxes of $.1 million) for services in connection with such
transaction. On September 30, 1996, we repurchased all of the common shares of
ALH we did not already own for $166.0 million in cash in the ALH Stock Purchase.
The Partnership II agreement provided that an additional ownership interest
in ALH would be allocated to Conseco if returns to the limited partners were in
excess of prescribed targets. Upon termination of Partnership II, such targets
were exceeded and the additional ownership interest allocated to Conseco was
recognized as follows: (i) $10.2 million, which represents Conseco's increased
ownership interest in the previously reported net income of Partnership II, was
recorded as a reduction of amounts that would otherwise be charged to the
minority interest; and (ii) $16.6 million was recorded as net investment gains.
Such income of Conseco was offset by $16.2 million of expenses incurred in
connection with the realization of the investment gains.
61
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Bankers Life Holding Corporation
At January 1, 1995, we owned 58 percent of the common stock of BLH, which
was acquired in various transactions beginning in 1992. During 1995, we acquired
12.8 million shares of BLH common stock for $262.4 million in open market and
negotiated transactions, increasing our ownership of BLH to 85 percent. Income
tax expense was reduced by $66.5 million in the second quarter of 1995 as a
result of the release of deferred income taxes previously accrued on income
related to BLH. Such deferred tax was no longer required since we were permitted
to file a consolidated tax return with BLH. In addition, BLH repurchased 2.2
million shares of its common stock during 1995 at a cost of $42.1 million,
increasing our ownership interest in BLH to 88 percent as of December 31, 1995.
During the first three months of 1996, BLH repurchased 1.3 million shares of its
common stock at a cost of $27.7 million. As a result of such repurchases,
Conseco's ownership interest in BLH increased to 90.5 percent.
On December 31, 1996, we completed the BLH Merger. Each outstanding share
of BLH common stock not already owned by Conseco was exchanged for 0.7966 of a
share of Conseco common stock. We issued 3.9 million shares of common stock
(including .1 million common equivalent shares in exchange for BLH's outstanding
options) with a value of $123.0 million.
CCP Insurance, Inc.
At January 1, 1995, we owned 45 percent of the common stock of CCP, which
was acquired through several separate transactions beginning in 1990. In early
1995, CCP repurchased an additional 2.2 million shares under this program
increasing our ownership interest to 49 percent.
In August 1995, we completed the purchase of all of the shares of common
stock of CCP that we did not previously own. A total of 11.8 million shares were
purchased for $281.8 million (including transaction costs and the cost to settle
outstanding stock options of CCP) in a transaction pursuant to which CCP was
merged with Conseco, with Conseco being the surviving corporation. Income tax
expense was reduced by $8.4 million in the third quarter of 1995 as a result of
the release of deferred income taxes previously accrued on income related to
CCP. Such deferred tax is no longer required because the CCP Merger was
completed without incurring additional tax. We funded the CCP Merger with
available cash and borrowings from our credit facility.
Effect of Merger Transactions on Consolidated Financial Statements
We used purchase accounting to account for all our acquisitions during
1997, 1996 and 1995 and the pooling of interest method to account for the Green
Tree Merger. We allocated the total purchase cost of acquisitions completed in
1997 to the assets and liabilities acquired, based on a preliminary
determination of their fair values. We may adjust this allocation when we make a
final determination of such values (within one year of the acquisition date). We
don't expect any adjustment to be material, however.
The following unaudited pro forma results of operations of the Company are
presented as if the following had occurred as of January 1, 1995: (i) the LPG
Merger; (ii) the call for redemption of Conseco's Series D Convertible Preferred
Stock (the "Series D Call") completed on September 26, 1996; (iii) the ALH Stock
Purchase; (iv) the issuance of $600.0 million of Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts (see note 8); (v) the ATC
Merger; (vi) the THI Merger; (vii) the BLH Merger; (viii) the CCP Merger; (ix)
the increase of Conseco's ownership in BLH to 90.4 percent, as a result of
purchases of BLH common shares in 1995 and 1996; (x) the issuance of 4.37
million shares of Preferred Redeemable Increased Dividend Equity Securities, 7%
PRIDES Convertible Preferred Stock ("PRIDES") in January 1996; (xi) the BLH
tender offer for and repurchase of its 13 percent senior subordinated notes due
2002 and related financing transactions completed in March 1996; and (xii) the
debt
62
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
restructuring of ALH in the fourth quarter of 1995. The pro forma data are not
necessarily indicative of the results of Conseco's operations had these
transactions occurred on January 1, 1995, nor the results of future operations.
We have not presented pro forma data for the 1997 acquisitions because, in
accordance with the disclosure requirements of the Securities and Exchange
Commission, such acquisitions are not significant individually or in the
aggregate.
1996 1995(1)
---- ----
(Dollars in millions,
except per share data)
Revenues...................................................................................... $4,690.3 $4,737.5
Income before extraordinary charge............................................................ 552.5 564.6
Income before extraordinary charge per common share:
Basic.................................................................................... $1.88 $1.88
Diluted.................................................................................. 1.69 1.76
<FN>
(1) We have excluded $74.9 million from pro forma income before extraordinary
charge and $.23 from income before extraordinary charge per diluted
common share. These amounts related to the release of deferred income
taxes that are no longer required to be accrued as a result of the CCP
Merger and the purchase of additional BLH common shares in 1995.
</FN>
3. INVESTMENTS:
At December 31, 1997, the amortized cost and estimated fair value of
actively managed fixed maturities were as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
(Dollars in millions)
United States Treasury securities and obligations of
United States government corporations and agencies............. $ 541.4 $ 20.9 $ .1 $ 562.2
Obligations of states and political subdivisions................... 277.1 8.3 .8 284.6
Debt securities issued by foreign governments...................... 204.3 4.4 9.6 199.1
Public utility securities.......................................... 2,267.5 69.0 26.0 2,310.5
Other corporate securities......................................... 12,300.5 352.9 86.5 12,566.9
Mortgage-backed securities ........................................ 6,698.5 156.0 4.1 6,850.4
--------- ------- ------ ---------
Total actively managed fixed maturities..................... $22,289.3 $611.5 $127.1 $22,773.7
========= ====== ====== =========
At December 31, 1996, the amortized cost and estimated fair value of
actively managed fixed maturities were as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
----- ----- ------ -----
(Dollars in millions)
United States Treasury securities and obligations of
United States government corporations and agencies............. $ 509.9 $ 5.1 $ 1.2 $ 513.8
Obligations of states and political subdivisions................... 103.5 2.8 .2 106.1
Debt securities issued by foreign governments...................... 144.4 1.4 2.2 143.6
Public utility securities.......................................... 2,148.8 42.8 35.4 2,156.2
Other corporate securities......................................... 8,808.3 145.1 81.2 8,872.2
Mortgage-backed securities ........................................ 5,488.4 64.5 37.7 5,515.2
--------- ------ ------ ---------
Total actively managed fixed maturities..................... $17,203.3 $261.7 $157.9 $17,307.1
========= ====== ====== =========
63
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
At December 31, 1997, the amortized cost and estimated fair value of
actively managed fixed maturities based upon the pricing source used to
determine estimated fair value were as follows:
Estimated
Amortized fair
cost value
---- -----
(Dollars in millions)
Nationally recognized pricing services............................................................ $18,272.9 $18,703.7
Broker-dealer market makers....................................................................... 1,808.9 1,831.8
Internally developed methods (calculated based on a weighted-average
current market yield of 7.0 percent)........................................................... 2,207.5 2,238.2
---------- ----------
Total actively managed fixed maturities.................................................... $22,289.3 $22,773.7
========= =========
The following table sets forth fixed maturity investments at December 31,
1997, classified by rating categories. The category assigned is the highest
rating by a nationally recognized statistical rating organization or, as to
$651.2 million fair value of fixed maturities not rated by such firms, the
rating assigned by the National Association of Insurance Commissioners ("NAIC").
For purposes of the table, NAIC Class 1 is included in the "A" rating; Class 2,
"BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and below."
Percent of Percent of
Investment rating fixed maturities total investments
----------------- ---------------- -----------------
AAA.................................. 35% 29%
AA................................... 8 7
A.................................... 24 20
BBB+................................. 8 7
BBB.................................. 11 9
BBB- ................................ 7 6
--- ---
Investment grade................. 93 78
--- ---
BB+.................................. 2 2
BB................................... 1 1
BB-.................................. 1 1
B+ and below......................... 3 2
--- ---
Below-investment grade........... 7 6
--- ---
Total fixed maturities........ 100% 84%
=== ==
The following table sets forth below-investment-grade fixed maturity
investments as of December 31, 1997, summarized by the amount their amortized
cost exceeds fair value:
Estimated
Amortized fair
cost value
---- -----
(Dollars in millions)
Amortized cost exceeds fair value by 30% or more................................................. $ 9.5 $ 4.7
Amortized cost exceeds fair value by 15%, but less than 30%...................................... 141.3 110.0
Amortized cost exceeds fair value by 5%, but less than 15%....................................... 158.7 142.3
All others....................................................................................... 1,215.6 1,239.2
-------- --------
Total below-investment-grade fixed maturity investments................................ $1,525.1 $1,496.2
======== ========
64
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The following table sets forth the amortized cost and estimated fair
value of actively managed fixed maturities at December 31, 1997, 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 and because most mortgage-backed securities provide for
periodic payments throughout their lives.
Estimated
Amortized fair
cost value
---- -----
(Dollars in millions)
Due in one year or less......................................................................... $ 238.9 $ 239.8
Due after one year through five years........................................................... 2,243.1 2,264.7
Due after five years through ten years.......................................................... 5,481.4 5,539.5
Due after ten years............................................................................. 7,627.4 7,879.3
--------- ---------
Subtotal................................................................................... 15,590.8 15,923.3
Mortgage-backed securities...................................................................... 6,698.5 6,850.4
--------- ---------
Total actively managed fixed maturities ................................................ $22,289.3 $22,773.7
========= =========
Equity securities consisted of the following:
December 31, 1997 December 31, 1996
----------------- -----------------
Estimated Estimated
fair fair
Cost value Cost value
---- ----- ---- -----
(Dollars in millions)
Preferred stock, non-redeemable.......................................... $149.3 $152.5 $64.7 $66.3
Common stock............................................................. 78.3 76.4 32.9 33.4
------ ------ ----- -----
Total equity securities........................................... $227.6 $228.9 $97.6 $99.7
====== ====== ===== =====
Net investment income consisted of the following:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Assets held by insurance subsidiaries:
Fixed maturities................................................................. $1,467.5 $1,109.5 $ 988.6
Equity securities................................................................ 23.6 6.5 2.8
Mortgage loans................................................................... 39.5 42.6 43.3
Credit-tenant loans.............................................................. 44.5 28.8 19.7
Policy loans..................................................................... 38.6 25.9 19.4
Equity-indexed products.......................................................... 39.4 - -
Other invested assets............................................................ 74.8 27.8 17.5
Short-term investments........................................................... 39.6 15.6 26.4
Separate accounts................................................................ 70.3 48.4 28.8
--------- -------- --------
Gross investment income....................................................... 1,837.8 1,305.1 1,146.5
Investment expenses.................................................................. 12.5 2.6 3.9
--------- -------- --------
Net investment income on assets held by insurance subsidiaries................ 1,825.3 1,302.5 1,142.6
Finance receivables.................................................................. 214.5 138.1 124.7
Interest-only securities............................................................. 130.3 77.2 51.3
-------- -------- --------
Net investment income...................................................... $2,170.1 $1,517.8 $1,318.6
======== ======== ========
65
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The carrying value of fixed maturity investments and mortgage loans not
accruing investment income totaled $3.1 million, $2.1 million and $1.5 million
at December 31, 1997, 1996 and 1995, respectively.
The proceeds from sales of fixed maturity investments were $18.1 billion
in 1997, $8.2 billion in 1996, and $7.9 billion in 1995.
Investment gains (losses), net of investment gain expenses, were included
in revenue as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Fixed maturities:
Gross gains......................................................................... $342.6 $126.8 $270.8
Gross losses........................................................................ (41.4) (52.5) (17.5)
Other than temporary decline in fair value.......................................... (1.2) (.6) (21.9)
------ ------ ------
Net investment gains from fixed maturities before expenses..................... 300.0 73.7 231.4
Equity securities....................................................................... 13.2 2.6 .4
Mortgages............................................................................... (.8) (.4) (2.1)
Other than temporary decline in fair value of other invested assets..................... - (8.3) (3.0)
Other................................................................................... (1.2) 29.9 13.9
------ ------ ------
Net investment gains before expenses........................................... 311.2 97.5 240.6
Investment gain expenses................................................................ 44.7 36.7 36.5
------ ------ ------
Net investment gains........................................................... $266.5 $ 60.8 $204.1
====== ====== ======
Changes in unrealized appreciation (depreciation) on investments were as
follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Investments carried at fair value:
Actively managed fixed maturities .................................................. $380.6 $(504.4) $981.6
Interest-only securities............................................................ 35.2 - -
Equity securities................................................................... (.8) .1 5.4
Other investments................................................................... 9.6 (2.2) (2.7)
------ ------- ------
424.6 (506.5) 984.3
Equity in unrealized appreciation of CCP's investments.................................. - - 46.2
Adjustment for effect on other balance sheet accounts:
Cost of policies purchased ......................................................... (128.4) 141.6 (269.6)
Cost of policies produced........................................................... (36.4) 45.4 (56.7)
Other............................................................................... (4.4) - -
Income taxes........................................................................ (90.5) 116.4 (246.5)
Minority interest................................................................... - 129.3 (205.3)
------ ------- ------
Change in unrealized appreciation (depreciation) of investments ............... $164.9 $ (73.8) $252.4
====== ======== ======
At December 31, 1997, net appreciation of equity securities (before
income tax) was $1.3 million, consisting of $7.3 million of appreciation and
$6.0 million of depreciation.
At December 31, 1997, the amortized cost and fair value of fixed maturity
investments in default as to the payment of principal and interest totaled $2.4
million and $1.5 million, respectively. Conseco recorded writedowns of fixed
maturity investments and other invested assets of $1.2 million in 1997, $8.9
million in 1996 and $24.9 million in 1995. These writedowns were the result of
changes
66
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
in conditions that caused the Company to conclude that the decline in fair value
of the investment was other than temporary. Investment income forgone due to
defaulted securities was $.2 million in 1997, $3.8 million in 1996 and $1.6
million in 1995.
Investments in mortgage-backed securities at December 31, 1997, included
collateralized mortgage obligations ("CMOs") of $3,210.2 million and
mortgage-backed pass-through securities of $3,640.2 million. CMOs are securities
backed by pools of pass-through securities and/or mortgages that are segregated
into sections or "tranches." These securities provide for sequential retirement
of principal, rather than the pro rata share of principal return that occurs
through regular monthly principal payments on pass-through securities.
The following table sets forth the par value, amortized cost and
estimated fair value of investments in mortgage-backed securities including CMOs
at December 31, 1997, summarized by interest rates on the underlying collateral:
Par Amortized Estimated
value cost fair value
----- ---- ----------
(Dollars in millions)
Below 7 percent .................................................................... $2,025.5 $1,980.4 $2,014.7
7 percent - 8 percent............................................................... 3,568.0 3,546.5 3,638.2
8 percent - 9 percent............................................................... 712.9 716.1 730.5
9 percent and above................................................................. 445.1 455.5 467.0
-------- -------- --------
Total mortgage-backed securities................................... $6,751.5 $6,698.5 $6,850.4
======== ======== ========
The amortized cost and estimated fair value of mortgage-backed securities
including CMOs at December 31, 1997, summarized by type of security were as
follows:
Estimated fair value
--------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
(Dollars in millions)
Pass-throughs and sequential and targeted amortization classes................ $4,599.7 $4,697.5 21%
Planned amortization classes and accretion directed bonds..................... 1,515.9 1,547.6 7
Support classes............................................................... 36.0 36.9 -
Accrual (Z tranche) bonds..................................................... 27.9 28.8 -
Subordinated classes ......................................................... 519.0 539.6 2
-------- -------- ---
Total mortgage-backed securities............................. $6,698.5 $6,850.4 30%
======== ======== ==
At December 31, 1997, approximately 73 percent of the estimated fair
value of Conseco's mortgage-backed securities was determined by nationally
recognized pricing services, 8 percent was determined by broker-dealer market
makers, and 19 percent was determined by internally developed methods. The
call-adjusted modified duration of our mortgage-backed securities was 5.2 years
at December 31, 1997.
See note 4 for a discussion on interest-only securities.
At December 31, 1997, the mortgage loan balance was primarily comprised
of commercial loans, including multifamily residential loans. Approximately 20
percent, 11 percent and 9 percent of the mortgage loan balance were on
properties located in California, Texas and Florida, respectively. No other
state comprised greater than 7 percent of the mortgage loan balance. Less than 2
percent of the mortgage loan balance was noncurrent at December 31, 1997. At
December 31, 1997, the Company had an allowance for loss on mortgage loans of
$9.0 million.
At December 31, 1997, we held $558.6 million of CTLs. CTLs are mortgage
loans for commercial properties that we make based on the underwriting
guidelines described in note 1. We classify CTLs as a separate class of
securities because they are
67
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
principally underwritten based on the creditworthiness of the tenant rather than
the value of the underlying property. As with commercial mortgages, CTLs are
additionally collateralized by liens on the underlying property.
As part of its investment strategy, the Company enters into reverse
repurchase agreements and dollar-roll transactions to increase its return on
investments and improve its liquidity. Reverse repurchase agreements involve a
sale of securities and an agreement to repurchase the same securities at a later
date at an agreed upon price. Dollar rolls are similar to reverse repurchase
agreements except that, with dollar rolls, the repurchase involves securities
that are only substantially the same as the securities sold. These transactions
are accounted for as short-term collateralized borrowings. Such borrowings
averaged approximately $719.3 million during 1997 (compared with an average of
$424.7 million during 1996) and were collateralized by investment securities
with fair values approximately equal to the loan value. The weighted average
interest rate on short-term collateralized borrowings was 5.8 percent in 1997
and 5.2 percent in 1996. The primary risk associated with short-term
collateralized borrowings is that the counterparty will be unable to perform
under the terms of the contract. The Company's exposure is limited to the excess
of the net replacement cost of the securities over the value of the short-term
investments (which was not material at December 31, 1997). The Company believes
that the counterparties to its reverse repurchase and dollar-roll agreements are
financially responsible and that the counterparty risk is minimal.
Other invested assets include: (i) trading securities of $64.8 million;
(ii) S&P 500 Call Options issued in conjunction with equity-indexed annuities
described in note 1 of $41.4 million; and (iii) certain non-traditional
investments, including investments in venture capital funds, limited
partnerships, mineral rights and promissory notes of $424.5 million. During
1996, Conseco sold its non-traditional investment in Noble Broadcast Group, Inc.
and realized a gain of $30.0 million. During 1995, Conseco sold its
non-traditional investment in Eagle Credit (a finance subsidiary of
Harley-Davidson) and realized a gain of $20.6 million.
Life insurance companies are required to maintain certain investments on
deposit with state regulatory authorities. Such assets had an aggregate carrying
value of $202.5 million at December 31, 1997.
Conseco had no investments in any single entity in excess of 10 percent
of shareholders' equity at December 31, 1997, other than investments issued or
guaranteed by the United States government or a United States government agency.
4. INVESTMENTS, FINANCE RECEIVABLES AND SERVICING RIGHTS OF FINANCE
SUBSIDIARIES
We pool and securitize substantially all of the finance receivables we
originate, retaining: (i) investments in interest-only securities that are
subordinated to the rights of other investors; (ii) servicing on the contracts;
and (iii) investment in senior securities made by our insurance subsidiaries
(classified as fixed maturity securities). In a typical securitization, we sell
finance receivables to a special purpose entity, established for the limited
purpose of purchasing the finance receivables and selling securities
representing interests in the receivables. The special purpose entity issues
interest-bearing securities that are collateralized by the underlying pool of
finance receivables. We receive the proceeds from the sale of the securities in
exchange for the finance receivables. The securities are typically sold at the
same amount as the principal balance of the receivables sold. We retain a
residual interest representing the right to receive, over the life of the pool
of finance receivables, the excess of the cash flows received on the receivables
transferred to the trust over the return paid to the holders of other interests
in the securitization and servicing fees.
We recognize a gain on the sale of finance receivables equal to the
difference between the proceeds from the sale, net of related transaction costs,
and the allocated carrying amount of the receivables sold. We allocate the
carrying amount of finance receivables between the assets sold and retained
based on their relative fair values at the date of sale. The estimated fair
value of interest-only securities and servicing rights is determined by
discounting the projected cash flows over the expected life of the finance
receivables sold using prepayment, default, loss, servicing cost and discount
rate assumptions.
On a quarterly basis, we determine the estimated fair value of our
interest-only securities based on discounted projected future cash flows using
current assumptions. Differences between the estimated fair value and carrying
value of interest-only securities considered to be temporary declines are
recognized as reductions to shareholders' equity, while differences that are
considered to be other than temporary declines in value are recognized as a
reduction to earnings. Declines in value considered to be temporary are deemed
to occur when the present value of estimated future cash flows discounted at a
risk free rate using appropriate assumptions is less than the carrying value of
the interest-only securities. When declines in value considered to be other than
temporary occur, the carrying value is reduced to estimated fair value and a
loss is recognized in the statement of operations.
68
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
We recorded losses of $190 million and $200 million during 1997 and 1996
due to other than temporary declines in the fair value of interest-only
securities resulting from adverse prepayment experience. The reported value of
interest-only securities at December 31, 1997 reflects an unrealized gain.
Activity in the interest-only securities account during 1997 is as
follows (dollars in millions):
Balance at January 1..................................................... $1,014.3
Transfer to servicing rights in conjunction with implementation
of SFAS 125......................................................... (30.8)
Additions resulting from securitizations during the period............ 674.7
Investment income..................................................... 130.3
Principal and interest received....................................... (270.5)
Realized loss......................................................... (190.0)
Change in unrealized appreciation..................................... 35.2
--------
Balance at December 31................................................... $1,363.2
========
In 1995 and previous years, we sold a substantial portion of our
interest-only securities related to manufactured housing securitization
transactions between 1978 and 1995 in the form of securitized net interest
margin certificates. We retained a subordinated interest in the cash flow of the
interest-only securities sold. These interests are included in interest-only
securities and total $77.0 million at December 31, 1997.
Generally, interest-only securities relate to the sale of closed end
manufactured housing, home equity, home improvement, consumer and equipment
finance receivables. Interest-only securities are subject to a substantial
amount of credit loss and prepayment risk related to the receivables sold. In
connection with the valuation of interest-only securities, the Company has
provided for approximately $900.0 million of credit losses at December 31, 1997.
On a nondiscounted basis, the amount of credit losses provided for in connection
with the valuation of the interest-only securities is approximately $1.3
billion. These estimated losses, if realized, would reduce the amount of cash
flows available to the interest-only securities and are considered in the
determination of the estimated fair value of such securities.
The following summarizes assumptions used to determine the estimated fair
value of interest-only securities as of December 31, 1997.
Manufactured Home equity/ Consumer/
housing home improvement equipment Total
------- ---------------- --------- -----
(Dollars in millions)
Interest-only securities............................ $857.3 $335.1 $170.8 $1,363.2
Principal balance of sold managed finance
receivables...................................... 17,558.2 4,251.6 2,467.5 24,277.3
Weighted average customer interest rate on sold
managed finance receivables...................... 10.49% 11.82% 11.33%
Expected weighted average constant prepayment
rate as a percentage of principal balance of
sold managed finance receivables (1)............. 9.5% 24.0% 22.0%
Expected nondiscounted credit losses as a
percentage of principal balance of sold managed
finance receivables (1).......................... 6.2% 4.3% 2.1%
- -------------------
<FN>
(1) The valuation of interest-only securities is affected not only by the
projected level of prepayments of principal and net credit losses, as shown
above, but also by the projected timing of such prepayments and net credit
losses. Should the timing of projected prepayments of principal or net
credit losses differ materially from the timing projected by the Company,
such timing could have a material effect on the valuation of the
interest-only securities.
</FN>
69
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The weighted average interest rate we use to discount expected future
cash flows of the interest-only securities is 11.47 percent at December 31,
1997.
During the years ended December 31, 1997, 1996 and 1995, we sold $10.5
billion, $7.9 billion and $4.6 billion, respectively, of closed end receivables
in various securitized transactions and recognized gains of $569.1 million,
$388.1 million and $443.3 million, respectively.
Finance receivables, summarized by type, were as follows at December 31,
1997 (dollars in millions):
Lease........................................................................ $ 209.3
Commercial finance........................................................... 684.6
Revolving credit card........................................................ 166.3
Loans held for sale.......................................................... 930.6
--------
1,990.8
Less allowance for doubtful accounts......................................... (19.8)
--------
Net finance receivables................................................. $1,971.0
========
At January 1, 1997, we began to recognize servicing rights, as required by
SFAS 125. Servicing rights, retained subsequent to the sale of finance
receivables, are amortized in proportion to and over the estimated period of net
servicing income.
The activity in the servicing rights account during 1997 is as follows
(dollars in millions):
Balance at January 1, 1997................................................... $ -
Transfer from interest-only securities in conjunction with the
implementation of SFAS 125.............................................. 30.8
Additions resulting from securitizations
during the period....................................................... 80.9
Amortization.............................................................. (15.4)
-------
Balance at December 31, 1997................................................. $ 96.3
=======
Servicing rights are evaluated for impairment on an ongoing basis,
stratified by product type and origination period. To the extent the recorded
amount exceeds the fair value, a valuation allowance is established through a
charge to earnings. Upon subsequent measurement of the fair value of these
servicing rights in future periods, if the fair value equals or exceeds the
carrying amount, any previously recorded valuation allowance would be deemed
unnecessary and, therefore, represent current period earnings only to the extent
of such previously recorded allowance.
Prior to the implementation of SFAS 125 on January 1, 1997, we recorded
the value of our retained interests in securitizations as "excess servicing
rights" and "allowance for losses on loans sold" on our balance sheet. Excess
servicing rights receivable represented the discounted net excess cash flows
expected to be collected over the life of the loans securitized. When we
determined the value of excess servicing rights at the time of securitization,
we established an allowance for expected losses to be realized over the life of
the loans. At December 31, 1996, the excess servicing rights receivable net of
allowance for losses (currently classified as interest-only securities)
consisted of (dollars in millions):
70
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Projected residual cash flows to be received on loans sold............... $ 4,379.3
Less:
Expected prepayments.................................................. (2,221.0)
Expected servicing income............................................. (281.3)
Effect of discounting to current value................................ (505.3)
Other................................................................. (8.8)
Subordinated interests in net interest margin certifications............. 145.3
---------
1,508.2
Less allowance for losses................................................ 493.9
---------
Total net excess servicing rights................................... $ 1,014.3
=========
5. INSURANCE LIABILITIES:
Insurance liabilities consisted of the following:
Interest
Withdrawal Mortality rate
assumption assumption assumption 1997 1996
---------- ---------- ---------- ---- ----
(Dollars in millions)
Future policy benefits:
Interest-sensitive products:
Investment contracts............................ N/A N/A (c) $12,724.0 $11,491.6
Universal life-type contracts................... N/A N/A 5% 4,633.6 3,303.9
--------- -----------
Total interest-sensitive products............. 17,357.6 14,795.5
--------- ----------
Traditional products:
Traditional life insurance contracts............ Company (a) 4% 1,925.0 1,234.7
experience
Limited-payment contracts....................... None (b) 6% 968.4 761.5
Individual accident and health ................. Company Company 6% 2,820.4 1,184.0
experience experience
Group life and health........................... N/A N/A N/A 71.0 71.3
--------- ---------
Total traditional products.................... 5,784.8 3,251.5
----------- ---------
Claims payable and other policyholder funds ........ N/A N/A N/A 1,615.5 984.9
Unearned premiums................................... N/A N/A N/A 406.1 272.4
Liabilities related to separate accounts............ N/A N/A N/A 682.8 337.6
---------- ---------
Total insurance liabilities..................... $25,846.8 $19,641.9
========= =========
- -------------
<FN>
(a) Principally modifications of the 1965 - 70 and 1975 - 80 Basic, Select
and Ultimate Tables.
(b) Principally the 1984 United States Population Table and the NAIC 1983
Individual Annuitant Mortality Table.
(c) In both 1997 and 1996: (i) approximately 95 percent of this liability
represented account balances where future benefits are not guaranteed;
and (ii) 5 percent represented the present value of guaranteed future
benefits determined using an average interest rate of approximately 5
percent.
</FN>
Participating policies represented approximately 2 percent, 2 percent and
12 percent of total life insurance in force at December 31, 1997, 1996 and 1995,
respectively. Participating policies represented approximately 2 percent, 1
percent and 1 percent of premium income for the years ended December 31, 1997,
1996 and 1995, respectively. Dividends on participating policies amounted to
$13.0 million, $13.4 million and $12.3 million in 1997, 1996 and 1995,
respectively.
71
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
6. REINSURANCE:
Cost of reinsurance ceded where the reinsured policy contains mortality
risks totaled $499.0 million, $313.8 million and $72.6 million in 1997, 1996 and
1995, respectively. This cost was deducted from insurance premium revenue.
Conseco is contingently liable for claims reinsured if the assuming company is
unable to pay. Reinsurance recoveries netted against insurance policy benefits
totaled $587.5 million, $281.4 million, and $59.8 million in 1997, 1996 and
1995, respectively.
The Company has ceded certain policy liabilities under assumption
reinsurance agreements. Since all of Conseco's obligations under these insurance
contracts have been ceded to another company, insurance liabilities related to
such policies were not reported in the balance sheet. We believe the assuming
companies are able to honor all contractual commitments under the assumption
reinsurance agreements, based on our periodic reviews of financial statements,
insurance industry reports and reports filed with state insurance departments.
The Company's reinsurance receivable at December 31, 1997, relates to
approximately 181 reinsurers. Two major United States insurance companies rated
"A (Excellent)" or better by A.M. Best Company, a recognized insurance rating
agency, account for approximately 19 percent of such balance. Each of our other
reinsurers (the majority of which are rated "A- (Excellent)" or better) accounts
individually for less than 4 percent of reinsurance receivables.
7. INCOME TAXES:
Income tax liabilities were comprised of the following:
1997 1996
---- ----
(Dollars in millions)
Deferred income tax liabilities:
Actively managed fixed maturities.............................................................$ 95.9 $ (52.2)
Interest-only securities...................................................................... 737.2 451.1
Cost of policies purchased and cost of policies produced...................................... 750.5 573.7
Insurance liabilities......................................................................... (898.9) (474.0)
Unrealized appreciation....................................................................... 98.1 21.0
Net operating loss carryforward............................................................... (393.2) (174.7)
Other......................................................................................... 157.3 130.1
-------- ----------
Deferred income tax liabilities......................................................... 546.9 475.0
Current income tax assets ........................................................................ (14.1) (13.8)
-------- ---------
Income tax liabilities.................................................................. $ 532.8 $ 461.2
======= ========
Income tax expense was as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Current tax provision.........................................................................$207.9 $165.4 $165.0
Deferred tax provision........................................................................ 352.2 136.8 75.7
------ ------ ------
Income tax expense.............................................................$560.1 $302.2 $240.7
====== ====== ======
Income tax expense differed from that computed at the applicable federal
statutory rate (35 percent) for the following reasons:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Tax on income before income taxes at statutory rate........................................... $520.0 $285.5 $287.9
Goodwill...................................................................................... 29.6 12.3 7.9
State taxes................................................................................... 27.0 17.0 12.6
Other......................................................................................... (16.5) (12.6) 7.2
Reversal of deferred tax liabilities as a result of increased ownership in certain
subsidiaries............................................................................... - - (74.9)
------ ------ ------
Income tax expense................................................................... $560.1 $302.2 $240.7
====== ====== ======
72
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
At December 31, 1997, Conseco had federal income tax loss carryforwards
of $1,123.1 million available (subject to various statutory restrictions) for
use on future tax returns. Portions of these carryforwards begin expiring in
1999. Of the loss carryforwards: (i) $25.3 million may be used only to offset
income from the non-life insurance companies and, under certain circumstances, a
portion of the income of life insurance companies; and (ii) $463.5 million are
attributable to acquired companies and may be used only to offset the income
from those companies. None of the carryforwards are available to reduce the tax
provision for financial reporting purposes. With respect to determining that the
Company's net operating loss carryforwards will be fully utilized, the Company
is relying upon its past history of earnings.
The IRS has completed its examination of Conseco's consolidated tax
returns for years through 1994 and is currently conducting an examination for
years 1995 through 1996. Certain companies acquired in the LPG Merger have been
audited by the IRS through 1994. Colonial Penn Life Insurance Company is
currently being examined for the tax years 1992 and 1993. Conseco believes the
adjustment, if any, related to these audits will not be significant.
8. NOTES PAYABLE AND COMMERCIAL PAPER:
Notes payable and commercial paper related to corporate activities at
December 31, 1997 and 1996, were as follows:
Interest rate 1997 1996
------------- ---- ----
(Dollars in millions)
Bank debt............................................................ 6.23% (1) $1,000.0 (2) $ 465.0
Leucadia Notes....................................................... 6.44% (1) 400.0 -
Senior notes due 2003................................................ 8.125% 168.5 170.0
Senior notes due 2004................................................ 10.5% 184.9 200.0
Subordinated notes due 2004.......................................... 11.25% 10.9 98.1
Convertible subordinated notes due 2003.............................. 6.5% 86.1 -
Convertible subordinated debentures due 2005......................... 6.5% 29.1 102.8
Commercial paper..................................................... 5.8% (3) 448.2 -
Other................................................................Various 21.3 45.2
-------- --------
Total principal amount.......................................... 2,349.0 1,081.1
Unamortized net premium.............................................. 5.9 13.8
-------- --------
Total........................................................... $2,354.9 $1,094.9
======== ========
- --------------------
<FN>
(1) Current rate at December 31, 1997.
(2) See note 15 for description of $248.0 million repayment in 1998 using proceeds from the offering of 6.4 percent notes due
February 10, 2003.
(3) Weighted average rate during 1997.
</FN>
Maturities of notes payable and commercial paper at December 31, 1997,
were as follows:
Maturity date Amount
------------- ------
(Dollars in millions)
1998....................................................................... $1,049.3 (1)
1999....................................................................... 1.1
2000....................................................................... 1.1
2001....................................................................... 401.1
2002....................................................................... 2.0
Thereafter................................................................. 894.4
--------
Total par value at December 31, 1997.................................. $2,349.0
========
<FN>
(1) See note 15 for description of $248.0 million repayment in 1998 using proceeds from the offering of 6.4 percent notes due
February 10, 2003.
</FN>
73
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Bank debt. Bank debt is comprised of our revolving bank credit facility
and various bank loans described below.
The Company's current revolving credit agreement (the "Credit Facility"),
executed in November 1996, permits borrowings up to $1.4 billion. Maximum
permitted borrowings under the Credit Facility are reduced by any aggregate
outstanding commercial paper of Conseco. At December 31, 1997, outstanding
borrowings under the Credit Facility totaled $400.0 million. Borrowings bear
interest at the bank's base rate, a Eurodollar rate or a rate determined based
on a solicitation of bids from lenders. Eurodollar rates are equal to the
reserve-adjusted LIBOR rate plus a margin of .225 percent to .75 percent, based
on the credit rating of Conseco's senior notes. The current margin of .35
percent will increase by .125 percent after December 31, 1997, if Conseco's debt
to total capitalization ratio exceeds 35 percent. Borrowings at December 31,
1997, bore interest at a weighted average rate of 6.21 percent. The Credit
Facility also permits revolving Swingline loans up to $50.0 million. Such loans
are due within 7 days and bear interest at the bank's base rate or a reserve
adjusted three-month CD rate plus the Eurodollar rate margin and an assessment
rate.
Borrowings are due in November 2001. Mandatory prepayments, which reduce
the maximum permitted borrowings, are required under the Credit Facility upon
the sale or disposition of any significant assets other than in the ordinary
course of business. The Credit Facility contains various restrictive covenants
that primarily pertain to levels of indebtedness, limitations on payment of
dividends, limitations on the quality and types of investments, and capital
expenditures. Additionally, the Company must comply with several financial
covenant restrictions, including maintaining: (i) shareholders' equity and
Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts in excess of $2.4 billion in 1997 and 1998 and $3.5 billion thereafter;
(ii) the interest coverage ratio in excess of 2.5:1 through December 1997
(escalating to 2.75:1 during the period January 1, 1998 through December 31,
1999; and 3.0:1 thereafter); and (iii) the debt to total capital ratio less than
.45:1. As of December 31, 1997 the Company was in compliance with all covenants
under its debt agreements.
On the last day of each quarter, we pay a commitment fee that ranges from
.08 percent to .25 percent per annum (depending on the credit rating of
Conseco's senior debt) on the average daily unused commitments during the
quarter. This fee was .125 percent per annum during 1997.
During 1997, Conseco entered into various unsecured bank loans totaling
$600 million. The proceeds from such bank loans were used: (i) to finance the
WNIC Merger; (ii) to finance a portion of the Colonial Penn Purchase; (iii) to
redeem all of the $2.16 Redeemable Cumulative Preferred Stock of a subsidiary
formerly held by minority interest; and (iv) for general corporate purposes. The
interest rates on these bank loans are based on LIBOR and averaged 6.25 percent
at December 31, 1997. These bank loans mature at various dates through September
1998.
We recognized an extraordinary loss of $12.9 million during 1996 (net of
a $7.0 million tax benefit) as a result of prepaying our prior bank credit
agreements and the bank credit agreements of BLH and ALH.
Leucadia Notes. Conseco entered into these notes in conjunction with the
Colonial Penn Purchase. The notes bear interest at the one month LIBOR rate plus
a margin of .50 percent payable semi-annually on March 31 and September 30. Such
rate was 6.44 percent at December 31, 1997. The notes mature on January 2, 2003
and may be put back to Conseco by the holder at any time after December 31,
1997, in the event that: (i) all or substantially all of Leucadia's assets are
sold; or (ii) there is an acquisition of beneficial ownership of 20 percent or
more of Leucadia's voting securities. In addition, the notes are putable (in
whole or in increments of $10 million of par value) at any time on or after
September 30, 1999, at a discount to par. The discount rate is equal to (i) 3
percent of the then outstanding principal balance during the period September
30, 1999, through September 29, 2000; (ii) 2 percent of the then outstanding
principal balance during the period September 30, 2000, through September 29,
2001; and (iii) 1 percent of the then outstanding principal balance thereafter
prior to maturity. The notes and accrued interest thereon are secured by standby
letters of credit totaling $420.0 million which Conseco may use to fund
redemption of the notes. Such letters of credit expire on September 30, 1998,
but may be extended in one-year increments through 2003. The Company pays a fee
on the letters of credit based upon the credit rating of Conseco's senior debt.
At December 31, 1997, such fee was .20 percent per annum on the $420.0 million
of outstanding letters of credit.
8.125% senior notes due 2003 were issued to the public in 1993, are
unsecured and rank pari passu with all other unsecured and unsubordinated
indebtedness of the Company. The notes are not redeemable prior to maturity. We
recognized an extraordinary charge of $.1 million during 1997 as a result of
repurchasing $1.5 million par value of these notes.
74
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
10.5% senior notes due 2004 were issued to the public by CCP in 1994, are
unsecured and rank pari passu with all other unsecured and unsubordinated
indebtedness of Conseco. The notes are not redeemable prior to maturity. We
recognized an extraordinary charge of $1.2 million (net of a $.6 million tax
benefit) during 1997 as a result of repurchasing $15.1 million par value of
these notes.
11.25% senior subordinated notes due 2004 were issued to the public by
ALH in conjunction with its acquisition by Partnership II. Such notes are
unsecured and will be subordinated in the right of payment to the prior payment
in full of all senior indebtedness. The notes are redeemable at the Company's
option, in whole or in part, at any time on or after September 15, 1999,
initially at 105.625 percent of their principal amount, plus accrued interest,
declining to 100 percent of their principal amount, plus accrued interest, on
and after September 15, 2001. We recognized an extraordinary charge of $5.6
million (net of a $3.0 million tax benefit) during 1997 as a result of
repurchasing $87.2 million par value of these notes. We recognized an
extraordinary charge of $4.2 million (net of a $2.3 million tax benefit) during
1996 as a result of repurchasing $51.9 million par value of these notes.
6.5% convertible subordinated notes due 2003 were acquired in conjunction
with the PFS Merger and bear interest at 6.5 percent payable semi-annually on
April 1 and October 1. The notes are redeemable by Conseco, under certain
conditions, at 103.3 percent of par value after April 1999 under certain
conditions. The notes are convertible into Conseco common stock any time prior
to maturity at a conversion rate of 35.38 Conseco common shares per $1,000
principal amount of notes. During 1997, $.2 million par value of the notes were
converted into 6,613 shares of Conseco common stock. At December 31, 1997, the
value of the remaining debentures in excess of the principal balance (the value
attributable to the conversion feature) of $34.4 million is included in other
liabilities.
6.5% convertible subordinated debentures due 2005 were acquired in
conjunction with the ATC Merger and are convertible into Conseco common stock at
any time prior to maturity, at a conversion ratio of 76.96 shares of Conseco
common stock for each $1,000 principal amount of debentures. The convertible
debentures may be redeemed at Conseco's option at a price equal to 103.25
percent after October 1998, declining to 100 percent after October 2001. During
1997, we induced the conversion of $64.8 million par value of the debentures
into 5.0 million shares of Conseco common stock. Conseco paid $4.4 million to
induce the holders to convert. In addition, during 1997, Conseco repurchased
$7.5 million par value of the debentures for $24.8 million. An additional $1.4
million par value of the debentures was converted into .1 million shares of
Conseco common stock at the option of the holders during 1997. At December 31,
1997, the value of the remaining debentures in excess of the principal balance
(the value attributable to the conversion feature) of $38.2 million is included
in other liabilities.
Other debt. During the third quarter of 1997, we repurchased or called
for redemption the remaining $23.2 million par value of 12.75 percent senior
subordinated notes due 2002. Such notes had been assumed in connection with the
LPG Merger.
In March 1996, BLH completed a tender offer in which it repurchased
$148.3 million principal balance of its senior subordinated notes. In addition,
Conseco repurchased $28.5 million of such notes during 1996. Conseco recognized
an extraordinary charge of $9.0 million (net of a $4.9 million tax benefit)
related to such repurchases.
In conjunction with the LPG Merger and the THI Merger, Conseco repaid
acquired debt in 1996 of $214.5 million and $78.5 million, respectively. Conseco
also repurchased other debt of $65.8 million during 1996. Conseco recognized an
extraordinary charge of $.4 million (net of $.2 million tax benefit) related to
such repurchases.
Conseco recognized extraordinary charges of $2.1 million (net of a $1.5
million tax benefit) in 1995 related to the repayment of notes payable.
Commercial paper. We instituted a commercial paper program in April 1997
to lower our borrowing costs and improve our liquidity. Borrowings under our
commercial paper program averaged approximately $525.9 million during the period
April 24, 1997 through December 31, 1997. The weighted average interest rate on
such borrowings was 5.8 percent during 1997. Conseco's commercial paper has
maturities ranging from 2 to 37 days. However, the Company has the ability to
refinance such obligations through its bank credit facility.
75
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Notes payable related to consumer and commercial financing activities of
our subsidiary, Green Tree, were as follows:
December 31,
------------------
Interest rate 1997 1996
------------- ---- ----
(Dollars in millions)
Commercial paper..................................................... 6.08% $1,319.1 $431.2
Medium term notes.................................................... 6.62 246.6 26.7
Senior subordinated notes............................................ 10.80 263.7 263.7
Unsecured lines of credit............................................ 5.80 35.0 39.0
Other................................................................ 2.00 1.9 1.9
-------- ------
Total............................................................. $1,866.3 $762.5
======== ======
Commercial paper. At December 31, 1997, Green Tree had a commercial paper
program through which it was authorized to issue up to $2.0 billion in notes of
varying terms to meet its warehousing liquidity needs. This program was backed
by a combination of Green Tree's bank credit agreements and master repurchase
agreements. During the fourth quarter of 1997 and the first quarter of 1998,
Green Tree's senior unsecured debt ratings were lowered by each of the credit
rating agencies which provide ratings on its debt. As a result of these ratings
actions, Green Tree curtailed its issuance of commercial paper in favor of its
master repurchase agreements and bank credit lines.
Medium term notes. The medium term notes are senior notes with either
fixed or floating rates of interest and with maturities in excess of nine
months. Interest on these notes is payable semi-annually.
Senior subordinated notes. The senior subordinated notes are due June 1,
2002. Interest on the notes is payable semi-annually.
Unsecured lines of credit. At December 31, 1997, Green Tree had two lines
of credit totaling $1.5 billion, one of which expired April 28, 1998, and
another which expires April 28, 2000. Green Tree had total borrowings of $35.0
million outstanding under the lines at December 31, 1997. The lines contained
various restrictive covenants such as maintenance of a minimum net worth by
Green Tree of $750 million and a debt to net worth ratio of less than 5 to 1.
The lines were substantially restructured in early 1998 and were subsequently
paid off.
Green Tree also had various master repurchase agreements in place with
several investment banking firms which could provide up to $2.8 billion in
borrowings subject to the availability of eligible collateral. There were no
outstanding balances due under these facilities at December 31, 1997 and 1996.
Subsequent to year end, Green Tree amended several of its master
repurchase agreements to provide for financing a broader range of receivables,
which increased the total potential lines to $3.8 billion. In addition, Green
Tree entered into a $500 million line of credit secured by interest-only
securities. Such line matures on February 12, 2000, with an option to extend for
an additional one year term.
76
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
9. OTHER DISCLOSURES:
Leases
The Company rents office space, equipment and computer software under
noncancellable operating leases. Rental expense was $48.2 million in 1997, $30.0
million in 1996 and $26.9 million in 1995. Future required minimum rental
payments as of December 31, 1997, were as follows (dollars in millions):
1998....................................... $ 34.7
1999....................................... 30.6
2000....................................... 26.3
2001....................................... 22.1
2002....................................... 17.9
Thereafter................................. 55.5
------
Total.................... $187.1
======
Employment Arrangements
Some officers of the Company are employed under long-term employment
agreements. One of these agreements provides for a base salary plus an annual
bonus equal to 3 percent of the Company's consolidated defined pretax profits.
This contract was modified to permit a reduction in such bonus amount for 1997.
This agreement renews annually for a five-year period unless either party
notifies the other, in which case the agreement expires five years from the last
renewal date. In addition, a $1.9 million interest-free loan has been granted to
the officer. Repayment is due two years after termination of the officer's
employment contract.
The agreements described above also include provisions under which the
employees may elect to receive, in the event of a termination of the agreement
following a change in control of the Company (as defined), a severance allowance
equal to 60 months' salary, bonus and other benefits. The employee also may
elect to have the Company purchase all Conseco stock and all options to purchase
Conseco stock, without deduction of the applicable exercise prices, held by such
person at a price per share equal to the highest market price in the preceding
six months.
Green Tree had a key executive stock bonus plan pursuant to which shares
were issued based on Green Tree's earnings and the market price of a share of
Green Tree common stock at the date of the employment agreement (such price
being equivalent to $2.72 per share of Conseco common stock). Total equivalent
shares of Conseco common stock issued under the plan during 1997, 1996 and 1995
were 2.2 million, 1.8 million and 1.2 million, respectively. In January 1998,
the executive returned .7 million equivalent shares of Conseco common stock in
connection with Green Tree's recomputation of the bonus amount for 1996.
The Company has qualified defined contribution plans in which
substantially all employees are eligible to participate. Company contributions,
which match certain voluntary employee contributions to the plan, totaled $3.8
million in 1997, $2.0 million in 1996, and $2.2 million in 1995. These
contributions may be made either in cash or in Conseco common stock.
The Company also has a stock bonus and deferred compensation program for
certain officers and directors. Company contributions vary based on the
profitability of the Company. Each year's contribution, which is fully funded in
the form of Conseco common stock, vests five years later or upon certain other
events. The cost of the program is charged to expense over the vesting period
and amounted to $14.4 million in 1997 ($10.3 million of which is a nonrecurring
charge due to the death of an executive officer), $3.9 million in 1996 and $3.7
million in 1995. The market value of Conseco common stock held under the program
(included in other assets and other liabilities) was $158.0 million and $101.7
million at December 31, 1997 and 1996, respectively.
The Company has a noncontributory, unfunded deferred compensation plan
for qualifying members of Bankers Life's career agency force. Benefits are based
on years of service and career earnings. The liability recognized in the
consolidated balance sheet for the agents' deferred compensation plan was $37.3
million and $34.5 million at December 31, 1997 and 1996, respectively.
Substantially all of this liability represents vested benefits. Costs incurred
on this plan, primarily representing interest on unfunded benefit costs, were
$3.4 million, $3.2 million and $2.8 million during 1997, 1996 and 1995,
respectively.
77
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The Company also provides certain health care and life insurance benefits
for eligible retired employees of certain subsidiaries under partially funded
and unfunded plans in existence at the date on which such subsidiaries were
acquired. Benefits under the plans are provided on a contributory basis. Some of
the benefits provided are subject to cost-sharing features determined at the
discretion of management. Amounts related to these postretirement benefit plans
(which increased in 1997 as a result of acquisitions) are as follows:
1997 1996
---- ----
(Dollars in millions)
Accumulated postretirement benefit obligations:
Retirees, dependents and disabled participants.................... $23.1 $1.9
Fully eligible active plan participants........................... 2.1 4.6
Other active participants......................................... .5 .6
----- ----
Total accumulated postretirement benefit obligations............ 25.7 7.1
Unrecognized net reduction in prior service cost.................... 1.6 2.8
Fair value of assets held for partially funded plan................. (5.9) -
----- ----
Accrued liability included in other liabilities................. $21.4 $9.9
===== ====
The weighted average rate used in determining the accumulated
postretirement benefit obligations under the plans was 7.25 percent. The
weighted average after-tax expected rate of return on plan assets was 4.60
percent. The health care cost trend rate in 1997 was 11.1 percent for pre-age 65
and 9.3 percent for post-age 65 participants, graded evenly to 5.0 percent in 13
years. Increasing the trend rate by 1 percent would increase the accumulated
postretirement benefit obligation by $1.5 million at December 31, 1997 (for
plans without employer's maximum cost sharing provisions).
Green Tree has a qualified noncontributory defined benefit pension plan
covering substantially all of its employees over 21 years of age. The plan's
benefits are based on years of service and the employee's compensation. The plan
is funded annually based on the maximum amount that can be deducted for federal
income tax purposes. The assets of the plan are primarily invested in common
stock, corporate bonds and cash equivalents. In addition, Green Tree maintains a
nonqualified pension plan for certain key employees. Amounts related to the
Green Tree plans are as follows:
1997 1996
---------------------------- ---------------------------
Qualified Supplemental Qualified Supplemental
Plan Plan Plan Plan
---- ---- ---- ----
(Dollars in millions)
Vested benefit obligation.......................... $ 7.8 $17.1 $ 6.9 $13.0
===== ===== ===== =====
Accumulated benefit obligation..................... $11.1 $17.1 $ 8.3 $13.2
===== ===== ===== =====
Projected benefit obligation....................... $21.8 $51.1 $17.0 $22.8
Fair value of assets held for partially funded plan (9.1) - (7.1) -
----- ----- ----- -----
Excess of projected benefit obligation
over plan assets............................ 12.7 51.1 9.9 22.8
Unrecognized net loss.............................. (7.7) (35.4) (7.1) (13.4)
Prior service cost................................. .3 - .4 -
Unrecognized net obligation (asset)................ - (.2) .1 (.3)
----- ----- ----- -----
Accrued liability included in other liabilities $ 5.3 $15.5 $ 3.3 $ 9.1
===== ===== ===== =====
1997 1996 1995
---- ---- ----
(Dollars in millions)
Net periodic pension cost:
Service cost............................................. $ 4.9 $3.1 $1.1
Interest cost on projected benefit obligation............ 3.9 1.9 .6
Actual return on plan assets............................. (1.3) (.8) (.8)
Net amortization and deferral............................ 2.5 1.1 .4
----- ---- ----
Net periodic pension cost.............................. $10.0 $5.3 $1.3
===== ==== ====
The preretirement discount rate, postretirement discount rate and rate of
increase in future compensation levels used for determining obligations as of
December 31, 1997 were 6.75 percent, 6.5 percent and 5.5 percent, respectively,
and for determining expense at December 31, 1996 were 7.25 percent, 6.5 percent
and 5.5 percent, respectively. Preretirement mortality table and
78
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
postretirement mortality tables were used for determining expense and
obligations at December 31, 1997. The wage base under Social Security was
assumed to increase at 4.5 percent per year starting in 1997. The maximum
benefit and compensation contained in Sections 415(b) and 401(a)(17) of the IRS
Code are assumed to increase by 4.0 percent per year in the future. Total
pension expense for the Green Tree plans in 1997, 1996 and 1995 was $14.1
million, $5.3 million and $3.1 million, respectively.
Green Tree also has a 401(k) Retirement Savings Plan available to all
eligible employees. To be eligible for the plan, the employee must be at least
21 years of age and have completed six months of employment at Green Tree during
which the employee worked at least 1,000 hours. Eligible employees may
contribute to the plan up to 15 percent of their earnings with a maximum of
$9,500 for 1997 based on the Internal Revenue Service annual contribution limit.
The Company will match 50 percent of the employee contributions for an amount up
to 6 percent of each employee's earnings. Contributions are invested at the
direction of the employee to one or more funds. Company contributions vest after
three years. Company contributions to the Green Tree plan were $2.5 million,
$1.3 million and $.9 million in 1997, 1996 and 1995, respectively.
Litigation
Green Tree has been served with various related lawsuits which were filed
against Green Tree in United States District Court for the District of
Minnesota. These lawsuits were filed by certain former stockholders of Green
Tree as purported class actions on behalf of persons or entities who purchased
common stock of Green Tree during the alleged class periods that generally run
from February 1995 to January 1998. One such action did not include class action
claims. In addition to Green Tree, certain current and former officers and
directors of Green Tree are named as defendants in one or more of the lawsuits.
Green Tree and other defendants intend to seek consolidation in the United
States District Court for the District of Minnesota of each of the lawsuits
seeking class action status. Plaintiffs in the lawsuits assert claims under
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. In each case,
plaintiffs allege that Green Tree and the other defendants violated federal
securities laws by, among other things, making false and misleading statements
about the current state and future prospects of Green Tree (particularly with
respect to prepayment assumptions and performance of certain of Green Tree's
loan portfolios) which allegedly rendered Green Tree's financial statements
false and misleading. The Company believes that the lawsuits are without merit
and intends to defend such lawsuits vigorously.
The Company and its subsidiaries are involved in lawsuits related to
their operations. In most cases, such lawsuits involve claims under insurance
policies or other contracts of the Company.
None of the lawsuits currently pending, either individually or in the
aggregate, is expected to have a material effect on the Company's consolidated
financial condition, cash flows or results of operations.
Guaranty Fund Assessments
From time to time, mandatory assessments are levied on the Company's
insurance subsidiaries by life and health guaranty associations of most states
in which these subsidiaries are licensed. These assessments are to cover losses
to policyholders of insolvent or rehabilitated insurance companies. The
associations levy assessments (up to prescribed limits) on all insurers in a
particular state in order to pay claims on the basis of the proportionate share
of premiums written by insurers in the lines of business in which the insolvent
or rehabilitated insurer is engaged. These assessments may be deferred or
forgiven in certain states if they would threaten an insurer's financial
strength and, in some states, these assessments can be partially recovered
through a reduction in future premium taxes. The balance sheet at December 31,
1997, includes accruals of $16.9 million, which approximate the Company's
estimate of: (i) all known assessments that will be levied against the Company's
insurance subsidiaries by various state guaranty associations based on premiums
that have been written through December 31, 1997; less (ii) amounts that would
be recoverable through a reduction in
79
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
future premium taxes as a result of such assessments. Such estimate is subject
to change as the associations determine more precisely the losses that have
occurred and how such losses will be allocated to insurance companies. The
Company's cost for such assessments incurred by its insurance company
subsidiaries was $3.7 million in 1997, $4.0 million in 1996 and $3.2 million in
1995.
Minority Interest
Minority interest represents the interest of investors other than Conseco
in its subsidiaries. Minority interest at December 31, 1997, includes: (i)
Company-obligated mandatorily redeemable preferred securities of subsidiary
trusts with a carrying value of $1,383.9 million; and (ii) $.7 million interest
in the common stock of a subsidiary of ALH. Minority interest at December 31,
1996, included: (i) $600.0 million par value of Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts; (ii) $97.0 million
interest in the redeemable preferred stock of a subsidiary of ALH; and (iii) $.7
million interest in the common stock of a subsidiary of ALH.
Company-Obligated Mandatorily Redeemable Preferred Securities of
Subsidiary Trusts
Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts at December 31, 1997, were as follows:
Estimated
Amount Carrying fair
outstanding value value
----------- ----- -----
(Dollars in millions)
9.16% Trust Originated Preferred Securities ("TOPrS")................. $ 275.0 $ 275.0 $ 284.6
8.70% Capital Trust Pass-through Securities ("TruPS")................. 325.0 325.0 359.2
8.796% Capital Securities............................................. 300.0 300.0 335.3
FELINE PRIDES......................................................... 500.0 483.9 512.5
--------- -------- --------
$1,400.0 $1,383.9 $1,491.6
======== ======== ========
On November 19, 1996, Conseco Financing Trust I ("Trust I"), a wholly
owned subsidiary of Conseco, issued 11 million of the TOPrS at $25 per security.
Each TOPrS security pays cumulative cash distributions at the annual rate of
9.16 percent of the stated $25 liquidation amount per security, payable
quarterly. The TOPrS are fully and unconditionally guaranteed by Conseco.
Proceeds from the offering of $266.1 million (after underwriting and associated
costs) were used by the trust to purchase a subordinated debenture from Conseco.
Conseco then used the net proceeds to repay bank debt. Conseco has the right to
redeem the securities at any time, in whole or in part, on or after November 19,
2001, at the principal amount plus accrued and unpaid interest. The securities
are subordinated to all senior indebtedness of Conseco and mature on November
30, 2026. Conseco may extend the maturity date by one or more periods, but in no
event later than November 30, 2045. The terms of the TOPrS parallel the terms of
Conseco's debentures held by Trust I, which debentures account for substantially
all of the assets of Trust I.
On November 27, 1996, Conseco Financing Trust II ("Trust II"), a wholly
owned subsidiary of Conseco, issued 325,000 of the TruPS at $1,000 per security.
Each TruPS security pays cumulative cash distributions at the annual rate of
8.70 percent of the stated $1,000 liquidation amount per security, payable
semi-annually. The TruPS are fully and unconditionally guaranteed by Conseco.
Proceeds from the offering of $321.6 million (after underwriting and associated
costs) were used by the trust to purchase a subordinated debenture from Conseco.
Conseco then used the net proceeds to repay bank debt. Conseco has the right to
redeem the securities at the principal amount plus a premium equal to the
excess, if any, of the sum of the discounted present values of the remaining
scheduled payments of principal and interest over the principal amount of
securities to be redeemed. The securities are subordinated to all senior
indebtedness of Conseco and mature on November 15, 2026. The terms of the TruPS
parallel the terms of Conseco's debentures held by Trust II, which debentures
account for substantially all of the assets of Trust II.
On March 31, 1997, Conseco Financing Trust III ("Trust III"), a wholly
owned subsidiary of Conseco, issued 300,000 Capital Securities at $1,000 per
security. Each Capital Security pays cumulative cash distributions at the annual
rate of 8.796 percent of the stated $1,000 liquidation amount per security,
payable semi-annually. The Capital Securities are fully and unconditionally
guaranteed by Conseco. Proceeds from the offering of $296.7 million (after
underwriting and associated costs) were used by the trust to purchase
80
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
a subordinated debenture from Conseco. Conseco then used the net proceeds to
repay bank debt. Conseco has the right to redeem the securities at the principal
amount plus a premium equal to the excess, if any, of the sum of the discounted
present values of the remaining scheduled payments of principal and interest
over the principal amount of securities to be redeemed. The securities are
subordinated to all senior indebtedness of Conseco and mature on April 1, 2027.
The terms of the Capital Securities parallel the terms of Conseco's debentures
held by Trust III, which debentures account for substantially all of the assets
of Trust III.
On December 12, 1997, Conseco Financing Trust IV ("Trust IV"), a wholly
owned subsidiary of Conseco, issued 10,000,000 FELINE PRIDES at $50 per
security. Each FELINE PRIDES includes: (a) a stock purchase contract under which
(i) the holder will purchase a number of shares of Conseco common stock on
February 16, 2001 (ranging from .9363 and 1.1268 shares per FELINE PRIDES) under
the terms specified in the stock purchase contract; and (ii) will receive a
contract adjustment payment equal to .25 percent of the value of the security;
and (b) a beneficial ownership of a 6.75 percent trust originated preferred
security. Each holder will receive aggregate cumulative cash distributions at
the annual rate of 7 percent of the $50 stated amount per security, payable
quarterly. The applicable distribution rate on the trust originated preferred
securities that remain outstanding during the period February 16, 2001 through
February 16, 2003, will be reset so that the market value of the trust
originated preferred securities will be equal to 100.5 percent of the par value.
Conseco may limit the market rate reset to be no higher than the rate on the
2-year benchmark Treasury plus 200 basis points. The trust originated preferred
securities are fully and unconditionally guaranteed by Conseco. Proceeds from
the offering of approximately $483.7 million (after underwriting and associated
costs) were used by the trust to purchase a subordinated debenture from Conseco.
Conseco then used the net proceeds to repay bank debt and for other corporate
purposes. The trust originated preferred securities are subordinated to all
senior indebtedness of Conseco and mature on February 16, 2001. The terms of the
trust originated preferred security parallel the terms of Conseco's debentures
held by Trust IV, which debentures account for substantially all of the assets
of Trust IV.
Common Stock
At December 31, 1997 and 1996, minority interest in common stock of
Conseco's subsidiaries includes only the $.7 million interest in the common
stock of a subsidiary.
Changes in minority interest in common and preferred stock of
consolidated subsidiaries during 1997 and 1996 are summarized below:
1997 1996
---- ----
(Dollars in millions)
Minority interest, beginning of year........................................................... $ 97.7 $403.3
Changes in investments held by minority interest:
Repurchase of mandatorily redeemable preferred stock of a subsidiary.................... (93.4) -
Mandatorily redeemable preferred stock of a subsidiary held by PFS prior to the
PFS Merger........................................................................... (2.7) -
Transactions resulting from ALH Stock Purchase, BLH Merger and related events........... - (224.9)
Equity of minority interest in the change in financial position of the
Company's subsidiaries:
Dividends............................................................................. (3.3) (10.0)
Amortization of value in excess of par of mandatorily redeemable preferred stock...... (.9) -
Net income before extraordinary charge................................................ 3.3 31.3
Extraordinary charge.................................................................. - (1.7)
Unrealized depreciation of securities ................................................ - (100.3)
------ ------
Minority interest, end of year ................................................................ $ .7 $ 97.7
====== ======
During 1997, we completed the purchase of all of the mandatorily
redeemable preferred stock of a subsidiary formerly held by minority interests.
81
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
10. SHAREHOLDERS' EQUITY:
Authorized preferred stock is 20 million shares. On January 23, 1996,
Conseco completed the offering of 4.37 million shares of PRIDES. Proceeds from
the offering of $257.7 million (after underwriting and other associated costs)
were used to repay notes payable of Conseco. Each share of PRIDES pays quarterly
dividends at the annual rate of 7 percent of the $61.125 liquidation preference
per share (equivalent to an annual amount of $4.279 per share). On February 1,
2000, unless either previously redeemed by Conseco or converted at the option of
the holder, each share of PRIDES will mandatorily convert into four shares of
Conseco common stock, subject to adjustment in certain events. Shares of PRIDES
are not redeemable prior to February 1, 1999. From February 1, 1999 through
February 1, 2000, the Company may redeem any or all of the outstanding shares of
PRIDES. Upon such redemption, each holder will receive, in exchange for each
share of PRIDES, the number of shares of Conseco common stock equal to (i) the
sum of (a) $62.195, declining to $61.125; and (b) accrued and unpaid dividends
divided by (ii) the market price of Conseco common stock at such date. In no
event will a holder receive less than 3.42 shares of Conseco common stock.
During 1996, 400 shares of PRIDES were converted by holders of such shares into
1,368 shares of Conseco common stock. In 1997, the holders of 2,374,300 shares
of PRIDES converted such shares into 8.1 million shares of common stock. We paid
$13.2 million to induce these conversions. We recorded this payment in the
consolidated financial statements as a dividend paid to such holders. In
addition, during 1997, 100,050 shares of PRIDES were converted by holders of
such shares into 342,171 shares of Conseco common stock.
Conseco issued 5.75 million shares of Series D Cumulative Convertible
Preferred Stock ("Series D preferred stock") with annual dividends of $3.25 per
share and with a total stated value of $287.5 million ($50 per share) in January
1993 in a public offering. Prior to January 1, 1995, Conseco had repurchased or
the holders had converted 80,275 Series D preferred shares. In 1996, the Company
exercised its right to redeem all outstanding Series D preferred stock. A total
of 6,358 Series D shares were redeemed at $52.916 per share including $.641 per
share of accrued and unpaid dividends. Holders of the remaining 5,666,559 Series
D shares elected to convert their shares into 17,766,864 shares of Conseco
common stock.
Changes in the number of shares of common stock outstanding during the
years ended December 31, 1997, 1996 and 1995 were as follows:
1997 1996 1995
---- ---- ----
(Shares in thousands)
Balance, beginning of year...................................................... 293,359 205,202 212,737
Stock options exercised..................................................... 12,825 5,990 2,010
Shares issued in conjunction with acquired companies........................ 11,264 60,560 -
Common shares converted from convertible subordinated debentures............ 5,138 4,250 -
Common shares converted from Series D preferred shares...................... - 17,767 -
Common shares converted from PRIDES......................................... 8,463 1 -
Shares issued under employee and agent benefit compensation plans........... 1,498 1,246 425
Treasury stock purchased.................................................... (22,535) (1,657) (9,970)
------- ------- -------
Balance, end of year............................................................ 310,012 293,359 205,202
======= ======= =======
Dividends declared on common stock for 1997, 1996 and 1995, were $.313,
$.083 and $.046 per common share, respectively. A liability was accrued for
dividends declared but unpaid at December 31, 1997, totaling $23.5 million. Such
dividends were paid in January 1998.
The Company was authorized under its 1983 employee stock option plan to
grant options to purchase up to 48 million shares of Conseco common stock at a
price not less than its market value on the date the option was granted. The
1983 stock option plan continues to govern options granted thereunder, but
expired in all other respects in December 1993. The 1994 Stock and Incentive
Plan authorizes the granting of options to employees and directors of the
Company to purchase up to 24 million shares of Conseco common stock at a price
not less than its market value on the date the option is granted. The options
may become exercisable immediately or over a period of time. The plan also
permits granting of stock appreciation rights and certain other awards. In 1997,
the Company adopted the 1997 Non-qualified Stock Option Plan which authorizes
the granting of non-qualified options to employees of the Company to purchase
shares of Conseco common stock. The aggregate number of shares of common stock
for which options may be granted under the 1997 plan, when added to all
outstanding, unexpired options under the Company's other employee benefit
82
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
plans, shall not exceed 20 percent of the total of shares of common stock
outstanding plus the number of shares issuable upon conversion of any
outstanding convertible security on the date of grant (calculated in the manner
set forth in the 1997 plan).
Conseco implemented two option exercise programs under which its chief
executive officer and four of its executive vice presidents exercised
outstanding options to purchase 9.1 million shares of Conseco common stock under
the 1997 program (the "1997 Program") and 3.1 million shares under the 1996
program (the "1996 Program"). The options exercised would otherwise have
remained exercisable until various dates through 2006 with respect to the 1997
Program and until the years 2000 through 2002 with respect to the 1996 Program.
We implemented these programs in order to accelerate the recording of tax
benefits we derived from the exercise of the options and to better manage our
capital structure. With respect to both programs, no cash was exchanged as the
executives paid for the exercise price of the options by tendering previously
owned shares. The Company withheld shares or the executives tendered previously
held shares to cover federal and state taxes owed by the executives as a result
of the exercise transactions. The 1997 Program resulted in the following changes
to common stock and additional paid-in capital: (i) an increase for a tax
benefit of $81.9 million (net of payroll taxes incurred of $3.5 million); (ii)
an increase for the exercise price of $120.0 million; and (iii) a decrease of
$229.9 million related to shares withheld or tendered by the executives for the
exercise price and for federal and state taxes. The 1996 Program resulted in the
following changes to common stock and additional paid-in capital: (i) an
increase for a tax benefit of $15.1 million (net of payroll taxes incurred of
$.7 million); (ii) an increase for the exercise proceeds of $5.2 million; and
(iii) a decrease of $20.8 million related to shares withheld or tendered by the
executives for federal and state taxes. Net of shares withheld or tendered, the
Company issued approximately 3.3 million and 1.6 million shares of common stock
to the executives under the 1997 Program and the 1996 Program, respectively. As
an inducement to encourage the exercise of options prior to their expiration
date, we granted to the executive officers new options to purchase a total of
5.8 million shares at an average price of $39.52 per share and 1.6 million
shares at $16.22 per share (in each case equal to the market price per share on
the grant date) to replace the shares surrendered for taxes and the exercise
price in connection with the 1997 and 1996 Programs, respectively.
In 1997, 1996 and 1995, we repurchased approximately 22.5 million, 1.7
million and 10.0 million shares of our common stock for $857.0 million, $26.0
million and $146.3 million, respectively, in connection with our stock
repurchase programs and shares withheld or tendered for the exercise price of
options and for federal and state taxes. The cost of the common stock we
repurchased in connection with these programs was allocated to the shareholders'
equity accounts in 1997, 1996 and 1995 as follows: (i) $830.9 million, $3.1
million and $68.9 million, respectively, to common stock and additional paid-in
capital (such allocation was based on the average common stock and paid-in
capital balance per share) and (ii) $26.1 million, $22.9 million and $77.4
million, respectively, to retained earnings (representing the purchase price in
excess of such average).
Conseco's Director, Executive and Senior Officer Stock Purchase Plan was
implemented to encourage direct, long-term ownership of Conseco stock by Board
members, executive officers and certain senior officers. Under the program, 8
million shares of Conseco common stock have been purchased in open market or
negotiated transactions with independent parties. Purchases are financed by
personal loans to the participants from a bank. Such loans are collateralized by
the Conseco stock purchased. Conseco has guaranteed the loans, but has recourse
to the participants if we incur a loss under the guarantee. In addition, we
provide loans to the participants for interest payments under the bank loans. A
total of 39 directors and officers of Conseco participated in the plan. At
December 31, 1997, the bank loans guaranteed by us totaled $247.4 million, and
the loans provided by us for interest totaled $9.3 million. The common stock
that collateralizes the loans had a fair value of $343.5 million on December 31,
1997.
In December 1996, we granted options to selected key managers to purchase
1.1 million shares at a price of $30.41 per share (the "Key Manager Program").
These options contain lengthy vesting and non-compete requirements designed to
encourage continuity of employment with these individuals. The options will
become fully vested normally only upon both: (i) eleven years of continuous
employment; and (ii) the earlier of: (a) two years following termination of
employment during which time the individual is not in competition with the
Company; (b) the grantee reaching age 65; or (c) death or disability of the
grantee. In certain cases, the options remain exercisable throughout the
lifetime of the grantee.
83
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
We apply Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" and related interpretations in accounting for our
stock option plans. Accordingly, no compensation cost has been recognized for
such 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 Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"), the Company's pro forma net income and
pro forma earnings per share for the years ended December 31, 1997, 1996 and
1995 would have been as follows:
1997 1996 1995
------------------------- ------------------------- -------------------------
As reported Pro forma As reported Pro forma As reported Pro forma
----------- --------- ----------- --------- ----------- ---------
(Dollars in millions, except per share amounts)
Net income........................ $866.4 $800.6 $452.2 $434.7 $470.9 $459.3
Basic earnings per share.......... 2.72 2.50 1.85 1.77 2.19 2.13
Diluted earnings per share........ 2.52 2.32 1.69 1.62 2.03 1.98
The fair value of each option grant used to determine the pro forma
amounts summarized above is estimated on the date of grant using the
Black-Scholes option valuation model with the following weighted average
assumptions for 1997, 1996 and 1995:
1997 Grants 1996 Grants 1995 Grants
-------------------------- ------------------------------------ ---------------
Option Option Key
Traditional exercise Traditional exercise Manager Traditional
grants program grants program Program grants
------ ------- ------ ------ ------- -----
Weighted average risk-free interest rates.. 6.0% 6.5% 6.1% 6.0% 6.8% 6.2%
Weighted average dividend yields........... .9% .9% .1% .1% .1% .2%
Volatility factors......................... .28 .28 .28 .28 .28 .43
Weighted average expected life............. 6 years 4 years 5 years 5 years 25 years 5 years
Weighted average fair value per share...... $13.13 $11.95 $10.17 $5.54 $24.50 $5.53
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferrable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because our employee stock options have characteristics
significantly different from those of traded options, and because changes in
subjective assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not provide a reliable single
measure of the fair value of our employee stock options. Because SFAS 123 is
effective only for awards granted after January 1, 1995, the pro forma
disclosures provided above may not be representative of the effects on reported
net income for future years.
In conjunction with the CAF Merger and the PFS Merger in 1997 and the LPG
Merger, the ATC Merger, the THI Merger and the BLH Merger in 1996, outstanding
options to purchase common stock of the acquired companies were converted into
options to purchase Conseco stock. These options, which were immediately
exercisable, were for the number of shares and the price per share equal to what
holders would have been entitled to receive at the dates of the mergers had the
former options been exercised at that time and exchanged for Conseco shares in
the mergers. The fair value of these options is included in the cost to acquire
the companies (see note 2). A summary of options issued in connection with the
mergers and, together with related information, is presented below:
84
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Weighted
Total value average
at merger exercise price
Shares date per share
------ ---- ---------
(Shares in (Dollars in millions, except
thousands) per share amounts)
Options issued in 1997 in connection with the:
CAF Merger................................................... 226 $ 3.5 $23.96
PFS Merger................................................... 1,132 22.4 19.78
----- -----
1,358 $25.9 20.48
===== =====
Options issued in 1996 in connection with the:
LPG Merger................................................... 1,133 $ 7.7 11.18
ATC Merger................................................... 2,049 26.9 16.87
THI Merger................................................... 644 6.5 14.90
BLH Merger................................................... 609 2.6 27.18
----- -----
4,435 $43.7 16.54
===== =====
A summary of the Company's stock option activity and related information
for the years ended December 31, 1997, 1996 and 1995, is presented below (shares
in thousands):
1997 1996 1995
---------------------- ---------------------- ----------------------
Weighted Weighted Weighted
average average average
exercise exercise exercise
Shares price Shares price Shares price
------ ----- ------ ----- ------ -----
Outstanding at the beginning of year.. 37,951 $17.98 31,221 $12.33 26,745 $10.27
Granted or assumed in connection with:
Traditional grants................. 2,394 40.37 6,368 33.73 6,880 18.06
Option exercise program............ 5,818 39.52 1,605 16.22 - -
Key Manager Program................ - - 1,100 30.41 - -
Mergers............................ 1,358 20.48 4,435 16.54 - -
------- ------ -------
Total granted................ 9,570 37.03 13,508 25.73 6,880 18.06
------- ------ ------
Exercised............................. (12,825) 13.59 (5,990) 4.82 (2,010) 4.48
Forfeited............................. (1,185) 26.94 (788) 24.10 (394) 14.12
------- ------ ------
Outstanding at the end of the year.... 33,511 24.79 37,951 18.04 31,221 12.31
======= ====== ======
Options exercisable at year-end....... 13,079 11,686 9,859
======= ====== ======
Available for future grant............ 17,206 2,933 8,399
======= ====== ======
85
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The following table summarizes information about fixed stock options
outstanding at December 31, 1997 (shares in thousands):
Options outstanding Options exercisable
---------------------------------------- --------------------------
Weighted Weighted Weighted
average average average
Range of Number remaining exercise Number exercise
exercise prices outstanding life (in years) price exercisable price
- --------------- ----------- -------------- ----- ----------- -----
$ 1.36 - 1.56...................... 50 .6 $ 1.51 50 $ 1.51
2.61 - 3.24...................... 797 3.2 3.21 797 3.21
4.57 - 6.72...................... 886 4.1 5.63 844 5.59
6.91 - 10.28...................... 113 2.1 8.24 113 8.24
10.47 - 15.55...................... 13,286 5.3 14.27 1,713 13.28
15.73 - 23.49...................... 958 6.5 19.15 914 19.13
23.67 - 30.41...................... 3,888 6.6 27.58 1,806 27.26
30.41 (Key Manager Program).......... 1,100 24.0 30.41 - -
30.73 - 45.84...................... 12,399 8.0 37.98 6,842 38.69
48.38 - 51.28...................... 34 9.9 48.99 - -
------ ------
33,511 13,079
====== ======
In connection with the THI Merger, the outstanding warrants to purchase
shares of THI common stock were converted into warrants to purchase the same
number of shares of Conseco common stock at the same total cost that the holders
would have been entitled to receive if such warrants were exercised immediately
prior to the THI Merger. Such warrants may be exercised to buy 700,000 shares of
Conseco common stock for $13.8 million at anytime through September 29, 2005.
Accordingly, 700,000 shares of common stock are reserved for issuance under the
warrants. The value of the warrants on the THI Merger date of $3.8 million is
included in the total cost to acquire THI (see note 2).
A total of 69.0 million shares of common stock are reserved for issuance
under the previously described convertible subordinated debentures, PRIDES,
FELINE PRIDES, stock options granted and available for future grant, warrants,
and stock bonus and deferred compensation plans.
86
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
A reconciliation of income and shares used to calculate basic and diluted
earnings per share is as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions and shares in thousands)
Income:
Net income before extraordinary charge.................................. $873.3 $478.7 $473.0
Preferred stock dividends............................................... 21.9 27.4 18.4
------ ------ ------
Income before extraordinary charge applicable to common ownership
for basic earnings per share........................................ 851.4 451.3 454.6
Effect of dilutive securities:
Preferred stock dividends............................................. 8.7 27.4 18.4
------ ------ ------
Income before extraordinary charge applicable to common ownership
and assumed conversions for diluted earnings per share.............. $860.1 $478.7 $473.0
====== ====== ======
Shares:
Weighted average shares outstanding for basic earnings per share........ 311,050 230,141 206,639
Effect of dilutive securities on weighted average shares:
Stock options......................................................... 13,011 9,281 6,079
Employee stock plans.................................................. 2,268 2,172 1,768
PRIDES................................................................ 6,936 14,042 -
Convertible preferred stock........................................... - 12,049 17,787
Convertible debentures................................................ 5,457 - -
------ ------ -------
Dilutive potential common shares.................................. 27,672 37,544 25,634
------ ------ -------
Weighted average shares outstanding for diluted earnings
per share.................................................... 338,722 267,685 232,273
======= ======= =======
11. OTHER OPERATING STATEMENT DATA:
Insurance policy income consisted of the following:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Traditional products:
Direct premiums collected......................................................... $5,264.4 $3,528.2 $3,173.0
Reinsurance assumed............................................................... 290.3 65.8 6.1
Reinsurance ceded................................................................. (499.0) (313.8) (72.6)
-------- -------- --------
Premiums collected, net of reinsurance...................................... 5,055.7 3,280.2 3,106.5
Change in unearned premiums....................................................... (2.2) (14.6) 6.6
Less premiums on universal life and products
without mortality and morbidity risk which are
recorded as additions to insurance liabilities ................................ 2,099.4 1,881.3 1,757.5
-------- -------- --------
Premiums on traditional products with mortality or morbidity risk,
recorded as insurance policy income...................................... 2,954.1 1,384.3 1,355.6
Fees and surrender charges on interest sensitive products............................. 456.7 269.9 109.4
-------- ------- --------
Insurance policy income..................................................... $3,410.8 $1,654.2 $1,465.0
======== ======== ========
87
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The five states with the largest shares of premiums collected in 1997
were Florida (9.4 percent), Illinois (9.0 percent), California (8.4 percent),
Texas (8.1 percent) and Michigan (5.0 percent). No other state accounted for
more than 5 percent of total collected premiums.
Other operating costs and expenses were as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Commission expense.................................................................... $ 201.2 $ 72.5 $ 47.7
Other................................................................................. 805.1 561.7 468.8
-------- ------ -----
Other operating costs and expenses........................................... $1,006.3 $634.2 $516.5
======== ====== ======
Conseco considers anticipated returns from the investment of policyholder
balances in determining the amortization of the cost of policies purchased and
cost of policies produced for universal life-type and investment-type contracts.
Sales of fixed maturity investments change the incidence of profits on such
policies because gains (losses) are recognized currently and, if the sale
proceeds are reinvested at the current market yields, the expected future yields
on the investment of policyholder balances are reduced (increased). Accordingly,
amortization of the cost of policies purchased was increased by $151.4 million,
$31.1 million and $106.4 million in the years ended December 31, 1997, 1996 and
1995, respectively. Amortization of the cost of policies produced was increased
by $29.8 million, $4.9 million and $20.2 million in the years ended December 31,
1997, 1996 and 1995, respectively.
The changes in the cost of policies purchased were as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Balance, beginning of year............................................................ $2,015.0 $1,030.7 $1,021.6
Additional acquisition expense on acquired policies............................... 93.9 - -
Amortization related to operations:
Cash flow realized............................................................. (436.5) (285.1) (252.0)
Interest added................................................................. 174.7 127.6 133.2
Amortization related to sales of investments...................................... (151.4) (31.1) (106.4)
Amounts related to fair value adjustment
of actively managed fixed maturities........................................... (128.4) 141.6 (395.6)
Transferred to cost of policies produced related to
exchanged health policies...................................................... (16.1) (13.4) (13.5)
Amounts acquired in mergers and acquisitions...................................... 914.2 1,042.0 643.4
Nonrecurring charge............................................................... (8.8) - -
Reinsurance and other ............................................................ 9.8 2.7 -
---------- ---------- --------
Balance, end of year.................................................................. $2,466.4 $2,015.0 $1,030.7
======== ======== ========
Based on current conditions and assumptions as to future events on all
policies in force, the Company expects to amortize approximately 9 percent of
the December 31, 1997, balance of cost of policies purchased in 1998, 9 percent
in 1999, 8 percent in 2000, 7 percent in 2001, and 7 percent in 2002. The
discount rates used to determine the cost of policies purchased ranged from 18
percent to 20 percent during the three-year period ended December 31, 1997. The
discount rates used to determine the amortization of the cost of policies
purchased averaged 7 percent in 1997, 10 percent in 1996, and 12 percent in
1995.
88
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The changes in the cost of policies produced were as follows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Balance, beginning of year............................................................ $544.3 $391.0 $300.7
Additions......................................................................... 550.7 331.5 302.9
Amortization related to operations................................................ (110.4) (72.9) (62.0)
Amortization of deferred revenue.................................................. 5.4 1.4 1.3
Amortization related to sales of investments...................................... (29.8) (4.9) (20.2)
Amounts related to fair value adjustment of
actively managed fixed maturities.............................................. (36.4) 45.4 (74.9)
Transferred from cost of policies purchased related to
exchanged health policies, net of related reserves............................. 3.5 4.0 1.6
Amounts related to BLH Merger and share repurchases............................... - (54.7) (107.5)
Amounts related to ALH Stock Purchase............................................. - (96.5) -
Amounts related to CCP Merger..................................................... - - (62.8)
Consolidation of CCP, effective January 1, 1995................................... - - 111.9
Nonrecurring charge............................................................... (12.1) - -
------ ------ ------
Balance, end of year.................................................................. $915.2 $544.3 $391.0
====== ====== ======
Nonrecurring charges in 1997 include an increase to claim reserves of
$41.5 million and the write-off of cost of policies produced and cost of
policies purchased of $20.9 million related to premium deficiencies on our
Medicare supplement business in the state of Massachusetts. Regulators in that
state have not allowed premium increases for Medicare supplement products
necessary to avoid losses on the business. We are currently seeking rate
increases. We are no longer writing new Medicare supplement business in
Massachusetts.
Nonrecurring charges in 1997 also include expenses of $9.3 million (net
of proceeds from a life insurance policy) related to the death of an executive
officer.
89
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
12. CONSOLIDATED STATEMENT OF CASH FLOWS:
The following disclosures are provided to support and/or supplement our
consolidated statement of cash flows:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Impact of acquisition transactions (described in note 2) on the consolidated statement
of cash flows:
Total investments................................................................ $ 4,716.6 $ 5,643.4 $ 4,528.4
Finance receivables.............................................................. - 590.1 -
Cost of policies purchased....................................................... 914.2 1,046.4 493.7
Goodwill......................................................................... 1,133.9 1,806.4 241.6
Income taxes..................................................................... 6.4 134.9 (114.9)
Insurance liabilities............................................................ (5,193.8) (5,943.6) (4,405.8)
Notes payable.................................................................... (540.6) (448.2) (213.7)
Minority interest................................................................ - 210.4 225.4
Common stock and additional paid-in capital...................................... (471.5) (1,568.6) -
Other............................................................................ 194.5 (208.3) (168.4)
---------- --------- ---------
Net cash used.................................................................. $ 759.7 $ 1,262.9 $ 586.3
========= ========= =========
Additional non-cash items not reflected in the consolidated statement of cash
flows:
Issuance of common stock under stock option and employee benefit plans............. $ 20.2 $ 12.2 $ 4.2
Tax benefit related to the issuance of common stock under employee benefit plans... 85.2 15.9 .4
Conversion of preferred stock into common stock.................................... 151.3 283.2 -
Conversion of convertible debentures into common stock............................. 150.0 - -
Redemption of convertible subordinated debentures of a subsidiary using
segregated cash.................................................................. - - 9.2
Cash paid for:
Interest expense on debt and commercial paper...................................... 273.9 177.7 167.2
Income taxes....................................................................... 231.8 166.7 127.8
At December 31, 1997 and 1996, cash of approximately $552.8 million and
$346.3 million, respectively, was held in trust for subsequent payment to
investors. In addition, cash of $247.2 million and $171.5 million, respectively,
was restricted by the pooling and servicing agreements.
13. STATUTORY INFORMATION:
Statutory accounting practices prescribed or permitted for the Company's
insurance subsidiaries by regulatory authorities differ from GAAP. The Company's
life insurance subsidiaries reported the following amounts to regulatory
agencies, after appropriate eliminations of intercompany accounts among such
subsidiaries:
1997 1996
---- ----
(Dollars in millions)
Statutory capital and surplus.................................................................... $1,662.4 $1,170.8
Asset valuation reserve.......................................................................... 329.2 232.9
Interest maintenance reserve..................................................................... 414.9 272.6
Portion of surplus debenture carried as a liability ............................................. 99.2 98.8
-------- --------
Total...................................................................................... $2,505.7 $1,775.1
======== ========
90
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
Combined statutory net income of the Company's life insurance
subsidiaries for the periods during which such subsidiaries were included in our
consolidated financial statements was $243.4 million, $215.0 million and $183.8
million in 1997, 1996 and 1995, respectively, after appropriate eliminations of
intercompany amounts among such subsidiaries, but before elimination of
intercompany amounts between such subsidiaries and non-life insurance
subsidiaries and the parent company.
The statutory capital and surplus of the insurance subsidiaries include
surplus debentures issued to the parent holding companies totaling $793.4
million. Payments of interest and principal on such debentures are generally
subject to the approval of the insurance department of the subsidiary's state of
domicile.
Statutory accounting practices require the asset valuation reserve
("AVR") and the interest maintenance reserve ("IMR") be reported as liabilities.
The purpose of these reserves is to stabilize statutory surplus against
fluctuations in the market value of investments. The IMR captures all realized
investment gains and losses, net of income taxes, on debt instruments resulting
from changes in interest rates, and provides for subsequent amortization of such
amounts into statutory net income on a basis reflecting the remaining lives of
the assets sold. The AVR captures all realized and unrealized investment gains
(losses), net of income taxes, related to equity investments and to changes in
creditworthiness of debt instruments. AVR is also adjusted each year based on a
formula related to the quality and loss experience of the Company's investment
portfolio.
Included in statutory capital and surplus shown above are the following
investments in non-life insurance affiliates, all of which are eliminated in the
consolidated financial statements prepared in accordance with GAAP:
1997 1996
-------------------- ---------------------
Admitted Admitted
asset asset
Cost value Cost value
---- ----- ---- -----
(Dollars in millions)
Common stock of Conseco purchased in open market transactions
(1997 includes 39,823,149 shares and 1996
includes 39,021,822 shares)......................................... $ 99.8 $152.4 $ 89.6 $ 80.9
Notes payable of Conseco and its non-life subsidiaries................. 275.0 275.7 261.3 245.2
Common stock of ALH (463,649 shares in 1997 and 614,057
shares in 1996) .................................................... 2.4 6.3 5.8 9.8
Preferred stock of a non-life subsidiary............................... 900.0 - 900.0 -
Investment in ALH 1994 Series PIK Preferred Stock...................... 72.2 72.2 62.8 62.8
Preferred stock of American Life Holding Company....................... 6.5 6.5 6.5 6.5
91
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
The following table compares the consolidated pretax income determined on a
statutory accounting basis with such income reported in accordance with GAAP:
1997 1996 1995
---- ---- ----
(Dollars in millions)
Life insurance subsidiaries:
Pretax income as reported on a statutory accounting
basis before transfers to and from and amortization of the IMR...................... $ 606.3 $332.2 $370.4
GAAP adjustments:
Change in difference in carrying values of investments.............................. 111.7 51.9 185.9
Changes in cost of policies purchased and produced and insurance liabilities........ 256.2 70.1 (52.0)
Other adjustments, net.............................................................. (7.9) (.1) (7.7)
-------- ------ ------
GAAP pretax income of life insurance subsidiaries........................... 966.3 454.1 496.6
Non-life companies:
Interest expense:
Corporate........................................................................... (109.4) (108.1) (119.4)
Consumer and commercial finance..................................................... (160.9) (70.1) (57.3)
All other income and expense, net:
Consumer and commercial finance..................................................... 643.5 392.3 461.5
Other non-life companies............................................................ 146.2 147.6 41.3
-------- ------- ------
GAAP consolidated pretax income............................................. $1,485.7 $815.8 $822.7
======== ====== ======
State insurance laws generally restrict the ability of insurance
companies to pay dividends or make other distributions. Net assets of the
Company's wholly owned life insurance subsidiaries, determined in accordance
with GAAP, aggregated approximately $7.8 billion at December 31, 1997, of which
approximately $165.1 million is available for distribution to Conseco in 1998
without the permission of state regulatory authorities.
Most states have adopted risk-based capital ("RBC") rules to evaluate the
adequacy of statutory capital and surplus in relation to investment and
insurance risks. The RBC formula is designed as an early warning tool to help
state regulators identify possible weakly capitalized companies for the purpose
of initiating regulatory action. At December 31, 1997, the average ratio of
total adjusted capital to RBC (as defined by the rules) for our principal
insurance subsidiaries was greater than twice the level at which regulatory
attention is triggered.
92
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
14. BUSINESS SEGMENT AND DISTRIBUTION CHANNELS:
Conseco conducts and manages its business through six segments,
reflecting the Company's major lines of business and target markets: (i)
consumer and commercial finance; (ii) supplemental health; (iii) annuities; (iv)
life insurance; (v) individual and group major medical insurance; and (vi)
other. Summarized data for the Company's business segments follows:
Income before
Amortization income taxes,
of cost of minority
policies produced interest and
Premiums Total and cost of policies extraordinary Total
collected revenues purchased (a) charge assets
--------- -------- ------------- ------ ------
(Dollars in millions)
1997
Consumer and commercial finance..........$ - $1,088.0 $ - $ 482.6 $ 4,768.4
Supplemental health...................... 1,843.7 2,160.2 194.9 371.9 7,522.5
Annuities................................ 1,689.6 1,350.5 198.9 358.3 16,535.6
Life insurance........................... 709.0 1,130.3 87.8 307.1 9,717.8
Individual and group major medical....... 744.2 775.5 16.8 40.3 896.8
Other ................................... 69.2 151.9 7.3 61.6 577.4
Corporate................................ - - - (136.1) 611.4
-------- -------- ------ -------- ---------
Total.................................. $5,055.7 $6,656.4 $505.7 $1,485.7 $40,629.9
======== ======== ====== ======== =========
1996
Consumer and commercial finance.......... $ - $ 722.5 $ - $ 322.2 $ 3,080.0
Supplemental health...................... 810.8 873.2 81.2 136.7 3,841.1
Annuities................................ 1,670.3 1,047.4 95.1 254.3 14,186.5
Life insurance........................... 403.6 642.6 41.5 124.8 6,512.4
Individual and group major medical....... 341.0 365.8 15.1 32.1 418.2
Other ................................... 54.5 138.3 7.9 58.1 170.0
Corporate ............................... - - - (112.4) 484.5
-------- -------- ------ ---------- ---------
Total.................................. $3,280.2 $3,789.8 $240.8 $ 815.8 $28,692.7
======== ======== ====== ========= =========
1995
Consumer and commercial finance.......... $ - $ 705.9 $ - $ 404.2 $ 2,212.6
Supplemental health...................... 738.8 827.2 78.3 97.1 1,759.6
Annuities................................ 1,693.9 1,135.5 169.9 316.1 12,152.8
Life insurance........................... 253.6 404.0 38.6 70.2 2,667.6
Individual and group major medical....... 353.6 361.7 13.1 35.2 269.4
Other ................................... 66.6 111.7 7.6 25.2 193.8
Corporate................................ - 15.2 - (125.3) 254.3
-------- -------- ------ --------- ---------
Total.................................. $3,106.5 $3,561.2 $307.5 $ 822.7 $19,510.1
======== ======== ====== ========= =========
<FN>
(a) Includes additional amortization related to gains on sales of investments.
</FN>
93
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
15. QUARTERLY FINANCIAL DATA (UNAUDITED):
We compute earnings per common share for each quarter independently of
earnings per share for the year. The sum of the quarterly earnings per share may
not equal the earnings per share for the year because of: (i) transactions
affecting the weighted average number of shares outstanding in each quarter; and
(ii) the uneven distribution of earnings during the year.
1997
----------------------------------------------
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
-------- -------- -------- --------
(Dollars in millions, except per share data)
Insurance policy income................................................... $ 670.1 $ 885.0 $ 885.8 $ 969.9
Revenues.................................................................. 1,365.2 1,676.8 1,830.1 1,784.3
Income before income taxes, minority interest
and extraordinary charge .............................................. 342.5 404.7 465.2 273.3
Net income................................................................ 202.7 238.1 271.5 154.1
Net income per common share:
Basic:
Income before extraordinary charge .................................. $.63 $.76 $.86 $.49
Extraordinary charge................................................. .01 .01 - -
---- ---- ---- ----
Net income......................................................... $.62 $.75 $.86 $.49
==== ==== ==== ====
Diluted:
Income before extraordinary charge .................................. $.58 $.70 $.80 $.45
Extraordinary charge................................................. .01 .01 - -
---- ---- ---- ----
Net income......................................................... $.57 $.69 $.80 $.45
==== ==== ==== ====
1996
----------------------------------------------
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
-------- -------- -------- --------
(Dollars in millions, except per share data)
Insurance policy income..................................................... $369.8 $371.6 $451.8 $461.0
Revenues.................................................................... 859.9 868.6 1,054.0 1,007.3
Income before income taxes, minority interest
and extraordinary charge ................................................ 227.2 222.9 269.4 96.3
Net income.................................................................. 112.7 125.5 163.6 50.4
Net income per common share:
Basic:
Income before extraordinary charge .................................... $.59 $.56 $.64 $.21
Extraordinary charge................................................... .08 - - .03
---- ---- ---- ----
Net income........................................................... $.51 $.56 $.64 $.18
==== ==== ==== ====
Diluted:
Income before extraordinary charge .................................... $.53 $.50 $.57 $.21
Extraordinary charge................................................... .07 - - .03
---- ---- ---- ----
Net income........................................................... $.46 $.50 $.57 $.18
==== ==== ==== ====
Our quarterly results of operations are based on numerous estimates,
principally related to policy reserves, amortization of cost of policies
purchased, amortization of cost of policies produced and income taxes. We revise
all such estimates each quarter and we ultimately adjust them to year-end
amounts. When we determine revisions are necessary, we report them as part of
operations of the current quarter.
94
CONSECO, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
------------------------------------
16. SUBSEQUENT EVENTS (UNAUDITED):
On February 9, 1998, we completed the offering of $250.0 million of 6.4
percent Notes (the "Notes") due February 10, 2003. Proceeds from the offering of
approximately $248.0 million (after original issue discount and other associated
costs) were used to retire bank debt. Interest is paid semi-annually on February
10 and August 10 of each year. The Notes are redeemable in whole or in part at
the option of Conseco at any time, at a redemption price equal to the sum of (a)
the greater of: (i) 100 percent of the principal amount; and (ii) the sum of the
present values of the remaining scheduled payments of principal and interest
thereon from the redemption date to the maturity date, computed by discounting
such payments, in each case, to the redemption date on a semi-annual basis at
the Treasury rate (as defined in the Notes) plus 25 basis points, plus (b)
accrued and unpaid interest on the principal amount thereof to the date of
redemption. The Notes are unsecured and rank pari passu with all other unsecured
and unsubordinated obligations of Conseco.
We periodically use options and interest rate swaps to hedge interest
rate risk associated with our investments and borrowed capital. Although we had
no such agreements outstanding at December 31, 1997, we entered into four
interest rate swap agreements in March 1998. The Company entered into such
agreements to create a hedge that effectively converts a portion of its
fixed-rate borrowed capital into floating-rate instruments for the period during
which the agreements are outstanding. Such interest rate swap agreements have an
aggregate notional principal amount of $1.0 billion, mature in various years
through 2008 and have an average remaining life of 7 years. If the
counterparties of these interest rate swaps do not meet their obligations,
Conseco could have a loss. Conseco limits its exposure to such a loss by
diversifying among several counterparties believed to be financially sound and
creditworthy. At March 13, 1998, all of the counterparties were rated A or
higher by Standard & Poor's Corporation.
On March 3, 1998, we commenced a new program to repurchase up to 5
million Conseco common shares in open market or negotiated transactions. The
timing and terms of the purchases are to be determined based on market
conditions and other considerations. As of March 17, 1998, we had repurchased .5
million shares under the program for $26.4 million.
In March 1998, we repurchased $139 million par value of our 10.5 percent
senior notes due 2004 for $171 million. We will recognize an extraordinary
charge of approximately $15.6 million (net of an $8.3 million tax benefit)
related to the repurchases in the quarter ended March 31, 1998.
On July 7, 1998, we announced that we would be taking a charge of $498.0
million (net of income taxes of $190.0 million) in the quarter ended June 30,
1998, related to the Green Tree Merger. The charge is comprised of 148.0 million
of merger-related costs and non-cash charges of $350.0 million to recognize an
other-than-temporary impairment of our interest-only securities.
95