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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the period ended September 30, 2003
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ -------
Commission File Number 001-31792
Conseco, Inc.
Delaware 75-3108137
---------------------- -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
-------------------------------------- --------------
Address of principal executive offices Telephone
Conseco, Inc. (an Indiana corporation)
--------------------------------------
Former Name
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [x] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act): Yes [x] No [ ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court: Yes [x] No [ ]
Shares of common stock outstanding as of November 10, 2003: 100,098,119
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
Successor Predecessor
----------------------------- ---------------
September 30, August 31, December 31,
2003 2003 2002
---- ---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
September 30, 2003 - $18,885.5; August 31, 2003 - $18,701.0;
December 31, 2002 - $18,989.8)..................................... $19,352.7 $18,701.0 $19,417.4
Equity securities at fair value (cost: September 30, 2003 - $104.6;
August 31, 2003 - $101.4; December 31, 2002 - $161.4).............. 107.5 101.4 156.0
Mortgage loans....................................................... 1,154.1 1,159.7 1,308.3
Policy loans......................................................... 514.2 515.8 536.2
General Motors building.............................................. - 1,336.3 -
Trading securities................................................... 944.9 952.1 -
Venture capital investment in AT&T Wireless Services, Inc. at fair
value (cost: September 30, 2003 - $36.4; August 31, 2003 - $36.4;
December 31, 2002 - $14.2)......................................... 33.7 36.4 25.0
Other invested assets ............................................... 308.7 321.5 340.8
--------- --------- ---------
Total investments................................................ 22,415.8 23,124.2 21,783.7
Cash and cash equivalents:
Unrestricted......................................................... 1,724.3 1,215.9 1,268.9
Restricted........................................................... 22.1 - -
Accrued investment income............................................... 316.0 304.6 389.8
Value of policies in force at the Effective Date........................ 2,770.4 2,836.9 -
Cost of policies purchased.............................................. - - 1,170.0
Cost of policies produced............................................... 23.2 - 2,014.4
Reinsurance receivables................................................. 933.6 932.3 934.2
Income tax assets....................................................... 86.7 88.0 101.5
Goodwill................................................................ 935.4 1,102.8 100.0
Other intangible assets................................................. 173.8 174.8 -
Assets held in separate accounts and investment trust .................. 37.5 87.7 447.0
Assets of discontinued operations....................................... - - 17,624.3
Other assets............................................................ 421.1 545.7 675.2
--------- --------- ---------
Total assets..................................................... $29,859.9 $30,412.9 $46,509.0
========= ========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
2
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Successor Predecessor
---------------------------- --------------
September 30, August 31, December 31,
2003 2003 2002
---- ---- ----
(unaudited)
Liabilities:
Liabilities for insurance and asset accumulation products:
Interest-sensitive products........................................... $12,851.5 $12,837.9 $13,469.5
Traditional products.................................................. 10,727.5 10,701.0 7,971.4
Claims payable and other policyholder funds........................... 873.1 886.7 909.2
Liabilities related to separate accounts and investment trust......... 37.5 87.7 447.0
Other liabilities....................................................... 748.5 875.2 673.5
Liabilities of discontinued operations.................................. - - 17,624.3
Investment borrowings................................................... 524.4 1,224.4 669.7
Notes payable - direct corporate obligations............................ 1,300.0 1,300.0 -
--------- --------- ---------
Total liabilities not subject to compromise....................... 27,062.5 27,912.9 41,764.6
--------- --------- ---------
Liabilities subject to compromise....................................... - - 4,873.3
--------- --------- ---------
Total liabilities................................................. 27,062.5 27,912.9 46,637.9
--------- --------- ---------
Minority interest:
Company-obligated mandatorily redeemable preferred securities
of subsidiary trusts.................................................... - - 1,921.5
Shareholders' equity (deficit):
Preferred stock......................................................... 865.0 859.7 501.7
Common stock and additional paid-in capital ($0.01 par value,
8,000,000,000 shares authorized, shares issued and outstanding: September
30, 2003 - 100,098,119; August 31, 2003 - 100,098,119; no par value,
1,000,000,000 shares authorized, shares issued and
outstanding at December 31, 2002 - 346,007,133)....................... 1,640.3 1,640.3 3,497.0
Accumulated other comprehensive income.................................. 273.2 - 580.6
Retained earnings (deficit)............................................. 18.9 - (6,629.7)
--------- --------- ---------
Total shareholders' equity (deficit).............................. 2,797.4 2,500.0 (2,050.4)
--------- --------- ---------
Total liabilities and shareholders' equity (deficit).............. $29,859.9 $30,412.9 $46,509.0
========= ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Successor Predecessor
------------- --------------------------------
One month Two months Three months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Revenues:
Insurance policy income........................................... $256.2 $ 516.8 $ 902.6
Net investment income:
General account assets.......................................... 106.0 237.3 373.0
Policyholder and reinsurer accounts............................. (2.1) 6.8 (32.6)
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc................................... (2.7) 2.0 (6.6)
Net realized investment gains (losses) ......................... 6.7 (35.8) (261.1)
Fee revenue and other income...................................... 2.2 7.8 15.5
------ --------- ---------
Total revenues................................................ 366.3 734.9 990.8
------ --------- ---------
Benefits and expenses:
Insurance policy benefits......................................... 243.3 407.4 883.4
Provision for losses.............................................. - 24.5 59.9
Interest expense (contractual interest of $73.7 for the two months
ended August 31, 2003).......................................... 7.0 55.4 84.5
Amortization...................................................... 26.9 44.8 200.2
Other operating costs and expenses................................ 51.3 106.8 180.8
Goodwill impairment............................................... - - 500.0
Special charges................................................... - - 34.9
Reorganization items.............................................. - (2,163.0) -
------ --------- ---------
Total benefits and expenses................................... 328.5 (1,524.1) 1,943.7
------ --------- ---------
Income (loss) before income taxes, minority interest,
and discontinued operations................................ 37.8 2,259.0 (952.9)
Income tax expense (benefit):
Tax expense (benefit) on period income (losses)................... 13.6 17.7 (154.8)
Valuation allowance for deferred tax assets....................... - - 311.4
------ --------- ---------
Income (loss) before minority interest and discontinued
operations................................................. 24.2 2,241.3 (1,109.5)
Minority interest:
Distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts, net of income taxes. - - 29.2
------ --------- ---------
Income (loss) before discontinued operations.................. 24.2 2,241.3 (1,138.7)
Discontinued operations, net of income taxes......................... - - (630.3)
------ --------- ---------
Net income (loss)............................................. 24.2 2,241.3 (1,769.0)
Preferred stock dividends............................................ 5.3 - .2
------ --------- ---------
Net income (loss) applicable to common stock.................. $ 18.9 $ 2,241.3 $(1,769.2)
====== ========= =========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor
-------------
One month
ended
September 30,
2003
----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 100,098,000
===========
Net income................................................. $.19
====
Diluted:
Weighted average shares outstanding........................ 144,671,000
===========
Net income................................................. $.17
====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Successor Predecessor
------------- --------------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Revenues:
Insurance policy income........................................... $256.2 $ 2,204.3 $ 2,726.2
Net investment income:
General account assets.......................................... 106.0 933.3 1,164.2
Policyholder and reinsurer accounts............................. (2.1) 25.2 (106.3)
Venture capital income (loss) related to investment in
AT&T Wireless Services, Inc................................... (2.7) 10.5 (106.6)
Net realized investment gains (losses) ......................... 6.7 (5.4) (493.9)
Fee revenue and other income...................................... 2.2 34.3 56.1
------ --------- ---------
Total revenues................................................ 366.3 3,202.2 3,239.7
------ --------- ---------
Benefits and expenses:
Insurance policy benefits......................................... 243.3 2,138.7 2,469.9
Provision for losses.............................................. - 55.6 199.9
Interest expense (contractual interest of $268.5 for the eight
months ended August 31, 2003)................................... 7.0 202.5 248.8
Amortization...................................................... 26.9 341.4 635.2
Other operating costs and expenses................................ 51.3 422.3 510.1
Goodwill impairment............................................... - - 500.0
Special charges................................................... - - 103.1
Extraordinary gain on extinguishment of debt...................... - - (1.8)
Reorganization items.............................................. - (2,130.5) -
------ --------- ---------
Total benefits and expenses................................... 328.5 1,030.0 4,665.2
------ --------- ---------
Income (loss) before income taxes, minority interest,
discontinued operations and cumulative effect of
accounting change.......................................... 37.8 2,172.2 (1,425.5)
Income tax expense (benefit):
Tax expense (benefit) on period income (losses)................... 13.6 (13.5) (316.1)
Valuation allowance for deferred tax assets....................... - - 1,314.4
------ --------- ---------
Income (loss) before minority interest, discontinued
operations and cumulative effect of accounting change...... 24.2 2,185.7 (2,423.8)
Minority interest:
Distributions on Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts, net of income taxes. - - 87.6
------ --------- ---------
Income (loss) before discontinued operations and cumulative
effect of accounting change................................. 24.2 2,185.7 (2,511.4)
Discontinued operations, net of income taxes......................... - 16.0 (686.6)
Cumulative effect of accounting change for goodwill impairment,
net of income taxes............................................... - - (2,949.2)
------ --------- ---------
Net income (loss)............................................. 24.2 2,201.7 (6,147.2)
Preferred stock dividends............................................ 5.3 - 2.1
------ --------- ---------
Net income (loss) applicable to common stock.................. $ 18.9 $ 2,201.7 $(6,149.3)
====== ========= =========
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS, continued
(Dollars in millions, except per share data)
(unaudited)
Successor
-----------
One month
ended
September 30,
2003
----
Earnings per common share:
Basic:
Weighted average shares outstanding........................ 100,098,000
===========
Net income................................................. $.19
====
Diluted:
Weighted average shares outstanding........................ 144,671,000
===========
Net income................................................. $.17
====
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)
(Dollars in millions)
(unaudited)
Common stock Accumulated other Retained
Preferred and additional comprehensive earnings
Total stock paid-in capital income (loss) (deficit)
----- ----- --------------- ------------- -------
Predecessor balance, January 1, 2003................. $(2,050.4) $ 501.7 $ 3,497.0 $ 580.6 $(6,629.7)
Comprehensive income, net of tax:
Net income...................................... 2,201.7 - - - 2,201.7
Change in unrealized appreciation
of investments (net of applicable income tax
benefit of nil)............................... (151.6) - - (151.6) -
---------
Total comprehensive income.................. 2,050.1
Change in shares for employee benefit plans....... .3 - .3 - -
--------- ------- --------- ------- ---------
Predecessor balance, August 31, 2003................. - 501.7 3,497.3 429.0 (4,428.0)
Elimination of Predecessor's
equity securities................................. (3,999.0) (501.7) (3,497.3) - -
Issuance of Successor's
equity securities................................. 2,500.0 859.7 1,640.3 - -
Fresh start adjustments.............................. 3,999.0 - - (429.0) 4,428.0
--------- ------- --------- ------- ---------
Successor balance, August 31, 2003................... 2,500.0 859.7 1,640.3 - -
Comprehensive income, net of tax:
Net income...................................... 24.2 - - - 24.2
Change in unrealized appreciation
of investments (net of applicable income tax
expense of $154.4)............................ 273.2 - - 273.2 -
---------
Total comprehensive income.................. 297.4
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 5.3 5.3 - - -
Dividends on preferred stock.................... (5.3) - - - (5.3)
--------- ------- --------- ------- ---------
Successor balance, September 30, 2003................ $ 2,797.4 $ 865.0 $ 1,640.3 $ 273.2 $ 18.9
========= ======= ========= ======= =========
Predecessor balance, January 1, 2002................. $4,753.0 $ 499.6 $ 3,484.3 $(439.0) $ 1,208.1
Comprehensive loss, net of tax:
Net loss........................................ (6,147.2) - - - (6,147.2)
Change in unrealized depreciation of
investments (net of applicable income tax
expense of $324.0)............................ 569.4 - - 569.4 -
----------
Total comprehensive loss.................... (5,577.8)
Issuance of shares for stock options and for
employee benefit plans.......................... 13.0 - 13.0 - -
Payment-in-kind dividends on convertible
preferred stock................................. 2.1 2.1 - - -
Dividends on preferred stock...................... (2.1) - - - (2.1)
----------- ------- --------- ------- ---------
Predecessor balance, September 30, 2002.............. $ (811.8) $ 501.7 $ 3,497.3 $ 130.4 $(4,941.2)
======== ======= ========= ======= =========
The accompanying notes are an integral part
of the consolidated financial statements.
8
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Successor Predecessor
-------------- ---------------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Cash flows from operating activities:
Insurance policy income....................................... $ 223.7 $ 1,876.2 $ 2,313.1
Net investment income......................................... 103.6 933.5 2,723.6
Fee revenue and other income.................................. 2.2 34.3 236.6
Insurance policy benefits..................................... (178.1) (1,466.1) (1,810.4)
Interest expense.............................................. - - (1,013.1)
Policy acquisition costs...................................... (25.6) (287.5) (391.4)
Special charges............................................... - - (46.7)
Reorganization items.......................................... - (26.5) -
Other operating costs......................................... (73.6) (360.8) (1,143.9)
Taxes......................................................... .3 44.2 (130.4)
--------- --------- ----------
Net cash provided by operating activities................... 52.5 747.3 737.4
--------- --------- ----------
Cash flows from investing activities:
Sales of investments.......................................... 2,121.9 5,378.9 15,592.4
Maturities and redemptions of investments..................... 288.7 1,854.7 1,143.9
Purchases of investments...................................... (1,225.6) (7,385.9) (15,771.7)
Cash received from the sale of finance receivables,
net of expenses............................................. - - 1,450.6
Finance receivables originated................................ - - (6,401.8)
Consolidation of partnership which holds
General Motors building..................................... 28.4 - -
Principal payments received on finance receivables............ - - 6,196.6
Change in restricted cash..................................... (22.1) - -
Other......................................................... 4.3 (19.6) (139.2)
--------- --------- ----------
Net cash provided (used) by investing activities ........... 1,195.6 (171.9) 2,070.8
--------- --------- ----------
Cash flows from financing activities:
Amounts received for deposit products......................... 121.8 1,272.7 3,465.0
Withdrawals from deposit products............................. (133.1) (1,784.2) (4,228.6)
Issuance of notes payable..................................... - - 6,034.3
Payments on notes payable..................................... - - (7,918.0)
Ceding commission received on reinsurance transactions........ - - 83.0
Change in cash held in restricted accounts for settlement
of borrowings............................................... - - (210.7)
Investment borrowings......................................... (700.0) (145.3) (1,399.6)
Dividends on preferred shares and distributions on
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts............................. - - (86.2)
--------- --------- ----------
Net cash used by financing activities..................... (711.3) (656.8) (4,260.8)
--------- --------- ----------
Net increase (decrease) in cash and cash equivalents...... 536.8 (81.4) (1,452.6)
Cash and cash equivalents, beginning of period................... 1,187.5 1,268.9 3,060.8
--------- --------- ----------
Cash and cash equivalents, end of period......................... $ 1,724.3 $ 1,187.5 $ 1,608.2
========= ========= ==========
The accompanying notes are an integral part
of the consolidated financial statements.
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2002 Form 10-K of our
predecessor, Conseco, Inc., an Indiana corporation ("Old Conseco").
Conseco, Inc., a Delaware corporation ("CNO"), is the top tier holding
company for our insurance subsidiaries that develop, market and administer
supplemental health insurance, annuity, individual life insurance and other
products. CNO became the successor to Old Conseco in connection with our
bankruptcy reorganization. The terms "Conseco," the "Company," "we," "us," and
"our" as used in this report refer to CNO and its subsidiaries and, unless the
context requires otherwise, Old Conseco and its subsidiaries.
PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE
On December 17, 2002 (the "Petition Date"), Old Conseco and three of its
non-insurance company subsidiaries (collectively, the "Filing Entities") filed
voluntary petitions for relief under Chapter 11 of the United States Bankruptcy
Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the
Northern District of Illinois, Eastern Division (the "Bankruptcy Court"). During
the pendency of the Chapter 11 cases, the Filing Entities continued to operate
their businesses as debtors-in-possession under the jurisdiction of the
Bankruptcy Court and in accordance with the applicable provisions of the
Bankruptcy Code and orders of the Bankruptcy Court.
We emerged from bankruptcy protection under the Sixth Amended Joint Plan of
Reorganization (the "Plan"), which was confirmed pursuant to an order of the
Bankruptcy Court on September 9, 2003 (the "Confirmation Date"), and became
effective on September 10, 2003 (the "Effective Date"). In accordance with
Statement of Position 90-7, "Financial Reporting by Entities in Reorganization
under the Bankruptcy Code," ("SOP 90-7"), we adopted fresh start accounting on
the Effective Date. However, in light of the proximity of such date to the
August month end, for accounting convenience purposes, the effects of fresh
start accounting have generally been reported "as if" they occurred on August
31, 2003. See the note entitled "Fresh Start Reporting" for more information
relating to fresh start accounting.
The Plan generally provided for the full payment or reinstatement of
allowed administrative claims, priority claims, fully secured claims and certain
intercompany claims, and the distribution of new equity securities (including
warrants) of CNO to partially secured and unsecured creditors of the Filing
Entities. Holders of claims arising under Old Conseco's $1.5 billion senior bank
credit facility also received a pro rata interest in a new $1.3 billion senior
bank credit facility. Holders of Old Conseco's common stock and preferred stock
did not receive any distribution under the Plan, and these securities, together
with all other prepetition securities and the $1.5 billion senior bank credit
facility of Old Conseco, were cancelled on the Effective Date.
On the Effective Date, under the terms of the Plan, we emerged from the
bankruptcy proceedings with a capital structure consisting of: (i) a new $1.3
billion senior bank credit facility; (ii) approximately 34.4 million shares of
Class A Senior Cumulative Convertible Exchangeable Preferred Stock of CNO (the
"Preferred Stock") with an initial aggregate liquidation preference of $859.7
million; (iii) 100 million shares of common stock of CNO, excluding shares
issued to our new non-executive chairman upon his appointment and shares issued
or to be issued to directors, officers, or employees under a new equity
incentive plan; and (iv) warrants to purchase 6.0 million shares of CNO common
stock. Under the terms of the Plan, we distributed CNO equity securities to the
creditors of Old Conseco in the amounts outlined below:
o lenders under Old Conseco's senior bank credit facility and director
and officer loan program received approximately 34.4 million shares of
our Preferred Stock with an initial aggregate liquidation preference
of $859.7 million;
o holders of Old Conseco's senior notes received approximately 32.3
million shares of our common stock;
o holders of Old Conseco's guaranteed senior notes received
approximately 60.6 million shares of our common stock;
o holders of Old Conseco's general unsecured claims received
approximately 2.9 million shares of our common stock; and
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
o holders of trust preferred securities issued by Old Conseco's
subsidiary trusts received approximately 1.5 million shares of our
common stock and warrants to purchase 6.0 million shares of our common
stock at an exercise price of $27.60 per share.
The distribution of our common stock summarized above represents
approximately 97 percent of all of the shares of common stock to be distributed
under the Plan. Approximately 2.7 million shares of common stock have been
reserved for distribution under the Plan in respect of disputed claims, the
resolution of which is still pending. If reserved shares remain after resolution
of these disputed claims, then the reserved shares will be reallocated to other
general unsecured creditors of Old Conseco as provided for under the Plan.
For a complete discussion of the distributions provided for under the Plan,
investors should refer to the complete text of the Plan confirmed by the
Bankruptcy Court on September 9, 2003, and filed with the Securities and
Exchange Commission on September 15, 2003 with our Current Report on Form 8-K.
Our common stock is listed on the New York Stock Exchange ("NYSE") under
the symbol "CNO," and our warrants are listed on the NYSE under the symbol "CNO
WS." Our Preferred Stock currently trades on the Over-the-Counter Bulletin Board
under the symbol "CNSJP."
DISCONTINUED FINANCE BUSINESS -- SALE OF CFC
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our finance business and exited from this line of business. Our
finance business was conducted through our indirect wholly-owned subsidiary,
Conseco Finance Corp. ("CFC"). We accounted for our finance business as a
discontinued operation in 2002 once we formalized plans to sell it. On April 1,
2003, CFC and 22 of its direct and indirect subsidiaries, which collectively
comprised substantially all of our finance business, filed liquidating plans of
reorganization with the Bankruptcy Court in order to facilitate the sale of this
business. The sale of the finance business was completed in the second quarter
of 2003. We did not receive any proceeds from this sale in respect of our
interest in CFC, nor did any creditors of Old Conseco. As of March 31, 2003, we
ceased to include the assets and liabilities of CFC on our consolidated balance
sheet.
BASIS OF PRESENTATION
References in these consolidated financial statements to "Predecessor"
refer to Old Conseco prior to August 31, 2003. References to "Successor" refer
to the Company on and after August 31, 2003, after giving effect to the
implementation of fresh start reporting. The accompanying consolidated financial
statements have been prepared in accordance with SOP 90-7. Accordingly, all
prepetition liabilities subject to compromise have been segregated in the
Predecessor's consolidated balance sheet and classified as "liabilities subject
to compromise" at the estimated amount of allowable claims.
Pursuant to SOP 90-7, professional fees associated with the Chapter 11
cases are expensed as incurred and reported as reorganization items. Interest
expense is reported only to the extent that it was paid during the Chapter 11
cases. During the period January 1, 2003 through August 31, 2003, the Company
recognized a charge of $70.9 million associated with the Chapter 11 cases for
fees payable to professionals to assist with the Chapter 11 cases.
Upon our emergence from bankruptcy, we implemented fresh start reporting in
accordance with SOP 90-7. These rules required the Company to revalue its assets
and liabilities to current estimated fair value, re-establish shareholders'
equity at the reorganization value determined in connection with the Plan, and
record any portion of the reorganization value which cannot be attributed to
specific tangible or identified intangible assets as goodwill. As a result, the
Company's financial statements for periods following August 31, 2003, will not
be comparable with those of Old Conseco prepared before that date.
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary to present fairly our financial position and
results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form 10-Q,
we have condensed or omitted certain information and disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). We have also reclassified certain amounts from
the prior periods to conform to the 2003 presentation. These reclassifications
have no effect on net income or
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
shareholders' equity. Results for interim periods are not necessarily indicative
of the results that may be expected for a full year.
During the third quarter of 2002, Old Conseco entered into an agreement to
sell Conseco Variable Insurance Company ("CVIC"), its wholly owned subsidiary
and the primary writer of its variable annuity products. The sale was completed
in October 2002. The operating results of CVIC have been reported as
discontinued operations in all periods presented in the accompanying
consolidated statement of operations. See the note to the consolidated financial
statements entitled "Discontinued Operations."
During 2001, we stopped renewing a large portion of our major medical lines
of business. These lines of business are referred to herein as the "major
medical business in run-off".
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect various
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions in calculating values for the cost of policies produced, the
cost of policies purchased, the value of policies in force at the Effective
Date, certain investments, assets and liabilities related to income taxes,
goodwill, liabilities for insurance and asset accumulation products, liabilities
related to litigation, guaranty fund assessment accruals and liabilities related
to guarantees of bank loans and the related interest loans to certain former
directors and to certain current and former officers and key employees. If our
future experience differs from these estimates and assumptions, our financial
statements would be materially affected.
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
FRESH START REPORTING
Upon the confirmation of the Plan on September 9, 2003, we implemented
fresh start reporting in accordance with SOP 90-7. However, in light of the
proximity of this date to the August month end, for accounting convenience
purposes, we have reported the effects of fresh start accounting as if they
occurred on August 31, 2003. We engaged an independent financial advisor to
assist in the determination of our reorganization value as defined in SOP 90-7.
We determined a reorganization value, together with our financial advisor, using
various valuation methods, including: (i) selected comparable companies
analysis; and (ii) actuarial valuation analysis. These analyses are necessarily
based on a variety of estimates and assumptions which, though considered
reasonable by management, may not be realized, and are inherently subject to
significant business, economic and competitive uncertainties and contingencies,
many of which are beyond our control. Changes in these estimates and assumptions
may have had a significant effect on the determination of our reorganization
value. The estimated reorganization value of the Company was calculated to be
approximately $3.7 billion to $3.9 billion. We selected the midpoint of the
range, $3.8 billion, as the reorganization value. Such value was confirmed by
the Bankruptcy Court on the Confirmation Date.
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Under fresh start reporting, a new reporting entity is considered to be
created and the Company is required to revalue its assets and liabilities to
current estimated fair value, re-establish shareholders' equity at the
reorganization value determined in connection with the Plan, and record any
portion of the reorganization value which can not be attributed to specific
tangible or identified intangible assets as goodwill. In addition, all
accounting standards that are required to be adopted in the financial statements
within twelve months following the adoption of fresh start accounting were
adopted as of August 31, 2003. Adjustments to the Predecessor's consolidated
balance sheet as of August 31, 2003, to reflect the discharge of debt, change in
capital structure and the fair value of our assets and liabilities are presented
in the following table (dollars in millions):
Debt Fresh
Predecessor discharge and start Successor
balance sheet(a) reorganization (b) adjustments balance sheet
---------------- ------------------ ----------- -------------
Assets:
Investments .............................................. $22,018.3 $ - $ 1,043.5 (c) $23,124.2
62.4 (d)
Cash and cash equivalents................................. 1,187.5 - 28.4 (c) 1,215.9
Accrued investment income................................. 304.6 - - 304.6
Value of policies in force at the Effective Date.......... - - 2,836.9 (e) 2,836.9
Cost of policies purchased................................ 1,099.2 - (1,099.2) (e) -
Cost of policies produced................................. 2,019.5 - (2,019.5) (e) -
Reinsurance receivables................................... 878.3 - 54.0 (f) 932.3
Goodwill.................................................. 99.4 - 1,003.4 (f) 1,102.8
Other intangible assets................................... - - 174.8 (f) 174.8
Income tax assets......................................... 88.0 - - 88.0
Assets held in separate accounts and investment trust..... 87.7 - - 87.7
Other assets.............................................. 535.6 - 10.1 (f) 545.7
--------- --------- --------- ---------
Total assets......................................... $28,318.1 $ - $ 2,094.8 $30,412.9
========= ========= ========= =========
Liabilities:
Liabilities for insurance and asset accumulation products. $22,175.6 $ - $ 2,337.7 (g) $24,513.3
Other liabilities......................................... 868.1 - (23.7) (f) 875.2
30.8 (c)
Investment borrowings..................................... 524.4 - 700.0 (c) 1,224.4
Notes payable - direct corporate obligations.............. - 1,300.0 - 1,300.0
--------- --------- --------- ---------
Total liabilities not subject to compromise.......... 23,568.1 1,300.0 3,044.8 27,912.9
Liabilities subject to compromise......................... 6,951.4 (6,951.4) - -
--------- --------- --------- ---------
Total liabilities ................................... 30,519.5 (5,651.4) 3,044.8 27,912.9
--------- --------- --------- ---------
Shareholders' equity (deficit):
Convertible preferred stock............................... 501.7 - (501.7) -
Convertible exchangeable preferred stock.................. - 859.7 - 859.7
Common stock and additional paid-in capital............... 3,497.3 1,640.3 (3,497.3) 1,640.3
Retained earnings (accumulated deficit)................... (6,629.4) 3,151.4 3,478.0 -
Accumulated other comprehensive income.................... 429.0 - (429.0) -
--------- --------- --------- ---------
Total shareholders' equity (deficit)................. (2,201.4) 5,651.4 (950.0) 2,500.0
--------- --------- --------- ---------
Total liabilities and shareholders' equity (deficit).......... $28,318.1 $ - $ 2,094.8 $30,412.9
========= ========= ========= =========
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
- -----------------
(a) Predecessor balance sheet as of August 31, 2003, prior to the
recording of the discharge of prepetition liabilities and the effects
of the fresh start adjustments.
(b) The fresh start balance sheet reflects the reorganization value for
Conseco of $3,800.0 million. After deducting from Conseco's
reorganization value the long-term indebtedness of Conseco at the
Effective Date, consisting of $1,300 million of indebtedness under the
new senior secured bank credit facility, the total equity of Conseco
is $2,500 million. After deducting from Conseco's total equity the
value of the new Preferred Stock of $859.7 million, the value of the
new common stock is $1,640.3 million. These adjustments also reflect
the gain on the discharge of prepetition liabilities.
(c) In accordance with a new accounting pronouncement, the Company was
required to consolidate the assets and liabilities of the partnership
which owned the General Motors building into its balance sheet. As a
result of the consolidation and the adoption of fresh start accounting
we increased our investment in the General Motors building by $1,043.5
million and recognized the following other assets and liabilities held
by the partnership which owns the General Motors building: (i) cash of
$28.4 million; (ii) other liabilities of $30.8 million; and (iii) a
note payable of $700 million. We sold the General Motors building in
September 2003 at a value that was approximately equal to the fresh
start value. The note payable of the partnership was paid in full and
the net proceeds from the sale were distributed to the partners.
(d) The values of our mortgage loans, policy loans and other invested
assets were adjusted to market value at the Effective Date. In
addition, the cost basis of our actively managed fixed maturities was
increased by $436.6 million to recognize all of the unrealized
appreciation based on the Predecessor cost basis at the Effective
Date.
(e) The Company's historical cost of policies purchased and cost of
policies produced are eliminated and replaced with the value of
policies in force at the Effective Date. The value of policies in
force reflects the estimated fair value of the Company's business in
force and represents the portion of the estimated reorganization value
allocated to the value of the right to receive future cash flows from
the policies in force on the Effective Date.
A discount rate of 12 percent was used to determine the value of
policies in force and is the rate of return which management of the
Company (with assistance from an independent actuarial firm) believes
would be required by a purchaser of the business based on conditions
existing as of the Effective Date. In determining such rate of return,
the following factors, among others, are considered.
o The magnitude of the risks associated with each of the actuarial
assumptions used in determining the expected cash flows.
o Market rates of interest that would be applicable to an acquisition
of the business.
o The perceived likelihood of changes in insurance regulations and
tax laws.
o The complexity of the business.
o Prices paid for similar blocks of business.
(f) Assets and liabilities are adjusted to reflect their estimated fair
market value. The portion of the reorganization value that could not
be attributed to specific tangible or identified intangible assets has
been recorded as goodwill.
(g) The Company establishes reserves for insurance policy benefits based
on assumptions as to investment yields, mortality, morbidity,
withdrawals and lapses. These reserves include amounts for estimated
future payment of claims based on actuarial assumptions. Many factors
can affect these reserves, such as economic conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal
liability and extra contractual damage
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
awards. The balance is based on the Company's best estimate (with
assistance from an independent actuarial firm) of the future
performance of this business, given recent and expected future changes
in experience.
REORGANIZATION ITEMS
Reorganization items represent amounts the Predecessor incurred as a result
of its Chapter 11 reorganization, and are presented separately in the
consolidated statement of operations. These items consist of the following
(dollars in millions):
Two months Eight months
ended ended
August 31, 2003 August 31, 2003
--------------- ---------------
Gain on discharge of prepetition liabilities......... $3,151.4 $ 3,151.4
Fresh start adjustments.............................. (950.0) (950.0)
Professional fees.................................... (38.4) (70.9)
-------- ---------
Total reorganization items....................... $2,163.0 $ 2,130.5
======== =========
LIABILITIES SUBJECT TO COMPROMISE
Under the Bankruptcy Code, actions by creditors to collect indebtedness
owed prior to the Petition Date were stayed and certain other prepetition
contractual obligations could not be enforced against the Filing Entities. The
Filing Entities received approval from the Bankruptcy Court to pay certain
prepetition liabilities including employee salaries and wages, benefits and
other employee obligations. All other prepetition liabilities were classified as
"liabilities subject to compromise" in the accompanying consolidated balance
sheet.
The following table summarizes the components of the liabilities included
in the line "liabilities subject to compromise" in our consolidated balance
sheet at December 31, 2002 (dollars in millions):
Other liabilities:
Liability for guarantee of bank loans to former directors and current
and former officers and key employees of Old Conseco to
purchase common stock of Old Conseco................................ $ 480.8
Interest payable....................................................... 171.6
Accrual for distributions on Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts of Old Conseco. 90.1
Liability for retirement benefits pursuant to executive
employment agreements............................................... 22.6
Liability for deferred compensation.................................... 2.3
Other liabilities...................................................... 48.8
--------
Total other liabilities subject to compromise....................... 816.2
Notes payable - direct corporate obligations............................... 4,057.1
--------
Total liabilities subject to compromise............................. $4,873.3
========
GOODWILL
Upon our emergence from bankruptcy, we revalued our assets and liabilities
to current estimated fair value and established our capital accounts at the
reorganization value determined in connection with the Plan. We recorded the
$1,102.8 million of the reorganization value which could not be attributed to
specific tangible or identified intangible assets as goodwill. Under current
accounting rules (which became effective January 1, 2002) goodwill is not
amortized but is subject to an annual impairment test (or more frequent under
certain circumstances). We obtained an independent appraisal of our business in
connection with the preparation of the Plan and our implementation of fresh
start accounting.
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Although the goodwill balance will not be subject to amortization, it will
be reduced by future use of the Company's net deferred income tax assets
(including the tax operating loss carryforwards) existing at August 31, 2003
(such balance was reduced by $l67.4 million in the one month ended September 30,
2003). A valuation allowance has been provided for the remaining balance of such
net deferred income tax assets due to the uncertainties regarding their
realization. See the note entitled "Income Taxes" for further discussion.
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Changes in the carrying amount of goodwill are as follows (dollars in
millions):
Successor
--------------
One month
ended
September 30,
2003
----
Goodwill balance, beginning of period................................ $1,102.8
Recognition of tax valuation reserve established at the
Effective Date.................................................. (167.4)
--------
Goodwill balance, end of period...................................... $ 935.4
========
OTHER INTANGIBLE ASSETS
In conjunction with our adoption of fresh start accounting, we identified
certain intangible assets other than goodwill. We determined the value of these
assets with assistance from an independent valuation firm. In accordance with
Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"), other intangible assets with indefinite lives
are not amortized, but are subject to impairment tests on an annual basis (or
more frequent under certain circumstances). SFAS 142 requires intangible assets
with finite useful lives to be amortized over their estimated useful lives and
to be reviewed for impairment in accordance with Statement of Financial
Accounting Standards No. 144, "Accounting for Impairment or Disposal of
Long-Lived Assets" ("SFAS 144").
The following summarizes other identifiable intangible assets as of
September 30, 2003 (dollars in millions):
Indefinite lived other intangible assets:
Trademarks and tradenames...................................... $ 25.1
State licenses and charters.................................... 34.0
------
Total indefinite lived other intangible assets............. 59.1
------
Finite lived other intangible assets:
Career agency force............................................ 64.7
Independent agency force....................................... 49.8
Other.......................................................... 1.2
Less accumulated amortization.................................. (1.0)
------
Total finite lived other intangible assets................. 114.7
------
Total other intangible assets..................................... $173.8
======
CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND GOODWILL IMPAIRMENT RELATED TO
PREDECESSOR
The Financial Accounting Standards Board ("FASB") issued SFAS 142, in June
2001. Under the new rule, intangible assets with an indefinite life are no
longer amortized in periods subsequent to December 31, 2001, but are subject to
annual impairment tests (or more frequent under certain circumstances),
effective January 1, 2002. The Company determined that all of its goodwill had
an indefinite life and was therefore subject to the new rules. The Company
adopted SFAS 142 on January 1, 2002.
Pursuant to the transitional rules of SFAS 142, we completed the two-step
impairment test during 2002 and, as a result of that test, we recorded the
cumulative effect of the accounting change for the goodwill impairment charge of
$2,949.2 million. The impairment charge is reflected as the cumulative effect of
an accounting change in the accompanying
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
consolidated statement of operations for the nine months ended September 30,
2002. Subsequent impairment tests will be performed on an annual basis, or more
frequently if circumstances indicate a possible impairment. Subsequent
impairment charges are classified as an operating expense. As described below,
the Company performed an impairment test in the quarter ended September 30,
2002, as a result of circumstances which indicated a possible impairment.
The significant factors used to determine the amount of the initial
impairment included analyses of industry market valuations, historical and
projected performance of our insurance segment, discounted cash flow analyses
and the market value of our capital. The valuation utilized the best available
information, including assumptions and projections we considered reasonable and
supportable. The assumptions we used to determine the discounted cash flows
involve significant judgments regarding the best estimate of future premiums,
expected mortality and morbidity, interest earned and credited rates,
persistency and expenses. The discount rate used was based on an analysis of the
weighted average cost of capital for several insurance companies and considered
the specific risk factors related to Conseco. Pursuant to the guidance in SFAS
142, quoted market prices in active markets are the best evidence of fair value
and shall be used as the basis for measurement, if available.
On August 14, 2002, our insurance subsidiaries' financial strength ratings
were downgraded by A.M. Best to "B (fair)" and on September 8, 2002, the Company
defaulted on its public debt. These developments caused sales of our insurance
products to fall and policyholder redemptions and lapses to increase. The
adverse impact on our insurance subsidiaries resulting from the ratings
downgrade and parent company default required that an additional impairment test
be performed as of September 30, 2002, in accordance with SFAS 142.
In connection with the preparation of the Plan, we retained an outside
actuarial consulting firm to assist in valuing our insurance subsidiaries. That
valuation work and our internal evaluation were used in performing the
additional impairment tests that resulted in an impairment charge to goodwill in
the third quarter of 2002 of $500.0 million. The charge is reflected in the line
item entitled "Goodwill impairment" in our consolidated statement of operations
for the three and nine months ended September 30, 2002. The most significant
changes made to the January 1, 2002 valuation that resulted in the additional
impairment charge were: (i) reduced estimates of projected future sales of
insurance products; (ii) increased estimates of future policyholder redemptions
and lapses; and (iii) a higher discount rate to reflect the current rates used
by the market to value life insurance companies. Management believes that the
assumptions and estimates used were reasonable given all available facts and
circumstances at the time made.
Prior to the adoption of SFAS 142, we determined whether goodwill was
recoverable from projected undiscounted net cash flows for the earnings of our
subsidiaries over the remaining amortization period. If we determined that
undiscounted projected cash flows were not sufficient to recover the goodwill
balance, we would reduce its carrying value with a corresponding charge to
expense or shorten the amortization period. Cash flows considered in such an
analysis were those of the business acquired, if separately identifiable, or the
product line that acquired the business, if such earnings were not separately
identifiable.
Changes in the carrying amount of Predecessor's goodwill are as follows
(dollars in millions):
Predecessor
----------------------------------
Eight months Nine months
ended ended
August 31, September 30,
2003 2002
---- ----
Goodwill balance, beginning of period............................. $100.0 $ 3,695.4
Cumulative effect of accounting change............................ - (2,949.2)
Impairment charge................................................. - (500.0)
Reduction of tax valuation contingencies established at
acquisition date for acquired companies...................... (.6) (146.2)
------ ---------
Goodwill balance, end of period................................... $ 99.4 $ 100.0
====== =========
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity (deficit)); (ii) "trading" (which we carry at estimated
fair value with changes in such value recognized as trading income); and (iii)
"held to maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
At August 31, 2003, we established trading security accounts which are
designed to act as a hedge for embedded derivatives related to: (i) our
equity-indexed annuity products; and (ii) certain modified coinsurance
agreements. See the note entitled "Accounting for Derivatives" for further
discussion regarding the embedded derivatives and the trading accounts. In
addition, the trading account includes the investments backing the market
strategies of our multibucket annuity products. The change in market value of
these securities is substantially offset by the change in insurance policy
benefits for these products. All of our trading securities totaled $944.9
million at September 30, 2003. The change in the market value of these
securities is recognized currently in investment income (classified as income
from policyholder and reinsurer accounts).
Accumulated other comprehensive income is primarily comprised of unrealized
gains on actively managed fixed maturity investments. These amounts, included in
shareholders' equity (deficit) as of September 30, 2003, and December 31, 2002,
were as follows (dollars in millions):
Successor Predecessor
------------ ------------
September 30, December 31,
2003 2002
---- ----
Unrealized gains on investments....................................................... $ 470.6 $448.1
Adjustments to value of policies inforce at the Effective Date........................ (43.0) -
Adjustments to cost of policies purchased and cost of policies produced............... - (95.3)
Deferred income tax asset (liability)................................................. (154.4) 249.6
Other................................................................................. - (21.8)
------- ------
Accumulated other comprehensive income........................................... $ 273.2 $580.6
======= ======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC.
At September 30, 2003, our venture capital investments consisted of 4.1
million shares of AT&T Wireless Services, Inc. ("AWE") with a value of $33.7
million. Our investment in AWE is carried at fair value, with changes in fair
value recognized as investment income (loss). We recognized venture capital
investment income (losses) of $(2.7) million in the one month ended September
30, 2003; $2.0 million in the two months ended August 31, 2003; and $10.5
million in the eight months ended August 31, 2003, related to this investment.
Our venture capital investment losses related to this investment were $6.6
million and $106.6 million in the three and nine months ended September 30,
2002, respectively.
COST OF POLICIES PRODUCED
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balance of Old Conseco's cost of policies produced as
of August 31, 2003 and replaced it with the value of policies in force at the
Effective Date.
The costs that vary with, and are primarily related to, producing new
insurance business in the period after August 31, 2003 are referred to as cost
of policies produced. We amortize these costs (using the interest rate credited
to the underlying policy for universal life or investment-type products and the
projected investment earnings rate for other products): (i) in relation to the
estimated gross profits for universal life-type and investment-type products; or
(ii) in relation to future anticipated premium revenue for other products.
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the cost of
policies produced for the change in amortization that would have been recorded
if actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income (loss)
within shareholders' equity (deficit).
When we replace an existing insurance contract with another insurance
contract with substantially different terms, all unamortized cost of policies
produced related to the replaced contract is immediately written off. When we
replace an existing insurance contract with another insurance contract with
substantially similar terms, we continue to defer the cost of policies produced
associated with the replaced contract.
We regularly evaluate the recoverability of the unamortized balance of the
cost of policies produced. We consider estimated future gross profits or future
premiums, expected mortality or morbidity, interest earned and credited rates,
persistency and expenses in determining whether the balance is recoverable. If
we determine a portion of the unamortized balance is not recoverable, it is
charged to amortization expense.
VALUE OF POLICIES INFORCE AT THE EFFECTIVE DATE
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of Old Conseco's cost of policies purchased
and cost of policies produced as of the Effective Date and replaced them with
the value of policies inforce as of the Effective Date.
The cost assigned to the right to receive future cash flows from contracts
existing at August 31, 2003 is referred to as the value of policies inforce as
of the Effective Date. We also defer renewal commissions paid in excess of
ultimate commission levels related to the existing policies in this account. The
balance of this account is amortized, evaluated for recovery, and adjusted for
the impact of unrealized gains (losses) in the same manner as the cost of
policies produced described above.
The discount rate we used to determine the value of policies inforce as of
the Effective Date is the rate of return we need to earn in order to invest in
the business. In determining this required rate of return, we consider many
factors including: (i) the magnitude of the risks associated with each of the
actuarial assumptions used in determining expected future cash flows; (ii) the
cost of our capital; (iii) the likelihood of changes in projected future cash
flows that might occur if there are changes in insurance regulations and tax
laws; (iv) the compatibility of the business with our future business plans that
may favorably affect future cash flows; (v) the complexity of the business; and
(vi) recent prices (i.e., discount rates used in determining valuations) paid by
others to acquire similar blocks of business. The weighted average discount rate
we used to determine the value of business inforce as of the Effective Date was
12 percent.
The Company expects to amortize approximately 2 percent of the August 31,
2003 balance of cost of policies purchased during the remainder of 2003, 8
percent in 2004, 9 percent in 2005, 9 percent in 2006 and 8 percent in 2007.
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
EARNINGS PER SHARE
A reconciliation of net income and shares used to calculate basic and
diluted earnings per share is as follows:
One month
ended
September 30, 2003
------------------
(Dollars in millions and
shares in thousands)
Net income.................................................................... $24.2
Preferred stock dividends..................................................... (5.3)
-----
Income applicable to common stock
for basic earnings per share........................................... 18.9
Effect of dilutive securities:
Preferred stock dividends.................................................. 5.3
-----
Income applicable to common stock and assumed conversions for
diluted earnings per share................................................. $24.2
=====
Shares:
Weighted average shares outstanding
for basic earnings per share............................................. 100,098
-------
Effect of dilutive securities on weighted average shares:
Preferred Stock (a)...................................................... 44,566
Stock options and employee benefit plans................................. 7
-------
Dilutive potential common shares....................................... 44,573
-------
Weighted average shares outstanding for diluted earnings per share......... 144,671
=======
<FN>
- ---------------
(a) The dilutive effect is determined under the treasury stock method using the
average market price during the period.
</FN>
On the Effective Date, the Successor adopted a new long-term incentive
plan, which permits the grant of CNO incentive or non-qualified stock options
and restricted stock awards to certain directors, officers and employees of CNO
and certain other individuals who perform services for the Company. A maximum of
10 million shares may be issued under the plan. Restricted share grants are
limited to 3.3 million shares. During September 2003, the Company granted
options to purchase 500,000 shares of CNO common stock at $16.40 per share and
500,000 restricted shares of CNO common stock to the Chief Executive Officer in
accordance with his employment agreement. These options and restricted stock
vest over the next four years. In addition, the Company granted options to
purchase 500,000 shares of CNO common stock at $19.61 per share and 500,000
restricted shares of CNO common stock to the non-executive Chairman of the Board
of Directors in accordance with his agreement. These options and restricted
shares vest over the next three years.
Basic earnings per common share ("EPS") is computed by dividing income
applicable to common stock by the weighted average number of common shares
outstanding for the period. Restricted shares are not included in basic EPS
until vested. Diluted EPS reflects the potential dilution that could occur if
the Preferred Stock were converted into common stock, the options were exercised
and the restricted stock was vested. The dilution from options and restricted
shares are calculated using the treasury stock method.
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
STOCK-BASED COMPENSATION
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure", an Amendment of FASB Statement No. 123 ("SFAS 148"), which provides
three alternative methods of transition to the fair value method of accounting
for stock options. SFAS 148 also amends the disclosure requirements of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123").
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" and related interpretations in accounting for our stock
option plans. Since the amount an employee must pay to acquire the stock is
equal to the market price of the stock on the grant date, no compensation cost
has been recognized for our stock option plans. Had compensation cost been
determined based on the fair value at the grant dates consistent with the method
of SFAS 123, the Company's pro forma net income (loss) and pro forma earnings
(loss) per share would have been as follows (dollars in millions, except per
share amounts):
Successor Predecessor
--------------- ----------------------------------------------------------
One month Two months Three months Eight months Nine months
ended ended ended ended ended
September 30, August 31, September 30, August 31, September 30,
2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Net income (loss), as reported .................. $24.2 $2,241.3 $(1,769.0) $2,201.7 $(6,147.2)
Less stock-based employee compensation
expense determined under the fair value
based method for all awards, net of income
taxes....................................... - (2.0) 2.5 7.2 10.5
----- -------- --------- -------- ---------
Pro forma net income (loss)...................... $24.2 $2,243.3 $(1,771.5) $2,194.5 $(6,157.7)
===== ======== ========= ======== =========
Earnings per share:
Basic, as reported.......................... $.19
====
Basic, pro forma............................ $.19
====
Diluted, as reported........................ $.17
====
Diluted, pro forma.......................... $.17
====
All outstanding stock options of the Predecessor were cancelled pursuant to
the Plan. Pro forma compensation expense in the two and eight months ended
August 31, 2003, has been reduced by $5.0 million due to the reversal of expense
for options that were not vested upon cancellation of the outstanding stock
options of the Predecessor.
BUSINESS SEGMENTS
We have historically managed our business operations through two segments,
based on the products offered, in addition to the corporate segment. We are
reorganizing our business and plan to manage them through three segments in the
future: (i) products marketed through career agents and direct marketing; (ii)
products marketed through professional independent producers; and (iii) the
long-term care products which were sold through professional independent
producers but are no longer being marketed. The Company is currently modifying
its accounting and reporting systems to provide information consistent with this
structure.
Insurance and fee-based segment. Our insurance and fee-based segment
provides supplemental health, annuity and life insurance products to a broad
spectrum of customers through multiple distribution channels, each focused on a
specific market segment. These products are primarily marketed through career
agents, professional independent producers and direct
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
marketing. Fee-based activities include services performed for other companies,
including investment management and insurance product marketing.
Finance segment. CFC historically provided a variety of finance products
including: (i) loans for the purchase of manufactured housing, home improvements
and various consumer products; (ii) home equity loans; and (iii) private label
credit card programs. As a result of the formalization of the plan to sell the
finance business and the filing of petitions under the Bankruptcy Code by CFC
and several of its subsidiaries, we accounted for the finance business as a
discontinued business in our consolidated financial statements in 2002. As of
March 31, 2003, we no longer included the assets and liabilities of CFC in our
consolidated financial statements.
Corporate and other segment. Our corporate segment includes certain
investment activities, such as our venture capital investment in AWE. In
addition, the corporate segment includes interest expense related to the
Company's corporate debt, special corporate charges, income (loss) from the
major medical business in run-off and other income and expenses. Corporate
expenses are net of charges to our subsidiaries for services provided by the
corporate operations.
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Operating information regarding the insurance and corporate segments was as
follows (dollars in millions):
Successor Predecessor
--------------- --------------------------------------------------------
One month Two months Three months Eight months Nine months
ended ended ended ended ended
September 30, August 31, September 30, August 31, September 30,
2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Revenues:
Insurance and fee-based segment:
Insurance policy income:
Annuities................................ $ 7.3 $ 16.0 $ 48.1 $ 84.5 $ 111.3
Supplemental health...................... 192.2 380.3 568.6 1,529.2 1,705.9
Life..................................... 43.6 94.9 155.0 395.4 469.8
Other.................................... 5.8 8.5 28.8 46.2 88.1
Net investment income (a).................. 103.2 239.5 332.5 938.6 1,034.7
Fee revenue and other income (a)........... 1.9 8.2 19.9 34.4 69.9
Net realized investment gains
(losses) (a)............................ 6.7 (35.8) (261.1) (5.4) (493.9)
------- ------- -------- -------- --------
Total insurance and fee-based
segment revenues.................... 360.7 711.6 891.8 3,022.9 2,985.8
------- ------- -------- -------- --------
Corporate and other:
Net investment income...................... .1 3.2 3.5 12.4 8.8
Venture capital gain (loss) related
to investment in AWE..................... (2.7) 2.0 (6.6) 10.5 (106.6)
Revenue from the major medical
business in run-off...................... 8.2 18.1 107.0 156.4 366.8
------- ------- -------- -------- --------
Total corporate segment revenues...... 5.6 23.3 103.9 179.3 269.0
Eliminations................................ - - (4.9) - (15.1)
-------- ------- -------- -------- --------
Total revenues........................ 366.3 734.9 990.8 3,202.2 3,239.7
-------- ------- -------- -------- --------
Expenses:
Insurance and fee-based segment:
Insurance policy benefits.................. 236.8 380.1 (b) 841.1 1,999.5 2,256.9
Amortization............................... 27.0 58.4 (b) 160.1 337.6 555.1
Interest expense on investment
borrowings............................... .6 1.9 2.1 8.3 12.4
Other operating costs and expenses......... 47.0 100.7 133.6 380.6 378.7
Goodwill impairment........................ - - 500.0 - 500.0
Special charges............................ - - 2.3 - 42.0
------- ------- -------- -------- --------
Total insurance and fee-based
segment expenses..................... 311.4 541.1 1,639.2 2,726.0 3,745.1
------- ------- -------- -------- --------
(continued on the following page)
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Successor Predecessor
--------------- ----------------------------------------------------------
One month Two months Three months Eight months Nine months
ended ended ended ended ended
September 30, August 31, September 30, August 31, September 30,
2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Corporate and other:
Interest expense on corporate debt.......... 6.4 53.5 82.5 194.1 236.5
Provision for losses and interest
expense related to stock purchase
plan................................... - 24.5 59.9 55.6 199.9
Expenses from the major medical
business in run-off.................... 8.2 18.1 107.0 156.4 366.8
Other corporate expenses, less charges
to subsidiaries for services
provided............................... 2.5 1.7 27.4 28.4 72.7
Extraordinary gain on extinguishment
of debt................................ - - - - (1.8)
Reorganization items........................ - (2,163.0) - (2,130.5) -
Special charges............................. - - 32.6 - 61.1
------ -------- -------- --------- ---------
Total corporate segment expenses.......... 17.1 (2,065.2) 309.4 (1,696.0) 935.2
Eliminations.................................. - - (4.9) - (15.1)
------ -------- -------- --------- ---------
Total expenses............................ 328.5 (1,524.1) 1,943.7 1,030.0 4,665.2
------ -------- -------- --------- ---------
Income (loss) before income taxes,
minority interest, discontinued operations
and cumulative effect of accounting change:
Insurance and fee-based operations.......... 49.3 170.5 (747.4) 296.9 (759.3)
Corporate operations........................ (11.5) 2,088.5 (205.5) 1,875.3 (666.2)
------ -------- -------- --------- ----------
Income (loss) before income taxes,
minority interest, discontinued
operations and cumulative effect
of accounting change.................. $ 37.8 $2,259.0 $ (952.9) $ 2,172.2 $(1,425.5)
====== ======== ======== ========= =========
<FN>
- --------------------
(a) It is not practicable to provide additional components of revenue by
product or service.
(b) In August 2003, the Company decided to change a non-guaranteed element of
certain policies. This element was not required by the policy and the
change will eliminate the former practice of reducing the cost of insurance
charges to amounts below the level permitted under the provisions of the
policies. As a result of this decision, our estimates of future expected
gross profits on these products used as a basis for amortization of cost of
policies purchased and cost of policies produced and the establishment of
insurance liabilities has changed. We adjusted the total amortization and
reserve charge we had recorded since the acquisition of these policies as a
result of the change to our earlier estimates in accordance with Statement
of Financial Accounting Standards No. 97, "Accounting and Reporting by
Insurance Enterprises of Certain Long-Duration Contracts and for Realized
Gains and Losses from the Sale of Investments." The effect of the change in
estimate was a $220.2 million reduction to insurance policy benefits and a
$39.8 million reduction in amortization recorded in the two months ended
August 31, 2003.
</FN>
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return linked to the performance of the S&P 500
Index based on a percentage (the participation rate) over an annual period. At
the beginning of each policy year, a new index period begins. We are able to
change the participation rate at the beginning of each index period, subject to
contractual minimums. We buy S&P 500 Call Options in an effort to hedge
potential increases to policyholder benefits resulting from increases in the S&P
500 Index to which the product's return is linked. We include the cost of the
S&P 500 Call Options in the pricing of these products. Policyholder account
balances for these annuities fluctuate in relation to changes in the values of
these options. We reflect changes in the estimated market value of these options
in net investment income. Option costs that are attributable to benefits
provided were $5.2 million in the one month ended September 30, 2003; $53.5
million in the eight months ended August 31, 2003; and $72.9 million in the
first nine months of 2002. These costs are reflected in the change in market
value of the S&P 500 Call Options included in investment income. Net investment
income (loss) related to equity-indexed products before this expense was $(3.1)
million in the one month ended September 30, 2003; $78.7 million in the eight
months ended August 31, 2003; and $(24.9) million in the first nine months of
2002. These amounts were substantially offset by the corresponding charge to
insurance policy benefits. The estimated fair value of the S&P 500 Call Options
was $83.7 million and $32.8 million at September 30, 2003 and December 31, 2002,
respectively. We classify these instruments as other invested assets. The
Company accounts for the options attributed to the policyholder for the
estimated life of the annuity contract as embedded derivatives as defined by
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", as amended by Statement of Financial
Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement
No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities". We record
the change in the fair values of the embedded derivatives in current earnings as
a component of policyholder benefits. The fair value of these derivatives, which
are classified as "liabilities for interest-sensitive products", was $243.7
million and $301.9 million at September 30, 2003 and December 31, 2002,
respectively. We have transferred a specified block of investments which are
equal to the balance of these liabilities to our trading securities account,
which we carry at estimated fair value with changes in such value recognized as
investment income (classified as investment income from policyholder accounts).
The change in value of these trading securities should largely offset the
portion of the change in the value of the embedded derivative which is caused by
interest rate fluctuations.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At September 30, 2003, all of the counterparties were rated "A" or
higher by Standard & Poor's Corporation.
The FASB's Derivative Implementation Group issued SFAS No. 133
Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance
Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that
are Unrelated or Only Partially Related to the Creditworthiness of the Obligor
of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific
circumstances under which bifurcation of an instrument into a host contract and
an embedded derivative is required. DIG B36 requires the bifurcation of a
derivative from the receivable or payable related to a modified coinsurance
agreement, where the yield on the receivable and payable is based on a return of
a specified block of assets rather than the creditworthiness of the ceding
company. We implemented this guidance on August 31, 2003, in conjunction with
our adoption of fresh start accounting. We have determined that certain of our
reinsurance payable balances contain embedded derivatives. Such derivatives had
an estimated fair value of $20.9 million and $29.5 million at August 31, 2003
and September 30, 2003, respectively. We record the change in the fair value of
these derivatives as a component of investment income (classified as investment
income from policyholder and reinsurer accounts). We have transferred the
specific block of investments related to these agreements to our trading
securities account, which we carry at estimated fair value with changes in such
value recognized as investment income (also classified as investment income from
reinsurer accounts). The change in value of these trading securities should
largely offset the change in value of the embedded derivatives.
GUARANTEES
In conjunction with the Plan, $481.3 million principal amount of bank loans
made to certain former directors and certain current and former officers and key
employees to enable them to purchase common stock of Old Conseco were
transferred to the Company. These loans had been guaranteed by Old Conseco. We
received all rights to collect the balances due pursuant to the original terms
of these loans. In addition, we hold loans to participants for interest on the
bank loans which total approximately $200 million. The former bank loans and the
interest loans are collectively referred to as the
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
"D&O loans." We regularly evaluate the collectibility of these loans in light of
the collateral we hold and the credit worthiness of the participants. At August
31, 2003 and September 30, 2003, we have estimated that approximately $52.3
million of the D&O balance (which is included in other assets) is collectible
(net of the cost of collection). An allowance has been established to reduce the
recorded balance of the D&O loans to this balance.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by Old Conseco's subsidiary trusts and eliminated in our reorganization)
who did not opt out of the bankruptcy settlement, will be entitled to receive 45
percent of any proceeds from the collection of certain D&O loans in an aggregate
amount not to exceed $30 million. We have established a liability of $23.5
million (which is included in other liabilities), representing our estimate of
the amount which will be paid to the former holders of TOPrS pursuant to the
settlement.
In accordance with the terms of the Company's former Chief Executive
Officer's employment agreement, Bankers Life and Casualty Company, a
wholly-owned subsidiary of the Company, is the guarantor of the former
executive's nonqualified supplemental retirement benefit. The liability for such
benefit at September 30, 2003 was $15.4 million and is included in the caption
"Other liabilities" in the liability section of the consolidated balance sheet.
REINSURANCE
The cost of reinsurance ceded totaled $25.0 million in the one month ended
September 30, 2003; $199.1 million in the eight months ended August 31, 2003;
and $258.9 million in the first nine months of 2002. We deducted this cost from
insurance policy income. In each case, the ceding Conseco subsidiary is
contingently liable for claims reinsured if the assuming company is unable to
pay. Reinsurance recoveries netted against insurance policy benefits totaled
$24.9 million in the one month ended September 30, 2003; $183.4 million in the
eight months ended August 31, 2003; and $232.8 million in the first nine months
of 2002. Reinsurance premiums assumed totaled $10.6 million in the one month
ended September 30, 2003; $57.3 million in the eight months ended August 31,
2003; and $56.3 million in the first nine months of 2002. See the note entitled
"Accounting for Derivatives" for a discussion of the derivative embedded in the
payable related to certain modified coinsurance agreements.
INCOME TAXES
The components of income tax expense (benefit) are as follows (dollars in
millions):
Successor Predecessor
------------------ -----------------------------------
One month Eight months Nine months
ended ended ended
September 30, 2003 August 31, 2003 September 30, 2002
------------------ --------------- ------------------
Current tax provision..................................... $ .6 $ (13.5) $ 127.7
Deferred tax provision (benefit).......................... 13.0 - (443.8)
----- -------- --------
Income tax expense (benefit) on period income.... 13.6 (13.5) (316.1)
Valuation allowance....................................... - - 1,314.4
----- -------- --------
Total income tax expense (benefit)............... $13.6 $ (13.5) $ 998.3
===== ======= ========
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Successor Predecessor
------------------ -----------------------------------
One month Eight months Nine months
ended ended ended
September 30, 2003 August 31, 2003 September 30, 2002
------------------ --------------- ------------------
U.S. statutory corporate rate............................. 35.0% 35.0% (35.0)%
Valuation allowance....................................... - 25.8 92.2
Gain on debt restructuring................................ - (39.7) -
Subsidiary stock basis adjustment......................... - (21.8) -
Nondeductible goodwill amortization and impairment........ - - 12.2
Other nondeductible expenses.............................. .1 (.1) -
State taxes............................................... .9 .2 (.1)
Provision for tax issues and other........................ - - .7
--- ------ -----
Effective tax rate............................... 36.0% (.6)% 70.0%
==== ====== =====
Conseco and its affiliates are currently under examination by the Internal
Revenue Service (the "IRS") for tax years ending December 31, 1999 through
December 31, 2001. The outcome of the examination is not expected to result in
material adverse deficiencies, but may result in utilization or adjustment to
the income tax loss carryforwards reported below.
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
Successor Predecessor
------------- -------------
September 30, December 31,
2003 2002
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to CFC worthless investment............................... $ 1,133.9 $ -
Other.......................................................................... 135.2 615.0
Deductible temporary differences:
Actively managed fixed maturities.............................................. - 196.0
Capital loss carryforwards..................................................... 406.8 112.8
Interest-only securities....................................................... - 536.3
Insurance liabilities.......................................................... 1,258.5 750.4
Allowance for loan losses...................................................... - 252.2
Reserve for loss on loan guarantees............................................ 221.5 229.2
Venture capital income......................................................... 26.6 -
Unrealized depreciation........................................................ - -
Debt obligations............................................................... - 39.4
Other.......................................................................... 75.4 14.0
--------- ---------
Gross deferred tax assets.................................................... 3,257.9 2,745.3
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (9.3) -
Cost of policies purchased and cost of policies produced....................... (613.6) (773.8)
Unrealized appreciation........................................................ (154.4) (126.2)
Other.......................................................................... (60.8) (125.7)
--------- ---------
Gross deferred tax liabilities............................................... (838.1) (1,025.7)
--------- ---------
Valuation allowance............................................................ (2,419.8) (1,719.6)
--------- ---------
Net deferred tax assets...................................................... - -
--------- ---------
Current income taxes prepaid.......................................................... 86.7 66.9
Income tax liabilities classified as liabilities of discontinued operations........... - 34.6
--------- ---------
Net income tax assets........................................................ $ 86.7 $ 101.5
========= =========
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting bases of assets and
liabilities, capital loss carryforwards and net operating loss carryforwards. In
assessing the realization of deferred income tax assets, we consider whether it
is more likely than not that the deferred income tax assets will be realized.
The ultimate realization of our deferred income tax assets depends upon
generating future taxable income during the periods in which our temporary
differences become deductible and before our net operating loss carryforwards
expire. In addition, the use of the Company's net ordinary loss carryforwards is
dependent, in part, on whether the IRS ultimately agrees with the tax position
we plan to take in our current and future tax returns. We evaluate the
realizability of our deferred income tax assets by assessing the need for a
valuation allowance on a quarterly basis.
A valuation allowance has been provided for the entire balance of net
deferred income tax assets at September 30, 2003, as we believe the realization
of such assets in future periods is uncertain. We reached this conclusion after
considering the availability of taxable income in prior carryback years, tax
planning strategies, our recent history of significant losses and the likelihood
of future taxable income exclusive of reversing temporary differences and
carryforwards.
As of September 30, 2003, we had about $3.6 billion of net operating loss
carryforwards (after taking into account the reduction in tax attributes
described in the paragraph which follows and the loss resulting from the
worthlessness of CFC discussed below), which expire as follows: $2.3 million in
2003; $11.2 million in 2004; $4.5 million in 2005; $0.2 million in 2006; $5.7
million in 2007; $6.6 million in 2008; $10.5 million in 2009; $4.2 million in
2010; $2.5 million in 2011; $16.0 million in 2012; $43.4 million in 2013; $6.9
million in 2014; $60.5 million in 2016; $116.7 million in 2017; $3,322.5 million
in 2018; $.2 million in 2019; $12.1 million in 2020. The timing and manner in
which we will utilize the net operating loss carryforwards in any year or in
total may be limited by various provisions of the Internal Revenue Code (the
"Code") (and interpretation thereof) and our ability to generate sufficient
future taxable income in the relevant carryforward period.
The Code provides that any income realized as a result of the cancellation
of indebtedness (cancellation of debt income or "CODI") in bankruptcy, will
reduce certain tax attributes including net operating loss carryforwards. We
realized an estimated $2.5 billion of CODI when we emerged from bankruptcy.
Accordingly, our net operating loss carryforwards were reduced by $2.5 billion.
The following paragraphs summarize some of the various limitations and
contingencies which exist with respect to the future utilization of the net
operating loss carryforwards.
The Company realized an estimated $5.4 billion tax loss in 2003 as a result
of its investment in CFC. In consultation with our tax advisors and based on
relevant provisions of the Code, the Company intends to treat this loss as an
ordinary loss, thereby increasing the Company's net operating loss carryforward.
The Company has requested a pre-filing examination by the IRS to confirm that
this loss should be treated as an ordinary loss. If the IRS were to disagree
with our conclusion and such determination ultimately prevailed, the loss would
be treated as a capital loss, which would only be available to reduce future
capital gains for the next 5 years. The procedures related to the pre-filing
examination are in process, but are not expected to be completed before August
2004.
The Code limits the extent to which losses realized by a non-life entity
(or entities) may offset income from a life insurance company (or companies) to
the lesser of: (i) 35 percent of the income of the life insurance company; or
(ii) 35 percent of the total loss. There is no limitation with respect to the
ability to utilize net operating losses generated by a life insurance company.
Subsequent to our emergence from bankruptcy, we reorganized certain of our
subsidiaries to improve their capital position. As a result of the
reorganization, the loss related to CFC was realized by a life insurance
company. Accordingly, we believe the loss should be treated as a life insurance
loss and would not be subject to the limitations described above.
The timing and manner in which the Company will be able to utilize its net
operating loss carryforward will be limited by Section 382 of the Code. Section
382 imposes on a corporation's ability to use its net operating losses if the
company undergoes an ownership change. Because the Company underwent an
ownership change pursuant to its reorganization, we have determined that this
limitation applies to the Company. In order to determine the amount of this
limitation we must determine how much of our net operating loss carryforward
relates to the period prior to our emergence from bankruptcy (such amount will
be subject to the 382 limitation) and how much relates to the period after
emergence (such amount will not be subject to the 382 limitation). Pursuant to
the Code, we may: (i) allocate the current year tax loss on a pro rata basis to
determine earnings (loss) post- and pre-emergence; or (ii) specifically identify
transactions in each period and record it in the
29
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
period it actually occurred. We intend to elect the latter, which we believe
will result in a substantial portion of the loss related to CFC being treated as
post emergence and therefore not subject to the Section 382 limitation. Any
losses that are subject to the Section 382 limitation will only be utilized by
the Company up to approximately $140 million per year with any unused amounts
carried forward to the following year.
The use of the Company's net deferred income tax assets (including the net
operating loss carryforwards) existing as of August 31, 2003, will be accounted
for as a reduction of goodwill when utilized pursuant to SOP 90-7. If goodwill
is eliminated, any additional use of net deferred income tax assets existing at
August 31, 2003 will be accounted for as a reduction of other intangible assets
until exhausted and thereafter as an addition to paid-in-capital. Goodwill was
reduced by $167.4 million during the one month ended September 30, 2003, due to
a reduction in the valuation allowance for net deferred income tax assets
established at the Effective Date.
CHANGES IN DIRECT CORPORATE OBLIGATIONS
This note contains information regarding the following notes payable that
were direct corporate obligations of the Company as of September 30, 2003 and
December 31, 2002 (dollars in millions):
Successor Predecessor
------------- ------------
September 30, December 31,
2003 2002
---- ----
$1.3 billion credit agreement........................................................... $1,300.0 $ -
$1.5 billion senior credit facility..................................................... - 1,531.4
8.5% senior notes due 2002.............................................................. - 224.9
8.5% guaranteed senior notes due 2003................................................... - 1.0
8.125% senior notes due 2003............................................................ - 63.5
6.4% senior notes due 2003.............................................................. - 234.1
6.4% guaranteed senior notes due 2004................................................... - 14.9
10.5% senior notes due 2004............................................................. - 24.5
8.75% senior notes due 2004............................................................. - 423.7
8.75% guaranteed senior notes due 2006.................................................. - 364.3
6.8% senior notes due 2005.............................................................. - 99.2
6.8% guaranteed senior notes due 2007................................................... - 150.8
9.0% senior notes due 2006.............................................................. - 150.8
9.0% guaranteed senior notes due 2008................................................... - 399.2
10.75% senior notes due 2008............................................................ - 37.6
10.75% guaranteed senior notes due 2009................................................. - 362.4
-------- ---------
Total principal amount............................................................. 1,300.0 4,082.3
Unamortized net discount related to issuance of notes payable .......................... - (34.0)
Unamortized fair market value of terminated interest rate
swap agreements.................................................................... - 8.8
-------- ---------
Less amounts subject to compromise...................................................... - (4,057.1)
-------- ---------
Direct corporate obligations....................................................... $1,300.0 $ -
======== =========
30
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Pursuant to the Plan, we entered into a senior secured bank credit facility
with a principal balance of $1.3 billion (the "New Credit Facility"). The New
Credit Facility consists of two tranches: Tranche A - $1.0 billion; and Tranche
B - $.3 billion. Principal repayments are due as follows (dollars in millions):
Tranche A Tranche B
--------- ---------
June 30, 2004......................................................... $ 50.0 $ 3.0
June 30, 2005......................................................... 50.0 3.0
June 30, 2006......................................................... 50.0 1.5
December 31, 2006..................................................... 50.0 1.5
June 30, 2007......................................................... 75.0 1.5
December 31, 2007..................................................... 75.0 1.5
June 30, 2008......................................................... 75.0 1.5
December 31, 2008..................................................... 75.0 1.5
June 30, 2009......................................................... - 1.5
September 10, 2009.................................................... 500.0 -
December 31, 2009..................................................... - 1.5
September 10, 2010.................................................... - 282.0
-------- ------
$1,000.0 $300.0
======== ======
Tranche A and Tranche B borrowings bear interest, payable monthly, based on
either an offshore rate or a base rate. Offshore rates are equal to LIBOR plus
an applicable margin based on the rating of the Company's senior secured
long-term debt securities by Moody's Investors Service, Inc. ("Moody's") or
Standard & Poor's Ratings Group ("S&P"). Base rates are equal to: (i) the
greater of: (a) the Federal funds rate plus .50 percent; or (b) Bank of
America's prime rate; plus (ii) an applicable margin based on the rating of the
Company's senior secured long-term debt securities by Moody's or S&P. With
respect to Tranche A, the LIBOR rate may not be less than 2.0 percent through
September 30, 2004, or less than 2.50 percent thereafter. With respect to
Tranche B, the LIBOR rate may not be less than 2.25 percent through September
30, 2004, or less than 2.75 percent thereafter. The range of applicable margins
are summarized in the following table:
Offshore Base rate
rate margin margin
----------- ---------
Tranche A...................................................... 3.75% - 5.25% 1.75% - 3.25%
Tranche B...................................................... 5.75% - 7.25% 3.75% - 5.25%
On September 30, 2003, the interest rates on our Tranche A and Tranche B
borrowings were 7.25 percent and 9.50 percent, respectively.
Pursuant to the New Credit Facility, the Company is required to make
mandatory prepayments with all or a portion of the proceeds from the following
transactions or events including: (i) the issuance of certain indebtedness; (ii)
equity issuances; (iii) certain asset sales or casualty events; (iv) a certain
percentage of amounts received or recovered with respect to the D&O loans; and
(v) excess cash flow as defined in the credit agreement. Proceeds not used to
prepay indebtedness must generally be: (i) used to redeem a portion of our
Preferred Stock; or (ii) contributed to the capital of our insurance
subsidiaries.
The New Credit Facility requires the Company to maintain various financial
ratios and balances, as defined in the agreement including: (i) a debt-to-total
capitalization ratio of less than .358:1.0 or less at September 30, 2003, and
decreasing over time to .200:1.0 at June 30, 2008 (such ratio was .341:1.0 at
September 30, 2003); (ii) an interest coverage ratio greater than or equal to
1.00:1.0 for the quarter ending December 31, 2003, and increasing over time to
4.50:1.0 for the year ending December 31, 2009; (iii) EBITDA, as defined in the
credit agreement, greater than or equal to $490.0 million for the two quarters
ended March 31, 2004, and increasing over time to $1,296.0 million for the four
quarters ending March 31, 2010; (iv) an aggregate risk-based capital ratio, as
defined in the credit agreement, greater than or equal to 158 percent at
September 30, 2003, and increasing over time to 225 percent at March 31, 2006
(such ratio was 257 percent at September 30, 2003); (v)
31
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
minimum individual risk-based capital ratios for certain insurance companies as
of the end of each fiscal year; (vi) minimum levels of statutory capital and
surplus, as defined in the credit agreement (statutory capital and surplus at
September 30, 2003 exceeded such requirements); and (vii) minimum investment
portfolio requirements (such minimum investment portfolio requirements were met
at September 30, 2003). In addition, if we experience a ratings downgrade, or if
we fail to achieve an A.M. Best "A-" rating by August 15, 2005 (or December 31,
2005 if we meet certain financial ratios), we will suffer an event of default
under the New Credit Facility. If we experience a ratings downgrade below "B
(Fair)" or a downgrade by two or more levels in any six-month period, a "trigger
event" will also occur and holders of our Preferred Stock will have the right to
vote with holders of our common stock on all matters on an as-converted basis.
The New Credit Facility prohibits or restricts, among other things: (i) the
payment of cash dividends on the Company's common or preferred stock; (ii) the
repurchase of our common stock; (iii) the issuance of additional debt or capital
stock; (iv) liens; (v) asset dispositions; (vi) affiliate transactions; (vii)
certain investment activities; (viii) change in business; and (ix) prepayment of
indebtedness (other than the New Credit Facility). The obligations under our New
Credit Facility are guaranteed by Conseco's current and future domestic
subsidiaries, other than: (i) its insurance companies; (ii) subsidiaries of the
insurance companies; or (iii) certain immaterial subsidiaries as defined in the
credit agreement. This guarantee was secured by granting liens on substantially
all the assets of the guarantors including the capital stock of our top tier
insurance company, Conseco Life Insurance Company of Texas.
Pursuant to the New Credit Facility, the Company is required to pay a fee
of $6.5 million on June 30, 2004, unless all borrowings under the credit
agreement have been repaid.
The outstanding notes payable that were direct corporate obligations of Old
Conseco prior to our emergence from bankruptcy and the $1.5 billion senior
credit facility were discharged in accordance with the Plan.
PREFERRED STOCK
Pursuant to the Plan, CNO issued 34.4 million shares of Preferred Stock
with an aggregate liquidation preference of approximately $859.7 million. The
Preferred Stock has a par value of $.01 per share and a liquidation preference
of $25 per share. Dividends are payable at a rate equal to 10.5 percent of the
liquidation preference per share, payable semi-annually on March 1 and September
1. This rate will increase to 11 percent beginning September 11, 2005. These
dividends are payable in additional shares of Preferred Stock until the later
of: (i) September 10, 2005; or (ii) the beginning of the first fiscal quarter
after which our primary insurance companies have received a financial strength
rating of at least "A-" by A.M. Best Company ("A.M. Best"). Thereafter,
dividends are payable, at our option, in cash or additional shares of Preferred
Stock. The Preferred Stock may be redeemed by CNO, in whole or in part, at any
time in cash equal to the liquidation preference plus cumulative unpaid
dividends thereon.
The Preferred Stock is convertible, at the option of the holder, into
common stock of CNO at any time on or after September 30, 2005. The conversion
rate is equal to the total liquidation preference plus cumulative unpaid
dividends thereon divided by the greater of: (i) the average price of CNO's
common stock, as defined, for each of the trading days in the 60 calendar day
period immediately preceding January 8, 2004; or (ii) $.15 per share of common
stock.
The Preferred Stock is exchangeable, at the option of the holder, into
common stock of CNO at any time on or after September 10, 2013. The exchange
rate is equal to the total liquidation preference plus cumulative unpaid
dividends thereon divided by the average market price of CNO's common stock, as
defined, for the ten trading days ending on the date of exchange. The maximum
number of common shares that can be issued shall not exceed the greater of: (i)
7.84 billion shares of common stock; or (ii) the number of authorized but
unissued shares of CNO's common stock. In addition, CNO, at its option, may pay
cash in an amount equal to the liquidation preference in lieu of delivering the
exchanged common stock.
The holders of the Preferred Stock will be entitled to voting rights
beginning September 30, 2005 or earlier if there is: (i) a reduction in the
financial strength rating assigned to any of our active material insurance
subsidiaries (as defined) by A.M. Best; (ii) an event of default under our
credit agreement; (iii) the occurrence of a material adverse regulatory event,
as defined, with respect to any of our material insurance subsidiaries (as
defined); or (iv) a failure to maintain various financial ratios and balances
(none of which are more restrictive than the covenants contained in our credit
agreement).
32
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
WARRANTS
Pursuant to the Plan, we issued 6.0 million Series A Warrants (the
"Warrants") entitling the holders to purchase shares of CNO common stock at a
price of $27.60 per share. The Warrants expire on September 10, 2008. The
exercise price and number of common shares issuable are subject to adjustment
based on the occurrence of certain events, including: (i) stock dividends; (ii)
stock splits; and (iii) the issuance of instruments or securities which are
exercisable for or convertible into shares of common stock entitling the holders
to purchase shares of common stock at a price per share that is less than the
market price on the date of issuance.
SALE OF THE GENERAL MOTORS BUILDING
During the summer of 2003, we successfully enforced our contractual right
to buy out our 50 percent equity partner in the General Motors building ("GM
building"), a landmark 50-story office tower in New York City. After obtaining
an award in arbitration, and confirming that award in the New York court system,
we finally settled our differences with our equity partner, thus permitting us
to put the building up for sale. On September 26, 2003, we sold our investment
in the GM building. We received cash of $636.8 million, which was approximately
equal to the value established upon the adoption of fresh start accounting.
Our investment in the GM building was made through a partnership which
acquired the building in 1998 for $878 million. The initial capital structure of
the partnership consisted of: (i) a $700 million senior mortgage; (ii) $200
million of subordinated debt with a stated fixed return of 12.7 percent
payable-in-kind, and the opportunity to earn an additional residual return; and
(iii) $30 million of partnership equity, owned 50 percent by Conseco and 50
percent by an affiliate of Donald Trump. A Trump affiliate also served as
general manager of the acquired building. We owned 100 percent of the
subordinated debt.
The $30 million of partnership equity represented less than 10 percent of
the total capital of the partnership. In addition, the subordinated debt was
intended to absorb virtually all expected losses and receive a significant
portion of expected residual returns. Based on our 100 percent ownership of the
subordinated debt, we were the primary beneficiary of the GM building. The
partnership was consolidated in our financial statements effective August 31,
2003 in accordance with the requirements of FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities" ("FIN 46"), which was implemented
in conjunction with fresh start accounting. The August 31, 2003 fresh start
balance sheet reflected the following balances of the partnership: the GM
building at $1,336.3 million; cash of $28.4 million; and a non-recourse loan of
$700 million (classified as an investment borrowing). Our income statement for
the one month ended September 30, 2003, reflected investment income of $2.9
million related to this investment (representing our equity interest in the
income from the building for the 26 days prior to the sale).
RECENTLY ISSUED ACCOUNTING STANDARDS
Pursuant to SOP 90-7, we have implemented the provisions of accounting
principles required to be adopted within twelve months of the adoption of fresh
start accounting. The following summarizes the new accounting pronouncements we
have recently adopted:
The FASB's Derivative Implementation Group issued DIG B36 in April 2003.
DIG B36 addresses specific circumstances under which bifurcation of an
instrument into a host contract and an embedded derivative is required. DIG B36
requires the bifurcation of a derivative from the receivable or payable related
to a modified coinsurance agreement, where the yield on the receivable and
payable is based on a return of a specified block of assets rather than the
creditworthiness of the ceding company. We implemented this guidance on August
31, 2003, in conjunction with our adoption of fresh start accounting. See the
note entitled "Accounting for Derivatives" for a discussion of the impact of
implementing this guidance.
The FASB issued Financial Accounting Standards No. 149 "Amendment of SFAS
No. 133 on Derivative Instruments and Hedging Activities" ("SFAS 149") in April
2003. SFAS 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities." Except for
certain
33
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
implementation guidance included in SFAS 149 which is already effective, the new
guidance is effective for: (i) contracts entered into or modified after June 30,
2003; and (ii) hedging relationships designated after June 30, 2003. The
adoption of SFAS 149 did not have a material impact on the Company's
consolidated financial statements.
The FASB issued Financial Accounting Standards No. 150, "Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity" ("SFAS 150") in May 2003. SFAS 150 establishes standards for classifying
and measuring certain financial instruments that embody obligations of the
issuer and have characteristics of both liabilities and equity. For example,
mandatorily redeemable preferred stock is required to be classified as a
liability pursuant to SFAS 150. SFAS 150 is effective immediately for financial
instruments entered into or modified after May 31, 2003, and for all other
financial instruments beginning with the third quarter of 2003. Effective July
1, 2003, Old Conseco's Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts, or TOPrS, with an aggregate carrying value of
$1,921.5 million, were reclassified to liabilities pursuant to the provisions of
SFAS 150. The adoption of SFAS 150 does not impact the financial statements of
Conseco subsequent to the Effective Date since the Company-obligated mandatorily
redeemable preferred securities of subsidiary trusts are no longer outstanding.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants issued Statement of Position 03-1 "Accounting and
Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration
Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01
provides guidance on several insurance company disclosure and accounting matters
including the appropriate accounting for: (i) separate accounts; (ii) additional
interest (for example, persistency bonus) accruing to the investment contract
holder; (iii) the liability for contracts where the amounts assessed against the
contract holder each period are assessed in a manner that is expected to result
in profits in earlier years and losses in subsequent years; (iv) potential
benefits to annuity holders in addition to their account balance; (v) sales
inducements to contract holders; and (vi) other provisions. The Company recently
sold most of its separate account business. Accordingly, the new guidance
related to separate accounts will have no impact on the Company's consolidated
financial position, results of operations or cash flows. As a result of our
adoption of fresh start accounting, we were required to revalue our insurance
product liabilities and record them at their estimated fair market value. In
calculating the value of the liabilities for insurance and asset accumulation
products, we followed the guidance of SOP 03-01. We have changed the way we
classify the costs related to sales inducements in accordance with the new
guidance. However, such change was not material. Our reserve for sales
inducement persistency bonus benefits was $280.0 million at September 30, 2003,
and $278.6 million at August 31, 2003.
In January 2003, the FASB issued FIN 46, which requires expanded
disclosures for and, in some cases, consolidation of significant investments in
variable interest entities ("VIE"). A VIE is an entity in which the equity
investors do not have the characteristics of a controlling financial interest,
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties.
Under FIN 46, a company is required to consolidate a VIE if it is the primary
beneficiary of the VIE. FIN 46 defines primary beneficiary as the party which
will absorb a majority of the VIE's expected losses or receive a majority of the
VIE's expected residual returns, or both.
The Company has investments in various types of VIEs, some of which require
additional disclosure under FIN 46, and several of which will require
consolidation under FIN 46. As further discussed in the note to the consolidated
financial statements entitled "Investments in Variable Interest Entities", we
have consolidated all of our investments in VIEs. The adoption of the
consolidation requirements of FIN 46 did not have a material impact on our
financial condition or results of operations. The note entitled "Investments in
Variable Interest Entities" includes the expanded disclosures required by FIN
46.
The FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("FIN 45") in November 2002. FIN 45 requires certain
guarantees to be recognized as liabilities at fair value. In addition, it
requires a guarantor to make new disclosures regarding its obligations. We
implemented the new disclosure requirements as of December 31, 2002. FIN 45's
liability recognition requirement is effective on a prospective basis for
guarantees issued or modified after December 31, 2002. The adoption of FIN 45
did not impact the Company's results of operations or financial condition.
The FASB issued Statement of Financial Accounting Standards No. 146,
"Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146
addresses financial accounting and reporting for costs that are associated with
exit and disposal activities and supersedes Emerging Issues Task Force Issue No.
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)"
34
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal
activities that are initiated after December 31, 2002. The provisions of EITF
94-3 shall continue to apply for an exit activity initiated prior to the
adoption of SFAS 146. SFAS 146 requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of commitment to an exit or disposal plan. The Company adopted the provisions of
SFAS 146 on January 1, 2003. The initial adoption of SFAS 146 did not have an
impact on the Company's consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards No. 145,
"Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No.
13, and Technical Corrections" ("SFAS 145") in April 2002. Under previous
guidance all gains and losses resulting from the extinguishment of debt were
required to be aggregated and, if material, classified as an extraordinary item,
net of related income tax effect. SFAS 145 rescinds that guidance and requires
that gains and losses from extinguishments of debt be classified as
extraordinary items only if they are both unusual and infrequent in occurrence.
SFAS 145 also amends previous guidance to require certain lease modifications
that have economic effects similar to sale-leaseback transactions to be
accounted for in the same manner as sale-leaseback transactions. The Company
adopted SFAS 145 on January 1, 2003. Prior period amounts related to
extraordinary gains on the extinguishment of debt have been reclassified in
accordance with the new guidance.
The FASB issued SFAS 144 in August 2001. This standard addresses the
measurement and reporting for impairment of all long-lived assets. It also
broadens the definition of what may be presented as a discontinued operation in
the consolidated statement of operations to include components of a company's
business segments. SFAS 144 requires that long-lived assets currently in use be
written down to fair value when considered impaired. Long-lived assets to be
disposed of are written down to the lower of cost or fair value less the
estimated cost to sell. The Company adopted this standard on January 1, 2002. We
followed this standard in determining when it was appropriate to recognize
impairments on assets we decided to sell as part of our efforts to raise cash.
We also followed this standard in determining that our variable annuity business
line and CFC should be presented as discontinued operations in our consolidated
financial statements (see the note to the consolidated financial statements
entitled "Discontinued Operations").
35
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
DISCONTINUED OPERATIONS
As previously described in the notes to the consolidated financial
statements entitled "Discontinued Finance Business - Sale of CFC" and "Basis of
Presentation", the operations of CFC and CVIC were classified as discontinued
operations in the 2002 consolidated statement of operations. The following
summarizes selected financial information of CFC and CVIC:
Three months ended Nine months ended
September 30, 2002 September 30, 2002
------------------------- -------------------------
(dollars in millions)
CFC CVIC Total CFC CVIC Total
--- ---- ----- --- ---- -----
Insurance policy income.......................... $ - $ 12.4 $ 12.4 $ - $ 30.5 $ 30.5
Net investment income (loss)..................... 533.3 (120.6) 412.7 1,647.2 (217.3) 1,429.9
Impairment charge................................ (701.3) - (701.3) (701.3) - (701.3)
Fee revenue and other income..................... 70.1 - 70.1 201.3 .2 201.5
Total revenues................................... (129.2) (128.3) (257.5) 1,133.3 (244.4) 888.9
Provision for losses............................. 234.2 - 234.2 550.9 - 550.9
Insurance policy benefits........................ - (125.9) (125.9) - (234.7) (234.7)
Interest expense................................. 282.2 .1 282.3 852.4 1.0 853.4
Amortization..................................... - 132.8 132.8 - 224.6 224.6
Other operating costs and expenses............... 174.0 4.6 178.6 472.1 15.5 487.6
Special charges.................................. 53.4 - 53.4 109.9 - 109.9
Extraordinary gain on extinguishment
of debt...................................... - - - (6.2) - (6.2)
Total expenses................................... 743.8 11.6 755.4 1,979.1 6.4 1,985.5
Pre-tax loss..................................... (873.0) (139.9) (1,012.9) (845.8) (250.8) (1,096.6)
Income tax benefit............................... (331.6) (51.0) (382.6) (321.3) (88.7) (410.0)
------- ------- -------- -------- ------- --------
Amount classified as discontinued operations..... $(541.4) $ (88.9) $ (630.3) $ (524.5) $(162.1) $ (686.6)
======= ======= ======== ======== ======= ========
In addition, in the nine months ended September 30, 2002, CVIC recognized a
$43.8 million cumulative effect of accounting change for goodwill impairment
pursuant to the adoption of SFAS 142.
During 2002, we recognized estimated losses related to the ultimate sale
and disposition of the aforementioned discontinued businesses, including
estimated costs to sell and costs related to the resolution of contingencies.
During the eight months ended August 31, 2003, we reduced the accrual for such
estimated costs by $16.0 million (after income taxes of $.7 million) to reflect
our current estimate. We recorded the reduction of such accrual as income from
discontinued operations.
LITIGATION AND OTHER LEGAL PROCEEDINGS
We are involved on an ongoing basis in lawsuits (including purported class
actions) relating to our operations, including with respect to sales practices,
and we and current and former officers and former directors are defendants in
pending class action lawsuits asserting claims under the securities laws and
derivative lawsuits. The ultimate outcome of these lawsuits cannot be predicted
with certainty and we have estimated the potential exposure for each of the
matters and have recorded a liability if a loss is deemed probable.
Securities Litigation
Since we announced our intention to restructure our capital on August 9,
2002, a total of eight purported securities fraud class action lawsuits have
been filed in the United States District Court for the Southern District of
Indiana. The
36
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
complaints name us as a defendant, along with certain current and
former officers of Old Conseco. These lawsuits were filed on behalf of persons
or entities who purchased Old Conseco's common stock on various dates between
October 24, 2001 and August 9, 2002. In each case Plaintiffs allege claims under
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and allege
material omissions and dissemination of materially misleading statements
regarding, among other things, the liquidity of Conseco and alleged problems in
CFC's manufactured housing division, allegedly resulting in the artificial
inflation of Old Conseco's stock price. On March 13, 2003, all of these cases
were consolidated into one case in the United States District Court for the
Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco,
Inc., et al., File No. 02-CV-1332 DFH-TAB. The lawsuits were stayed as to all
defendants by order of the United States Bankruptcy Court for the Northern
District of Illinois. The stay was lifted on October 15, 2003. It is expected
that plaintiffs will file a consolidated class action complaint with respect to
the individual defendants in November 2003. Our liability with respect to these
lawsuits was discharged in the Plan and our obligation to indemnify certain
individual defendants is limited by the Plan. We believe these lawsuits are
without merit and intend to defend them vigorously. The ultimate outcome of
these lawsuits cannot be predicted with certainty.
Derivative Litigation
Nine shareholder derivative suits were filed in 2000 in the United States
District Court for the Southern District of Indiana. The complaints named as
defendants the then current directors, certain former directors, certain
non-director officers of Old Conseco (in one case), and, alleging aiding and
abetting liability, certain banks that made loans in relation to Old Conseco's
"Stock Purchase Plan" (in three cases). Old Conseco is also named as a nominal
defendant in each complaint. Plaintiffs allege that the defendants breached
their fiduciary duties by, among other things, intentionally disseminating false
and misleading statements concerning the acquisition, performance and proposed
sale of CFC, and engaged in corporate waste by causing Old Conseco to guarantee
loans that certain officers, directors and key employees of Old Conseco used to
purchase stock under the Stock Purchase Plan. These cases have now been
consolidated into one case in the United States District Court for the Southern
District of Indiana, captioned: In Re Conseco, Inc. Derivative Litigation, Case
Number IP00655-C-Y/S. An amended complaint was filed on April 12, 2001, making
generally the same allegations and allegations of violation of the Federal
Reserve Board's margin rules. Three similar cases have been filed in the
Hamilton County Superior Court in Indiana. Schweitzer v. Hilbert, et al., Case
No. 29D01-0004CP251; Evans v. Hilbert, et al., Case No. 29D01-0005CP308 (both
Schweitzer and Evans name as defendants certain non-director officers); Gintel
v. Hilbert, et al., Case No. 29003-0006CP393 (naming as defendants, and alleging
aiding and abetting liability as to, banks that allegedly made loans in relation
to the Stock Purchase Plan). We believe that these lawsuits are without merit
and intend to defend them vigorously. The cases filed in Hamilton County have
been stayed pending resolution of the derivative suits filed in the United
States District Court. We have asserted that these lawsuits are assets of the
estate pursuant to section 541(a) of the Bankruptcy Code and do not intend to
pursue them following emergence from bankruptcy because they are meritless. In
October and November 2003, CNO filed motions to dismiss all the pending
derivative matters. The ultimate outcome of these lawsuits cannot be predicted
with certainty.
Other Litigation
Collection efforts by the Company and Conseco Services, LLC related to the
1996-1999 director and officer loan programs have been commenced against various
past board members and executives/officers with outstanding loan balances. In
addition, certain former officers and directors have sued the companies for
declaratory relief concerning their liability for the loans. Currently, we are
involved in litigation with Stephen C. Hilbert, James D. Massey, Dennis E.
Murray, Sr., Rollin Dick and Bruce Crittenden. The specific lawsuits include:
Hilbert v. Conseco, Case No. 03A 04283 (Bankr. N.D. Ill.); Conseco Services v.
Hilbert, Case No.29C01-0310 MF 1296 (Cir. Ct. Hamilton Cty, Ind.); Murray and
Massey v. Conseco, Case No.1:03-CV-1482 LJM-WTL (S.D. Ind.); Dick v. Conseco
Services, Case No. 29 D01-0207-PL-549 (Sup. Ct. Hamilton Cty, Ind.); and
Crittenden v. Conseco, Case No.IP02-1823-C B/S (S.D. Ind.). The Company and
Conseco Services, LLC believe that all amounts due under the director and
officer loan programs, including all applicable interest, are valid obligations
owed to the companies. We intend to prosecute these claims to obtain the maximum
recovery possible. Further, with regard to the various claims brought against
the Company and Conseco Services, LLC by certain former directors and officers,
we believe that these claims are without merit and intend to defend them
vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
In October 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSave Plan filed an
action in the United States District Court for the Southern District of Indiana
against Old Conseco,
37
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Conseco Services, LLC and certain current and former officers of Old Conseco
(Roderick Russell, et al. v Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM).
The purported class action consists of all individuals whose 401(k) accounts
held common stock of Old Conseco at any time since April 28, 1999. The complaint
alleges, among other things, breaches of fiduciary duties under ERISA by
continuing to permit employees to invest in Old Conseco's common stock without
full disclosure of the Company's true financial condition. Old Conseco filed a
motion to dismiss the complaint in December 2002. This lawsuit was stayed as to
all defendants by order of the Bankruptcy Court. The stay was lifted on October
15, 2003. It is expected that there will be a ruling on the motion to dismiss
before further proceedings occur in this matter. We believe the lawsuit is
without merit and intend to defend it vigorously. The ultimate outcome of the
lawsuit cannot be predicted with certainty.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against Old Conseco, Conseco Services, LLC, and two former officers in
the Boone Circuit Court (Inlow et al. v. Conseco, Inc., et al., Cause No.
06C01-0206-CT-244). The heirs assert that unvested options to purchase 756,248
shares of Old Conseco common stock should have been vested at Mr. Inlow's death.
The heirs further claim that if such options had been vested, they would have
been exercised, and that the resulting shares of common stock would have been
sold for a gain of approximately $30 million based upon a stock price of $58.125
per share, the highest stock price during the alleged exercise period of the
options. We believe the heirs' claims are without merit and will defend the
action vigorously. The maximum exposure to the Company for this lawsuit is
estimated to be $33 million. The heirs did not file a proof of claim with the
Bankruptcy Court. Subject to dispositive motions which are yet to be filed, the
matter will continue to trial against Conseco Services, LLC and the other
co-defendants on September 13, 2004. The ultimate outcome cannot be predicted
with certainty.
On June 27, 2001, two suits against the Company's subsidiary, Philadelphia
Life Insurance Company (now known as Conseco Life Insurance Company), both
purported nationwide class actions seeking unspecified damages, were
consolidated in the U.S. District Court, Middle District of Florida (In Re PLI
Sales Litigation, Cause No. 01-MDL-1404), alleging among other things,
fraudulent sales and a "vanishing premium" scheme. Philadelphia Life filed a
motion for summary judgment against both named plaintiffs, which motion was
granted in June 2002. Plaintiffs appealed to the 11th Circuit. The 11th Circuit,
in July 2003, affirmed in part and reversed in part, allowing two fraud counts
with respect to one plaintiff to survive. The plaintiffs' request for a
rehearing with respect to this decision has been denied. Philadelphia Life has
filed a summary judgment motion with respect to the remaining claims.
Philadelphia Life believes this lawsuit is without merit and intends to defend
it vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company, was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New Mexico
(Robert Atencio and Theresa Atencio, for themselves and all other similarly
situated v. Manhattan National Life Insurance Company, an Ohio corporation,
Cause No. D-0101-CV-2000-2817), alleging among other things fraud by
non-disclosure of additional charges for those policyholders wishing to pay
premium modes other than annual. We retained liability for this litigation in
connection with the sale of Manhattan National Life in June 2002. We believe
this lawsuit is without merit and intend to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
On December 19, 2001, four of the Company's subsidiaries were named in a
purported nationwide class action seeking unspecified damages in the District
Court of Adams County, Colorado (Jose Medina and others similarly situated v.
Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers
National Life Insurance Company and Bankers Life and Casualty Company, Cause No.
01-CV-2465), alleging among other things breach of contract regarding alleged
non-disclosure of additional charges for those policy holders wishing to pay
premium modes other than annual. On July 14 and 15, 2003 the plaintiff's motion
for class certification was heard and the Court took the matter under
advisement. On November 10, 2003, the Court denied the motion for class
certification. The defendants believe this lawsuit is without merit and intend
to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted
with certainty.
On July 31, 2001, the Company's subsidiary, Conseco Senior Health Insurance
Company, was named in an action filed by the State of Texas in the District
Court of Travis County, Texas (State of Texas v. Conseco Senior Health Insurance
Company, Cause No. GV102103), alleging among other things a violation of the
Deceptive Trade Practices Act related to allegations of failure to adequately
notify policyholders that premium rates could increase. Conseco Senior has
reached a tentative settlement with the State of Texas, however in the event a
settlement is not consummated, Conseco Senior intends to defend this matter
vigorously as it believes the lawsuit is without merit. The ultimate outcome of
this lawsuit cannot be predicted with certainty.
38
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
On December 30, 2002 and December 31, 2002, five suits were filed in
various Mississippi counties against the Company's subsidiary, Conseco Life
Insurance Company (Kathie Allen, et al. v. Conseco Life Insurance Company, et
al., Circuit Court of Jones County, Mississippi, Cause No. 2002-448-CV12;
Malcolm Bailey, et al. v. Conseco Life Insurance Company, et al., Circuit Court
of Claiborne County, Mississippi, Cause No. CV-2002-371; Anthony Cascio, et al.
v. Conseco Life Insurance Company, et al, Circuit Court of LeFlore County,
Mississippi, Cause No. CV-2002-0242-CICI; William Garrard, et al. v. Conseco
Life insurance Company, et al., Circuit Court of Sunflower County, Mississippi,
Cause No. CV-2002-0753-CRL; and William Weaver, et al. v. Conseco Life Insurance
Company, et al., Circuit Court of LeFlore County, Mississippi, Cause No.
CV-2002-0238-CICI), alleging among other things, a "vanishing premium" scheme.
Conseco Life removed all of the cases to the U.S. District Courts in
Mississippi. In September 2003, plaintiffs' Motion to Remand was denied in the
Garrard and Weaver matters, but granted in the Cascio matter. Conseco Life
awaits the court's ruling on Plaintiff's Motion to Remand in the Allen matter.
In Bailey the parties have agreed to stay in Federal court. Conseco Life
believes the lawsuits are without merit and intends to defend them vigorously.
The ultimate outcome of the lawsuits cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits and arbitrations (including purported class actions)
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
Other Proceedings
The Company has been notified that the staff of the SEC has obtained a
formal order of investigation in connection with an inquiry that relates to
events in and before the spring of 2000, including CFC's accounting for its
interest-only securities and servicing rights. These issues were among those
addressed in the Company's write-down and restatement in the spring of 2000, and
were the subject of shareholder class action litigation, which was settled in
the second quarter of 2003. The Company is cooperating fully with the SEC staff
in this matter.
The deadline to file administrative claims in the bankruptcy proceeding was
October 9, 2003. The Plan provides that all such claims must be paid in full, in
cash. We are reviewing all timely filed administrative claims and may resolve
disputes regarding allowance of such claims in the Bankruptcy Court. If
significant administrative claims are allowed, our cash flow would be negatively
affected.
39
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Successor Predecessor
-------------- ---------------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Cash flows from operating activities:
Net income (loss).............................................. $ 24.2 $ 2,201.7 $(6,147.2)
Adjustments to reconcile net income (loss) to net cash provided
by operating activities:
Interest-only securities investment income................. - - (15.8)
Cash received from interest-only securities, net........... - - (54.2)
Servicing income........................................... - - (54.5)
Cash received from servicing activities.................... - - 33.7
Provision for losses....................................... - 55.6 735.2
Gain on sale of finance receivables........................ - - 13.9
Amortization and depreciation.............................. 30.3 369.8 800.3
Income taxes............................................... 13.9 31.4 410.7
Insurance liabilities...................................... 35.8 265.8 279.9
Accrual and amortization of investment income.............. (.7) 43.2 162.8
Deferral of cost of policies produced and purchased........ (25.6) (287.5) (391.4)
Impairment charges......................................... - - 701.3
Goodwill impairment........................................ - - 500.0
Special charges............................................ - - 166.3
Reorganization items....................................... - (2,157.0) -
Cumulative effect of accounting change..................... - - 2,949.2
Minority interest.......................................... - - 134.8
Net realized investment (gains) losses..................... (6.7) 5.4 551.7
Discontinued operations.................................... - (16.7) 109.3
Extraordinary gain on extinguishment of debt............... - - (8.1)
Other...................................................... (18.7) 235.6 (140.5)
------ --------- ---------
Net cash provided by operating activities................ $ 52.5 $ 747.3 $ 737.4
====== ========= =========
Non-cash items not reflected in the investing and financing activities sections
of the consolidated statement of cash flows:
Issuance of common stock under stock option and employee
benefit plans............................................. $ - $.3 $13.0
Issuance of convertible preferred shares.................... 5.3 - 2.1
At September 30, 2003, we held restricted cash of $22.1 million in trust
for the payment of bankruptcy-related professional fees.
40
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
INVESTMENTS IN VARIABLE INTEREST ENTITIES
The Company has investments in various types of special purpose entities
and other entities, some of which are VIEs under FIN 46. The following are
descriptions of our significant investments in VIEs:
Brickyard Trust
We liquidated and distributed all the assets of the Brickyard Loan Trust
("Brickyard") during the third quarter of 2003. We recognized a loss of $11.1
million during the second quarter of 2003 to record our investment at its
estimated fair value as we intended to liquidate it. No additional gain or loss
was recognized upon the ultimate disposition of Brickyard.
Brickyard was a collateralized debt obligation trust which participated in
an underlying pool of commercial loans. The initial capital structure of
Brickyard consisted of $575 million of senior financing provided by unrelated
third party investors and $127 million of notes and subordinated certificates
owned by the Company and others. As a result of our 85 percent ownership
interest in the subordinated certificates, we were the primary beneficiary of
Brickyard. In accordance with ARB 51 "Consolidated Financial Statements",
Brickyard was consolidated in our financial statements because: (i) our
investment management subsidiary, 40|86 Advisors, Inc. was the investment
manager; and (ii) we owned a significant interest in the subordinated
certificates. Included in "Assets held in separate accounts and investment
trust" at December 31, 2002 were $410.2 million of assets which served as
collateral for Brickyard's obligations. These amounts were offset by a
corresponding liability account, the value of which fluctuated in relation to
changes in the values of the investments. The senior note obligations had no
recourse to the general credit of the Company.
Other Investment Trusts
In December 1998, Old Conseco formed three investment trusts which were
special purpose entities formed to hold various fixed maturity, limited
partnership and other types of investments. The initial capital structure of
each of the trusts consisted of: (i) approximately 96 percent
principal-protected senior notes; (ii) approximately 3 percent subordinated
junior notes; and (iii) 1 percent equity. The senior principal-protected notes
are collateralized by zero coupon treasury notes with par values and maturities
matching the par values and maturities of the principal-protected senior notes.
Conseco's life insurance subsidiaries own 100 percent of the senior
principal-protected notes. Certain of Conseco's non-life insurance subsidiaries
own all of the subordinated junior notes, which have a preferred return equal to
the total return on the trusts' assets in excess of principal and interest on
the senior notes. The equity of the trusts is owned by unrelated third parties.
The three investment trusts are VIEs under FIN 46 because the trusts'
equity represents significantly less than 10 percent of total capital and the
subordinated junior notes were intended to absorb expected losses and receive
virtually all expected residual returns. Based on our 100 percent ownership of
the subordinated junior notes, we are the primary beneficiary of the investment
trusts. All three trusts are consolidated in our financial statements. The
carrying value of the total invested assets in the three trusts was
approximately $397 million and $382 million at September 30, 2003 and December
31, 2002, respectively, which also represents Conseco's maximum exposure to loss
as a result of our ownership interests in the trusts. The trusts have no
obligations or debt to outside parties.
Investment in General Motors Building
See the note entitled "Sale of the General Motors Building" for a
discussion of this investment.
41
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
SPECIAL CHARGES
2002
The following table summarizes the special charges incurred by the
Company during the three and nine months ended September 30, 2002, which are
further described in the paragraphs which follow (dollars in millions):
Three months ended Nine months ended
September 30, 2002 September 30, 2002
------------------ ------------------
Loss related to reinsurance transaction and businesses sold to
raise cash......................................................... $20.0 $ 47.0
Costs related to debt modification and refinancing transactions....... .3 17.7
Restructuring costs................................................... 12.1 12.1
Expenses related to the termination of the former chief
financial officer.................................................. - 6.5
Other items........................................................... 2.5 19.8
----- -----
Special charges before income tax benefit......................... $34.9 $103.1
===== ======
Loss related to debt modification and reinsurance transaction and
businesses sold to raise cash
We completed various asset sales and reinsurance transactions to raise cash
which resulted in net losses of $47.0 million during the first nine months of
2002. These amounts included: (i) a loss of $39.0 million related to the
reinsurance of a portion of our life insurance business; (ii) a loss of $20.0
million associated with the sale of our subsidiary in India; partially offset by
(iii) asset sales resulting in a net gain of $12.0 million.
Costs related to debt modification and refinancing transactions
In conjunction with the various modifications to borrowing arrangements
(including the debt exchange offer completed in April 2002) entered into in the
first nine months of 2002, we incurred costs of $17.7 million which are not
permitted to be deferred pursuant to GAAP.
Restructuring costs
We incurred expenses totaling $12.1 million in the three and nine months
ended September 30, 2002, related to professional and advisory fees incurred
related to the restructuring of our capital.
Expenses related to termination of the former chief financial officer
The employment of Old Conseco's chief financial officer was terminated in
the first quarter of 2002. As a result, the vesting provisions associated with
the restricted stock issued to the chief financial officer pursuant to his
employment agreement were accelerated. We recognized a charge of $5.1 million
related to the immediate vesting of such restricted stock in the first quarter
of 2002. In addition, we recognized severance benefits of $1.4 million
associated with the termination.
Other items
Other items include expenses incurred: (i) in conjunction with the transfer
of certain customer service and backroom operations to our India subsidiary;
(ii) for severance benefits related to the transfer of such operations; and
(iii) for other items which are not individually significant. The Company sold
its India subsidiary in the fourth quarter of 2002 and has significantly reduced
the customer service and backroom operations conducted there.
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at September 30, 2003, and the consolidated results of operations for: (i) the
one month ended September 30, 2003; (ii) the two months ended August 31, 2003;
(iii) the eight months ended August 31, 2003; and (iv) the three and nine months
ended September 30, 2002 and, where appropriate, factors that may affect future
financial performance. Please read this discussion in conjunction with the
accompanying consolidated financial statements and notes.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
All statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the Securities and
Exchange Commission, press releases, presentations by Conseco or its management
or oral statements) relative to markets for Conseco's products and trends in
Conseco's operations or financial results, as well as other statements including
words such as "anticipate," "believe," "plan," "estimate," "expect," "project,"
"intend," "may," "will," "would," "contemplate," "possible," "attempts,"
"seeks," "should," "could," "goal," "target," "on track," "comfortable with,"
"optimistic" and other similar expressions, constitute forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. Forward-looking statements are subject to known and unknown risks,
uncertainties and other factors which may cause actual results, performance or
achievements to be materially different from the future results, performance or
achievements expressed or implied by the forward-looking statements. Assumptions
and other important factors that could cause our actual results to differ
materially from those anticipated in our forward-looking statements include,
among other things: (i) the potential lingering adverse impact of the Chapter 11
petitions on Conseco's business operations, and relationships with our
customers, employees, regulators, distributors and agents; (ii) our ability to
operate our business under the restrictions imposed by our senior bank credit
facility; (iii) our ability to improve the financial strength ratings of our
insurance companies and the impact of recent rating downgrades on our business;
(iv) general economic conditions and other factors, including prevailing
interest rate levels, stock and credit market performance and health care
inflation, which may affect (among other things) Conseco's ability to sell its
products and access capital on acceptable terms, the market value of Conseco's
investments, and the lapse rate and profitability of policies; (v) Conseco's
ability to achieve anticipated synergies and levels of operational efficiencies;
(vi) customer response to new products, distribution channels and marketing
initiatives; (vii) mortality, morbidity, usage of health care services and other
factors which may affect the profitability of Conseco's insurance products;
(viii) performance of our investments; (ix) changes in the Federal income tax
laws and regulations which may affect the relative tax advantages of some of
Conseco's products; (x) increasing competition in the sale of insurance and
annuities; (xi) regulatory changes or actions, including those relating to
regulation of the financial affairs of our insurance companies (including the
payment of dividends to our holding company), regulation of financial services
affecting (among other things) bank sales and underwriting of insurance
products, regulation of the sale, underwriting and pricing of products, and
health care regulation affecting health insurance products; (xii) the ultimate
outcome of lawsuits filed against Conseco; and (xiii) the risk factors or
uncertainties listed from time to time in Conseco's filings with the Securities
and Exchange Commission. Other factors and assumptions not identified above are
also relevant to the forward-looking statements, and if they prove incorrect,
could also cause actual results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
CHAPTER 11 REORGANIZATION
On the Petition Date, the Filing Entities filed voluntary petitions for
relief under the Bankruptcy Code in the Bankruptcy Court. During the pendency of
the Chapter 11 cases, the Filing Entities continued to operate their businesses
as debtors-in-possession under the jurisdiction of the Bankruptcy Court and in
accordance with the applicable provisions of the Bankruptcy Code and orders of
the Bankruptcy Court.
We emerged from bankruptcy protection under the Plan, which was confirmed
pursuant to an order of the Bankruptcy Court on September 9, 2003, the
Confirmation Date, and became effective on September 10, 2003, the Effective
Date. In accordance with SOP 90-7, we adopted fresh start accounting on the
Effective Date. However, in light of the proximity of
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
this date to the August month end, for accounting convenience purposes, we have
reported the effects of fresh start accounting as if they occurred on August 31,
2003.
The Plan generally provided for the full payment or reinstatement of
allowed administrative claims, priority claims, fully secured claims and certain
intercompany claims, and the distribution of shares of new equity securities
(including warrants) of CNO to partially secured and unsecured creditors of the
Filing Entities. Holders of claims arising under Old Conseco's $1.5 billion
senior bank credit facility also received a pro rata interest in the New Credit
Facility. Holders of Old Conseco's common stock and preferred stock did not
receive any distribution under the Plan, and these securities, together with all
other prepetition securities and the $1.5 billion senior bank credit facility of
Old Conseco, were cancelled on the Effective Date.
On the Effective Date, under the terms of the Plan, we emerged from the
bankruptcy proceedings with a capital structure consisting of: (i) $1.3 billion
of indebtedness under the New Credit Facility; (ii) approximately 34.4 million
shares of Preferred Stock of CNO with an initial aggregate liquidation
preference of $859.7 million; (iii) 100 million shares of common stock of CNO,
excluding shares issued to our new non-executive chairman upon his appointment
and shares issued or to be issued to directors, officers, or employees under a
new equity incentive plan; and (iv) warrants to purchase 6.0 million shares of
CNO common stock. Under the terms of the Plan, we distributed CNO equity
securities to the creditors of Old Conseco in the amounts outlined below:
o lenders under Old Conseco's senior bank credit facility and director and
officer loan program received approximately 34.4 million shares of our
Preferred Stock with an initial aggregate liquidation preference of $859.7
million;
o holders of Old Conseco's senior notes received approximately 32.3 million
shares of our common stock;
o holders of Old Conseco's guaranteed senior notes received approximately
60.6 million shares of our common stock;
o holders of Old Conseco's general unsecured claims received approximately
2.9 million shares of our common stock; and
o holders of trust preferred securities issued by Old Conseco's subsidiary
trusts received approximately 1.5 million shares of our common stock and
warrants to purchase 6.0 million shares of our common stock at an exercise
price of $27.60 per share.
The distribution of our common stock summarized above represents
approximately 97 percent of all of the shares of common stock to be distributed
under the Plan. Approximately 2.7 million shares of common stock have been
reserved for distribution under the Plan in respect of disputed claims, the
resolution of which is still pending. If reserved shares remain after resolution
of these disputed claims, then the reserved shares will be reallocated to other
general unsecured creditors of Old Conseco as provided for under the Plan.
For a complete discussion of the distributions provided for under the Plan,
investors should refer to the complete text of the Plan confirmed by the
Bankruptcy Court on September 9, 2003, and filed with the Securities and
Exchange Commission on September 15, 2003 with our Current Report on Form 8-K.
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Old Conseco's 2002 Annual Report
on Form 10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements.
Since the Petition Date, our consolidated financial statements have been
prepared in accordance with SOP 90-7. Accordingly, all prepetition liabilities
subject to compromise were segregated in the consolidated balance sheet and
classified as "liabilities subject to compromise" at the estimated amount of
allowable claims. Pursuant to SOP 90-7, professional fees associated with the
Chapter 11 cases were expensed as incurred and reported as reorganization items.
Interest expense was reported only to the extent that it was paid during the
Chapter 11 cases or when it was probable that it would be an allowed claim.
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
Under fresh start reporting the Company was required to revalue its assets
and liabilities to current estimated fair value, re-establish shareholders'
equity at the reorganization value determined in connection with the Plan, and
record any portion of the reorganization value which can not be attributed to
specific tangible or identified intangible assets as goodwill. As a result, the
Company's financial statements for periods following August 31, 2003, will not
be comparable with those of Old Conseco prepared before that date. Consistent
with SOP 90-7 we have implemented accounting standards that were required to be
adopted in our consolidated financial statements within twelve months of our
Effective Date.
RISK FACTORS
We are subject to a number of risks. These risks could have a material
adverse effect on our business, financial condition or results of operations.
Our Recent Bankruptcy May Continue to Disrupt Our Operations and the
Operations of Our Subsidiaries.
The announcement of our intention to seek a restructuring of our capital in
August 2002 and the filing of bankruptcy petitions under the Bankruptcy Code in
December 2002 caused significant disruptions in our operations. In August 2002,
A.M. Best downgraded the financial strength ratings of our primary insurance
subsidiaries to "B (Fair)." Rating downgrades and other adverse publicity
concerning our financial condition and bankruptcy filings caused sales of our
insurance products to decline and policyholder redemptions and lapses to
increase. In some cases, this caused defections among our agent sales force or
increases in the commissions or sales incentives we must pay in order to retain
them.
We emerged from bankruptcy on September 10, 2003. The full extent to which
our bankruptcy impacted our business operations and relationship with our
customers, employees, regulators, distributors and agents may not be known for
some time and there may be lingering adverse effects associated with our
bankruptcy filing.
Our Degree of Leverage May Limit Our Financing and Operating Activities.
We continue to have significant indebtedness after our emergence from
bankruptcy. As of September 30, 2003, our debt to total capital ratio was 34
percent and our debt and preferred stock to total capital ratio was 57 percent.
Furthermore, our historical capital requirements have been significant and our
future capital requirements could vary significantly and may be affected by
general economic conditions, industry trends, performance, and many other
factors that are not within our control. We cannot assure you that we will be
able to obtain financing in the future. We have suffered significant losses in
the past and cannot assure you that we will not continue to experience losses in
the future. Our profitability and ability to generate cash flow will depend upon
our ability to successfully implement our business strategy. However, we cannot
assure you that we will be able to do so. We may encounter liquidity problems,
which could affect our ability to meet our obligations while attempting to meet
competitive pressures or adverse economic conditions.
A Failure to Improve and Maintain the Financial Strength Ratings of Our
Insurance Subsidiaries Could Negatively Impact Our Operations and Financial
Results.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. In July
2002, A.M. Best downgraded the financial strength ratings of our primary
insurance subsidiaries to "B++ (Very Good)" and placed the ratings "under review
with negative implications." On August 14, 2002, A.M. Best further lowered the
financial strength ratings of our primary insurance subsidiaries from "B++ (Very
Good)" to "B (Fair)". The A.M. Best downgrades caused sales of our insurance
products to decline and policyholder redemptions and lapses to increase. In some
cases, the downgrades also caused defections among our agent sales force or
increases in the commissions or sales incentives we must pay in order to retain
them. These events have had a material adverse effect on our operations,
financial results and liquidity.
On September 11, 2003, A.M. Best affirmed its financial strength ratings of
our primary insurance companies ("B (Fair)") and removed the ratings from under
review, indicating that the ratings outlook is positive. On October 3, 2003,
A.M. Best assigned a positive outlook to all of our ratings. Our plan of
reorganization contemplated that our insurance subsidiaries would achieve an
A.M. Best "A" rating approximately by the end of 2004, but we cannot assure you
that we will be able to either achieve or maintain this rating. If we fail to
achieve and maintain an A.M. Best "A" rating, sales of our insurance products
could fall and additional existing policyholders may redeem or allow their
policies to lapse, adversely affecting our future operations, financial results
and liquidity. In addition, if we experience a ratings downgrade, or if we fail
to achieve
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
an A.M. Best "A-" rating by August 15, 2005 (or December 31, 2005 if we meet
certain financial ratios), we will suffer an event of default under the New
Credit Facility. If we experience a ratings downgrade below "B (Fair)" or a
downgrade by two or more levels in any six-month period, a "trigger event" will
also occur and holders of our Preferred Stock will have the right to vote with
holders of our common stock on all matters on an as-converted basis.
The Covenants in the New Credit Facility Restrict Our Activities and
Require Us to Meet or Maintain Various Financial Ratios and Minimum
Insurance Ratings.
We entered into a senior secured bank credit facility with our lenders in
connection with our reorganization. The New Credit Facility contains a number of
covenants and other provisions that restrict our ability to engage in various
financing transactions and pursue certain operating activities without the prior
consent of the lenders under the New Credit Facility. We also must meet or
maintain various financial ratios and minimum financial strength ratings for our
insurance subsidiaries. For instance, if we experience a ratings downgrade by
A.M. Best, or if we fail to achieve an A.M. Best "A-" rating by August 15, 2005
(or December 31, 2005 if we meet certain financial ratios), we will suffer an
event of default under the New Credit Facility. Our ability to meet these
financial and ratings covenants may be affected by events beyond our control.
These requirements represent significant restrictions on the manner in which we
may operate our business. If we default under any of these requirements, the
lenders could declare all outstanding borrowings, accrued interest and fees to
be due and payable. If that were to occur, we cannot assure you that we would
have sufficient liquidity to repay or refinance this indebtedness or any of our
other debts. Refer to the note to the consolidated financial statements entitled
"Changes in Direct Corporate Obligations" for additional discussion of the New
Credit Facility and related covenants.
Conseco, Inc. and CDOC, Inc. are Holding Companies and Depend on their
Subsidiaries for Cash.
Conseco, Inc. and CDOC, Inc., our wholly owned subsidiary and a guarantor
under the New Credit Facility, are holding companies with no business operations
of their own; they depend on their operating subsidiaries for cash to make
principal and interest payments on debt, and to pay administrative expenses and
income taxes. The cash they receive from insurance subsidiaries consists of
dividends and distributions, principal and interest payments on surplus
debentures, fees for services, tax-sharing payments, and from our non-insurance
subsidiaries, loans and advances. A deterioration in the financial condition,
earnings or cash flow of the significant subsidiaries of Conseco or CDOC for any
reason could limit their ability to pay cash dividends or other disbursements to
Conseco and CDOC, which, in turn, would limit the ability of Conseco and CDOC to
meet debt service requirements and satisfy other financial obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid from earned surplus of the insurance company for any
12-month period in amounts equal to the greater of (or in a few states, the
lesser of): (i) net gain from operations or net income for the prior year; or
(ii) 10 percent of capital and surplus as of the end of the preceding year. Any
dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department. We recently were
subject to consent orders with the Commissioner of Insurance for the State of
Texas that, among other things, limited the ability of our insurance
subsidiaries to pay dividends. We have been informed by the Texas Department of
Insurance that it intends to formally release the consent orders in the near
future. We have agreed with the Commissioner of Insurance for the State of Texas
to provide prior notice of certain transactions, including up to 30 days prior
notice for the payment of ordinary dividends to any non-insurance company
parent, and periodic reporting of information concerning our financial
performance and operations. If our financial condition were to deteriorate, we
may be required to enter into consent orders in the future. In addition, actions
that we may need to take to improve the authorized control level risk based
capital ("ACLRBC") ratios of our insurance subsidiaries could affect the ability
of our insurance subsidiaries to pay dividends.
The Obligations of Conseco, Inc. and CDOC, Inc. are Structurally
Subordinated to the Obligations of Their Subsidiaries.
Because our operations are conducted through subsidiaries, claims of the
creditors of those subsidiaries (including policyholders) will rank senior to
claims to distributions from the subsidiaries, upon which we depend to make
payments on our obligations. CDOC's subsidiaries had indebtedness for borrowed
money (excluding indebtedness to affiliates), policy reserves and other
liabilities of approximately $25.6 billion at September 30, 2003. The
obligations of Conseco and CDOC, as parent holding companies, will rank
effectively junior to these liabilities.
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted under the insurance laws of its state of domicile by such
state's insurance regulator as the receiver with respect to such insurer's
property and business. In the event of a default on our debt or our insolvency,
liquidation or other reorganization, our creditors and stockholders will not
have the right to proceed against the assets of our insurance subsidiaries or to
cause their liquidation under federal and state bankruptcy laws.
Our Insurance Business Performance May Decline if Our Premium Rates Are Not
Adequate.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. In setting premium rates, we consider historical
claims information, industry statistics, the rates of our competitors and other
factors. If our actual claims experience proves to be less favorable than we
assumed and we are unable to raise our premium rates, our financial results may
be adversely affected. Our estimates of insurance liabilities assume we will be
able to raise rates if future experience results in blocks of our health
insurance business becoming unprofitable. We generally cannot raise our health
insurance premiums in any state unless we first obtain the approval of the
insurance regulator in that state. We review the adequacy of our premium rates
regularly and file rate increases on our products when we believe existing
premium rates are too low. It is possible that we will not be able to obtain
approval for premium rate increases from currently pending requests or requests
filed in the future. If we are unable to raise our premium rates because we fail
to obtain approval for a rate increase in one or more states, our net income may
decrease. If we are successful in obtaining regulatory approval to raise premium
rates due to unfavorable actual claims experience, the increased premium rates
may reduce the volume of our new sales and cause existing policyholders to allow
their policies to lapse. This could result in anti-selection if healthier
policyholders allow their policies to lapse. This would reduce our premium
income and profitability in future periods. Increased lapse rates also could
require us to expense all or a portion of the deferred policy costs relating to
lapsed policies in the period in which those policies lapse, adversely affecting
our financial results in that period.
The loss ratios for our long-term care products have increased in recent
periods and exceeded 96 percent during the one month period ended September 30,
2003. We will have to raise rates or take other actions with respect to certain
of these policies or this business will continue to be unprofitable and our
financial results will be adversely affected.
We May Not Achieve the Goals of Certain Initiatives We Have Undertaken With
Respect to the Restructuring of Our Principal Insurance Business.
Several of our principal insurance businesses have experienced substantial
recent losses in their investment portfolios, declining sales and expense levels
that exceed product pricing. We have adopted several initiatives designed to
improve these operations, including focusing sales efforts on higher margin
products; reducing operating expenses by eliminating or reducing the costs of
marketing certain products; personnel reductions and streamlined administrative
procedures; stabilizing the profitability of inforce business, particularly
long-term care policies; and combining certain legal insurance entities to
reduce burdens associated with statutory capital requirements and certain other
redundancies. We are subject to the risk that our investments will decline in
value. This has occurred in the past and may occur again. We are working to
improve the performance of investments by reducing exposure to credit events and
certain types of higher risk assets. We have only recently adopted some of these
initiatives and we cannot assure you that they will be successfully implemented.
Our Reserves for Future Insurance Policy Benefits and Claims May Prove To
Be Inadequate, Requiring Us to Increase Liabilities and Resulting in
Reduced Net Income and Shareholders' Equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on assumptions made by our actuaries. For our
health insurance business, we establish an active life reserve plus a liability
for due and unpaid claims, claims in the course of settlement, and incurred but
not reported claims, as well as a reserve for the present value of amounts not
yet due on claims. Many factors can affect these reserves and liabilities, such
as economic and social conditions, inflation, hospital and pharmaceutical costs,
regulatory actions (including those related to the pricing of our policies),
changes in doctrines of legal liability, and extra-contractual damage awards.
Therefore, the reserves and liabilities we establish are necessarily based on
extensive estimates, assumptions and prior years' statistics. Establishing
reserves is an uncertain process, and it is possible that actual claims will
materially exceed our reserves and have a material adverse effect on our results
of operations and financial condition. Our financial performance depends
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in setting our reserves and pricing our
policies. If our assumptions with respect to future claims are incorrect, and
our reserves are insufficient to cover our actual losses and
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
expenses, we would be required to increase our liabilities resulting in an
adverse effect to our financial results and financial position.
Our Insurance Subsidiaries May be Required to Pay Assessments to Fund
Policyholder Losses or Liabilities; This May Have a Material Adverse Effect
on Our Results of Operations.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments (up to certain
prescribed limits) to fund policyholder losses or liabilities of insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Any future assessments may have a material adverse effect on our
financial results and financial position.
We are Subject to Further Risk of Loss Notwithstanding Our Reinsurance
Arrangements.
We transfer exposure to certain risks to others through reinsurance
arrangements. Under these arrangements, other insurers assume a portion of our
losses and expenses associated with reported and unreported claims in exchange
for a portion of policy premiums. The availability, amount and cost of
reinsurance depend on general market conditions and may vary significantly.
Furthermore, we face credit risk with respect to reinsurance. When we obtain
reinsurance, we are still liable for those transferred risks if the reinsurer
cannot meet its obligations. Therefore, the inability of our reinsurers to meet
their financial obligations could materially affect our operations and financial
condition.
We Are Subject to Extensive Regulation.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate, which is primarily for the benefit and
protection of our customers, and not for the benefit of our investors or
creditors. Our insurance subsidiaries are subject to state insurance laws that
establish supervisory agencies with broad administrative powers relative to
granting and revoking licenses to transact business, regulating sales and other
practices, licensing agents, approving policy forms, setting reserve and
solvency requirements, determining the form and content of required statutory
financial statements, limiting dividends and prescribing the type and amount of
investments.
We have been operating under heightened scrutiny from state insurance
regulators. Our insurance subsidiaries domiciled in Texas, Bankers National Life
Insurance Company and Conseco Life Insurance Company of Texas (on behalf of
itself and its subsidiaries), entered into consent orders with the Commissioner
of Insurance for the State of Texas on October 30, 2002 which we expect to be
released in the near future.
In Certain Circumstances, Regulatory Authorities May Place Our Insurance
Subsidiaries Under Regulatory Control.
Our insurance subsidiaries are subject to risk-based capital requirements.
These requirements were designed to evaluate the adequacy of statutory capital
and surplus in relation to investment and insurance risks associated with: asset
quality; mortality and morbidity; asset and liability matching; and other
business factors. The requirements are used by states as an early warning tool
to discover potential weakly-capitalized companies for the purpose of initiating
regulatory action. Generally, if an insurer's ACLRBC falls below specified
levels, the insurer would be subject to different degrees of regulatory action
depending upon the magnitude of the deficiency. Possible regulatory actions
range from requiring the insurer to propose actions to correct the ACLRBC
deficiency to placing the insurer under regulatory control. The 2002 statutory
annual statements filed with the state insurance regulators of each of our
insurance subsidiaries reflected total adjusted capital in excess of levels
subjecting the subsidiary to any regulatory action. The 2002 audited financial
statements of our insurance subsidiaries were completed in June 2003. Two of our
subsidiaries' ACLRBC ratios, based on the capital balances reflecting audit
adjustments, were less than 250 percent. As a result of an additional adjustment
in the amended 2002 Annual Statement relating to one such subsidiary's
investment in the General Motors building its ACLRBC ratio exceeded 250 percent.
As a result of the sale of the General Motors building, the ACLRBC ratio for the
other subsidiary has increased to a level above 250 percent. However, as a
result of losses on the long-term care business within Conseco Insurance Group
during the third quarter of 2003, including claim reserve strengthening of $87
million, we will need to contribute additional capital to one subsidiary to
enable its ACLRBC to equal or exceed 250 at December 31, 2003. See the
information described under the
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
caption "Statutory Information" within "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
Recently Enacted and Pending or Future Legislation Could Also Affect the
Financial Performance of Our Insurance Operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and legislative proposals relating to healthcare
reform contain features that could severely limit or eliminate our ability to
vary our pricing terms or apply medical underwriting standards with respect to
individuals which could have the effect of increasing our loss ratios and have
an adverse effect on our financial results. In particular, Medicare reform and
legislation concerning prescription drugs could affect our ability to price or
sell our products.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards for inclusion in all long-term care
policies, including: guaranteed premium rates; protection against inflation;
limitations on waiting periods for pre-existing conditions; setting standards
for sales practices for long-term care insurance; and guaranteed consumer access
to information about insurers (including lapse and replacement rates for
policies and the percentage of claims denied). Enactment of any of these
proposals could adversely affect our financial results.
In addition, the federal government may seek to regulate the insurance
industry, and recent government regulation may increase competition in the
insurance industry and may affect our insurance subsidiaries' current sales
methods. Although the federal government generally does not directly regulate
the insurance industry, federal initiatives often have a direct impact on the
insurance business. Current and proposed measures that may significantly affect
the insurance business generally include limitations on antitrust immunity and
minimum solvency requirements.
Changing Interest Rates May Adversely Affect Our Results of Operations.
Our profitability may be directly affected by the level of and fluctuations
in interest rates. While we monitor the interest rate environment and have
previously employed hedging strategies designed to mitigate the impact of
changes in interest rates, our financial results could be adversely affected by
changes in interest rates. Our spread-based insurance and annuity business is
subject to several inherent risks arising from movements in interest rates,
especially if we fail to anticipate or respond to such movements. First,
interest rate changes can cause compression of our net spread between interest
earned on investments and interest credited on customer deposits, thereby
adversely affecting our results. Second, if interest rate changes produce an
unanticipated increase in surrenders of our spread-based products, we may be
forced to sell invested assets at a loss in order to fund such surrenders. The
profits from many non-spread-based insurance products, such as long-term care
policies will be adversely affected if interest rates decline. Finally, changes
in interest rates can have significant effects on the performance of our
mortgage-backed securities portfolio, including collateralized mortgage
obligations, as a result of changes in the prepayment rate of the loans
underlying such securities. We follow asset/liability strategies that are
designed to mitigate the effect of interest rate changes on our profitability.
However, we cannot assure that we will be successful in implementing these
strategies and achieving adequate investment spreads.
Litigation and Regulatory Investigations May Harm Our Financial Strength
and Reduce Our Profitability.
Insurance companies historically have been subject to substantial
litigation resulting from claims disputes and other matters. In addition to the
traditional policy claims associated with their businesses, insurance companies
are increasingly facing policyholder suits, class action suits and disputes with
reinsurers. The class action and policyholder suits are often in connection with
insurance sales practices, policy and claims administration practices and other
market conduct issues. State insurance departments are increasingly focusing on
sales practices and product issues in their market conduct examinations.
Negotiated settlements of class action and other lawsuits have had a material
adverse effect on the business, financial condition and results of operations of
insurance companies. As a result of these trends, we are, in the ordinary course
of our business, a plaintiff or defendant in actions arising out of our
insurance business and investment operations, including class actions and
reinsurance disputes, and, from time to time, are also involved in various
governmental and administrative proceedings. Such litigation and proceedings may
harm our financial strength and reduce our profitability. We cannot assure you
that such litigation will not adversely affect our future business, financial
condition or results of operations.
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
The Markets in Which We Compete Are Highly Competitive.
Each of the markets in which we operate is highly competitive. Competitors
include other life and accident and health insurers, commercial banks, thrifts,
mutual funds and broker-dealers. Many of our competitors in different segments
and regions are larger companies that have greater capital, technological and
marketing resources, and have access to capital at a lower cost. Because the
actual cost of products is unknown when they are sold, we are subject to
competitors who may sell a product at a price that does not cover its actual
cost. Agents placing insurance business with our insurance subsidiaries
generally are compensated on a commission basis. There are many life and health
insurance companies in the U.S., most of which currently enjoy higher financial
strength ratings than we do. Some of these companies may pay higher commissions
and charge lower premium rates, and many companies have more substantial
resources than we do. Publicity about our recent financial difficulties,
including our bankruptcy, caused agents to place business with other insurers,
and we may not be able to recapture lost business following our emergence from
bankruptcy.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among financial services companies
for efficient sales representatives. We compete with other financial services
companies for sales representatives primarily on the basis of our financial
position, financial strength ratings, support services and compensation and
product features. Our competitiveness for such agents also depends upon the
relationships we develop with these agents. If we are unable to attract and
retain sufficient numbers of sales representatives to sell our products, our
ability to compete and our revenues would suffer.
Tax Law Changes Could Adversely Affect Our Insurance Product Sales and
Profitability.
We sell deferred annuities and some forms of life insurance products which
are attractive to purchasers, in part, because policyholders generally are not
subject to United States federal income tax on increases in policy values until
some form of distribution is made. Recently, Congress enacted legislation to
lower marginal tax rates, reduce the federal estate tax gradually over a
ten-year period, with total elimination of the federal estate tax in 2010, and
increase contributions which may be made to individual retirement accounts and
401(k) accounts. While these tax law changes will sunset at the beginning of
2011 absent future congressional action, they could in the interim diminish the
appeal of our annuity and life insurance products. Additionally, Congress has
considered, from time to time, other possible changes to the U.S. tax laws,
including elimination of the tax deferral on the accretion of value within
certain annuities and life insurance products. There can be no assurance that
further tax legislation will not be enacted which would contain provisions with
possible adverse effects on our annuity and life insurance products.
A Broad Range of Uncertainties Arising Out of World Events May Adversely
Affect the Insurance Industry and Financial Markets.
Terrorist attacks in New York City and Washington, D.C. on September 11,
2001 adversely affected commerce throughout the United States and resulted in
significant disruption to the insurance industry and significant declines and
volatility in financial markets. The continued threat of terrorism within the
United States and abroad, the military action and heightened security measures
in response to that threat and the risk of global outbreaks of illnesses such as
SARS may cause additional disruptions to the insurance industry, reduced
economic activity and continued volatility in markets throughout the world,
which may adversely impact our financial results.
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
As previously discussed, due to the application of fresh start accounting,
the reported historical financial statements of the Predecessor for periods
prior to August 31, 2003, generally are not comparable to financial statements
prepared after that date. Therefore, the results of operations of the Successor
have not been combined with those of the Predecessor. Please read this
discussion in conjunction with the accompanying consolidated financial
statements and notes. The following tables and narratives summarize our
operating results for the periods presented (dollars in millions):
Successor Predecessor
------------ --------------------------------------------------------
One month Two months Three months Eight months Nine months
ended ended ended ended ended
September 30, August 31, September 30, August 31, September 30,
2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Earnings (losses) before taxes:
Insurance and fee-based segment earnings
(losses)................................... $49.3 $ 170.5 $(747.4) $ 296.9 $ (759.3)
Corporate operations:
Corporate expenses, less charges to
subsidiaries for services provided....... (2.5) (1.7) (27.4) (28.4) (72.7)
Interest expense on corporate debt, net
of corporate investment income........... (6.3) (50.3) (79.0) (181.7) (227.7)
Venture capital income (loss).............. (2.7) 2.0 (6.6) 10.5 (106.6)
Provision for losses....................... - (24.5) (59.9) (55.6) (199.9)
Special charges............................ - - (32.6) - (61.1)
Extraordinary gain on extinguishment
of debt.................................. - - - - 1.8
Reorganization items....................... - 2,163.0 - 2,130.5 -
----- -------- ------- -------- ---------
Income (loss) before income taxes, minority
interest, discontinued operations and
cumulative effect of accounting change... $37.8 $2,259.0 $(952.9) $2,172.2 $(1,425.5)
===== ======== ======= ======== =========
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
Insurance and fee-based operations (dollars in millions)
Successor Predecessor
------------ ----------------------------
One month Two months Three months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Premiums and asset accumulation product collections:
Annuities.................................................................. $ 68.7 $ 162.2 $ 270.4
Supplemental health........................................................ 191.7 386.6 588.1
Life....................................................................... 46.5 100.7 159.0
Group major medical........................................................ 17.4 28.9 83.8
--------- --------- ---------
Collections on insurance products from continuing lines
of business......................................................... 324.3 678.4 1,101.3
Individual major medical in run-off........................................ .5 1.6 16.6
Discontinued operations.................................................... - - 72.2
--------- --------- ---------
Total collections on insurance products................................ 324.8 680.0 1,190.1
Deposit type contracts..................................................... 30.8 57.5 78.3
Deposit type contracts - discontinued operations........................... - - 1.3
Mutual funds............................................................... 6.2 24.6 18.1
--------- --------- ---------
Total premiums and asset accumulation product collections.............. $ 361.8 $ 762.1 $ 1,287.8
========= ========= =========
Average liabilities for insurance and asset accumulation products (excluding
discontinued operations and our major medical business in run-off):
Annuities:
Mortality based........................................................ $ 338.8 $ 258.2 $ 251.3
Equity-linked.......................................................... 1,569.5 1,648.3 2,086.6
Deposit based.......................................................... 7,447.2 7,386.0 7,841.5
Separate accounts and investment trust liabilities..................... 87.7 271.9 627.1
Health................................................................... 8,112.9 6,055.1 5,518.1
Life:
Interest sensitive..................................................... 3,680.6 3,650.3 4,122.9
Non-interest sensitive................................................. 2,249.4 2,145.0 1,889.7
--------- --------- ---------
Total average liabilities for insurance and asset
accumulation products, net of reinsurance ceded.................... $23,486.1 $21,414.8 $22,337.2
========= ========= =========
Revenues:
Insurance policy income.................................................... $ 248.9 $ 499.7 $ 800.5
Net investment income:
General account invested assets.......................................... 105.3 232.7 365.1
Equity-indexed products based on the change in value of the
S&P 500 Call Options................................................... (8.3) 6.8 (27.3)
Separate account assets.................................................. - - (5.3)
Trading account income related to policyholder and reinsurer accounts.... 14.8 - -
Change in value of embedded derivatives related to modified
coinsurance agreements................................................. (8.6) - -
Fee revenue and other income............................................... 1.9 8.2 19.9
--------- --------- ---------
Total revenues (a)..................................................... 354.0 747.4 1,152.9
--------- --------- ---------
Expenses:
Insurance policy benefits.................................................. 203.9 288.1 729.3
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.......................................... 38.1 77.7 120.8
Equity-indexed products based on S&P 500 Index........................... (5.2) 14.3 (3.7)
Separate account liabilities............................................. - - (5.3)
Amortization related to operations......................................... 27.0 59.0 182.5
Interest expense on investment borrowings.................................. .6 1.9 2.1
Other operating costs and expenses......................................... 47.0 100.7 133.6
--------- --------- ---------
Total benefits and expenses (a)........................................ 311.4 541.7 1,159.3
--------- --------- ---------
Income (loss) before goodwill impairment, net investment gains (losses),
special charges, income taxes, minority interest, discontinued
operations and cumulative effect of accounting change................ 42.6 205.7 (6.4)
Goodwill impairment........................................................... - - (500.0)
Net investment gains (losses), including related costs and
amortization............................................................... 6.7 (35.2) (238.7)
Special charges............................................................... - - (2.3)
--------- --------- ---------
Income (loss) before income taxes, minority interest, discontinued
operations and cumulative effect of accounting change..................... $ 49.3 $ 170.5 $ (747.4)
========= ========= =========
(continued)
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
------------- ------------------------------
One month Two months Three months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Ratios (annualized):
Investment income, net of interest credited on annuities and universal life
products and interest expense on investment borrowings, as a percentage of
average liabilities for
insurance and asset accumulation products (b).............................. 2.90% 3.99% 3.93%
Operating costs and expenses (excluding amortization of cost
of policies produced and cost of policies purchased) as a
percentage of average liabilities for insurance and asset
accumulation products (c).................................................. 2.41% 2.85% 2.46%
Health loss ratios:
All health lines:
Insurance policy benefits.................................................. $154.0 $418.1 $575.0
Loss ratio................................................................. 77.78% 107.54% 96.25%
Medicare Supplement:
Insurance policy benefits.................................................. $57.3 $102.3 $161.8
Loss ratio................................................................. 67.15% 60.54% 64.07%
Long-Term Care:
Insurance policy benefits.................................................. $73.7 $252.4 $323.9
Loss ratio................................................................. 96.07% 167.18% 144.82%
Interest-adjusted loss ratio............................................... 66.35% 141.26% 122.44%
Specified Disease:
Insurance policy benefits.................................................. $18.3 $49.7 $66.0
Loss ratio................................................................. 60.68% 82.48% 71.50%
Interest-adjusted loss ratio............................................... 30.90% 52.32% 43.53%
Other:
Insurance policy benefits.................................................. $4.7 $13.7 $23.3
Loss ratio................................................................. 81.16% 160.82% 80.78%
<FN>
- --------------------
(a) Revenues exclude net investment gains (losses); benefits and expenses
exclude amortization related to realized gains.
(b) Investment income includes income from general account assets only. Average
insurance liabilities exclude liabilities related to separate accounts,
investment trust and reinsurance ceded.
(c) Average insurance liabilities exclude liabilities related to separate
accounts, investment trust and reinsurance ceded.
</FN>
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
Insurance and fee-based operations (dollars in millions)
Successor Predecessor
------------- -----------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Premiums and asset accumulation product collections:
Annuities.................................................................... $ 68.7 $ 772.4 $ 804.1
Supplemental health.......................................................... 191.7 1,552.9 1,794.4
Life......................................................................... 46.5 383.4 483.8
Group major medical.......................................................... 17.4 152.4 248.2
--------- --------- --------
Collections on insurance products from continuing lines
of business........................................................... 324.3 2,861.1 3,330.5
Individual major medical in run-off.......................................... .5 4.0 89.2
Discontinued operations...................................................... - - 260.8
--------- --------- --------
Total collections on insurance products.................................. 324.8 2,865.1 3,680.5
Deposit type contracts....................................................... 30.8 260.1 237.6
Deposit type contracts - discontinued operations............................. - - 5.8
Mutual funds................................................................. 6.2 159.7 144.6
--------- --------- ---------
Total premiums and asset accumulation product collections................ $ 361.8 $ 3,284.9 $ 4,068.5
========= ========= =========
Average liabilities for insurance and asset accumulation products (excluding
discontinued operations and our major medical business in run-off):
Annuities:
Mortality based.......................................................... $ 338.8 $ 255.9 $ 250.5
Equity-linked............................................................ 1,569.5 1,697.9 2,258.1
Deposit based............................................................ 7,447.2 7,376.3 7,998.1
Separate accounts and investment trust liabilities....................... 87.7 401.3 695.9
Health..................................................................... 8,112.9 5,941.0 5,376.3
Life:
Interest sensitive....................................................... 3,680.6 3,732.2 4,052.7
Non-interest sensitive................................................... 2,249.4 2,146.3 2,089.7
--------- --------- ---------
Total average liabilities for insurance and asset
accumulation products, net of reinsurance ceded...................... $23,486.1 $21,550.9 $22,721.3
========= ========= =========
Revenues:
Insurance policy income...................................................... $ 248.9 $ 2,055.3 $ 2,375.1
Net investment income:
General account invested assets............................................ 105.3 913.4 1,141.0
Equity-indexed products based on the change in value of the
S&P 500 Call Options..................................................... (8.3) 25.2 (97.8)
Separate account assets.................................................... - - (8.5)
Trading income related to policyholder and reinsurer accounts.............. 14.8 - -
Change in value of embedded derivatives related to modified
coinsurance agreements................................................... (8.6) - -
Fee revenue and other income................................................. 1.9 34.4 69.9
--------- --------- ---------
Total revenues (a)....................................................... 354.0 3,028.3 3,479.7
--------- --------- ---------
Expenses:
Insurance policy benefits.................................................... 203.9 1,621.3 1,907.0
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below............................................ 38.1 311.6 377.3
Equity-indexed products based on S&P 500 Index............................. (5.2) 66.6 (18.9)
Separate account liabilities............................................... - - (8.5)
Amortization related to operations........................................... 27.0 338.0 579.6
Interest expense on investment borrowings.................................... .6 8.3 12.4
Other operating costs and expenses........................................... 47.0 380.6 378.7
--------- --------- ---------
Total benefits and expenses (a).......................................... 311.4 2,726.4 3,227.6
--------- --------- ---------
Income before goodwill impairment, net investment gains (losses),
special charges, income taxes, minority interest, discontinued
operations and cumulative effect of accounting change.................. 42.6 301.9 252.1
Goodwill impairment............................................................. - - (500.0)
Net investment gains (losses), including related costs and
amortization................................................................. 6.7 (5.0) (469.4)
Special charges................................................................. - - (42.0)
--------- --------- ---------
Income (loss) before income taxes, minority interest, discontinued
operations and cumulative effect of accounting change...................... .$ 49.3 $ 296.9 $ (759.3)
========= ========= =========
(continued)
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
------------- ----------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Ratios (annualized):
Investment income, net of interest credited on annuities and universal life
products and interest expense on investment borrowings, as a percentage of
average liabilities for
insurance and asset accumulation products (b)........................... 2.90% 3.86% 4.27%
Operating costs and expenses (excluding amortization of cost
of policies produced and cost of policies purchased) as a
percentage of average liabilities for insurance and asset
accumulation products (c)............................................... 2.41% 3.03% 2.29%
Health loss ratios:
All health lines:
Insurance policy benefits............................................... $154.0 $1,417.8 $1,492.1
Loss ratio.............................................................. 77.78% 89.99% 83.17%
Medicare Supplement:
Insurance policy benefits............................................... $57.3 $450.5 $491.6
Loss ratio.............................................................. 67.15% 66.06% 65.33%
Long-Term Care:
Insurance policy benefits............................................... $73.7 $745.2 $741.0
Loss ratio.............................................................. 96.07% 123.49% 110.08%
Interest-adjusted loss ratio............................................ 66.35% 98.47% 88.52%
Specified Disease:
Insurance policy benefits............................................... $18.3 $184.7 $192.6
Loss ratio.............................................................. 60.68% 75.77% 68.72%
Interest-adjusted loss ratio............................................ 30.90% 46.33% 41.48%
Other:
Insurance policy benefits............................................... $4.7 $37.4 $66.9
Loss ratio.............................................................. 81.16% 80.81% 75.87%
<FN>
- --------------------
(a) Revenues exclude net investment gains (losses); benefits and expenses
exclude amortization related to realized gains.
(b) Investment income includes income from general account assets only. Average
insurance liabilities exclude liabilities related to separate accounts,
investment trust and reinsurance ceded.
(c) Average insurance liabilities exclude liabilities related to separate
accounts, investment trust and reinsurance ceded.
</FN>
General: As more fully described in "Premium and Asset Accumulation Product
Collections," within "Management's Discussion and Analysis of Financial
Condition and Results of Operations", our insurance subsidiaries' financial
strength ratings were downgraded by A.M. Best on August 14, 2002 to "B (Fair)"
and the ratings remain "under review with developing implications". The
downgrade has caused sales of our insurance products to fall and policyholder
redemptions and lapses to increase. This has had a material adverse impact on
our financial results. On September 11, 2003, A.M. Best affirmed its financial
strength ratings of our primary insurance companies ("B (Fair)") and removed the
ratings from under review, indicating that the ratings outlook is positive. On
October 3, 2003, A.M. Best assigned a positive outlook to all of our ratings.
Conseco's insurance subsidiaries develop, market and administer annuity,
supplemental health, individual life insurance and other insurance products. We
distribute these products through a career agency force, professional
independent producers and direct response marketing. This segment excludes our
discontinued operations and the major medical business in run-off.
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Liabilities for insurance products are calculated using management's best
judgments of mortality, morbidity, lapse rates, investment experience and
expense levels that are based on the Company's past experience and standard
actuarial tables.
Collections on insurance products from continuing operations were $.3
billion in the one month ended September 30, 2003; $.7 billion in the two months
ended August 31, 2003; $2.9 billion in the eight months ended August 31, 2003;
$1.1 billion in the three months ended September 30, 2002; and $3.3 billion in
the nine months ended September 30, 2002. Annuity premium collections were
positively impacted by sales inducements provided to purchasers of our
annuities, sales incentives to our career agents and by the attractive minimum
guaranteed rates on certain of these products. Our premium collections have been
negatively impacted by the A.M. Best ratings downgrade to "B (Fair)." See
"Premium and Asset Accumulation Product Collections" for further analysis.
Average liabilities for insurance and asset accumulation products, net of
reinsurance receivables, were $23.5 billion in the one month ended September 30,
2003; $21.4 billion in the two months ended August 31, 2003; $21.6 billion in
the eight months ended August 31, 2003; $22.3 billion in the three months ended
September 30, 2002; and $22.7 billion in the nine months ended September 30,
2002. The decrease in such liabilities through August 31, 2003, is primarily due
to the increase in policyholder redemptions and lapses following the downgrade
of our A.M. Best financial strength rating to "B (Fair)". See "Liquidity for
insurance and fee-based operations" within "Management's Discussion and Analysis
of Financial Condition and Results of Operations" for additional discussion of
the A.M. Best ratings downgrade. The increase in such liabilities for the one
month ended September 30, 2003, is due to the adoption of fresh start
accounting.
Insurance policy income is comprised of: (i) premiums earned on policies
which provide mortality or morbidity coverage; and (ii) fees and other charges
made against other policies. See "Premium and Asset Accumulation Product
Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $105.3 million in the one
month ended September 30, 2003; $232.7 million in the two months ended August
31, 2003; $913.4 million in the eight months ended August 31, 2003; $365.1
million in the three months ended September 30, 2002; and $1,141.0 million in
the nine months ended September 30, 2002. The average balance of general account
invested assets was $23.0 million in the one month ended September 30, 2003;
$22.3 million in the two months ended August 31, 2003; $22.2 million in the
eight months ended August 31, 2003; $22.6 million in the three months ended
September 30, 2002; and $23.6 million in the nine months ended September 30,
2002. The yield on these assets was 5.5 percent in the one month ended September
30, 2003; 6.3 percent in the two months ended August 31, 2003; 6.2 percent in
the eight months ended August 31, 2003; 6.5 percent in the three months ended
September 30, 2002; and 6.4 percent in the nine months ended September 30, 2002.
The decrease in yield for the month ended September 30, 2003 reflects the
adoption of fresh start accounting.
Net investment income related to equity-indexed products based on the
change in value of the S&P 500 Call Options represents the change in the
estimated fair value of our S&P 500 Index Call Options which are purchased in an
effort to cover certain benefits accruing to the policyholders of our
equity-indexed products. Our equity-indexed products are designed so that the
investment income spread earned on the related insurance liabilities should be
more than adequate to cover the cost of the S&P 500 Call Options and other costs
related to these policies. Option costs that are attributable to benefits
provided were $5.2 million in the one month ended September 30, 2003; $14.0
million in the two months ended August 31, 2003; $53.5 million in the eight
months ended August 31, 2003; $20.7 million in the three months ended September
30, 2002; and $72.9 million in the nine months ended September 30, 2002. These
costs are reflected in the change in market value of the S&P 500 Call Options
included in the investment income amounts. Net investment income (loss) related
to equity-indexed products before this expense was $(3.1) million in the one
month ended September 30, 2003; $20.9 million in the two months ended August 31,
2003; $78.7 million in the eight months ended August 31, 2003; $(6.6) million in
the three months ended September 30, 2002; and $(24.9) million in the nine
months ended September 30, 2002. Such amounts were partially offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products of $(5.2) million in the one month ended September
30, 2003; $14.3 million in the two months ended August 31, 2003; $66.6 million
in the eight months ended August 31, 2003; $(3.7) million in the three months
ended September 30, 2002; and $(18.9) million in the nine months ended September
30, 2002. Such income and related charge fluctuate based on the value of options
embedded in the Company's equity-indexed annuity policyholder account balances
subject to this benefit and to the performance of the S&P 500 Index to which the
returns on such products are linked.
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
Net investment income (loss) from separate account assets is offset by a
corresponding charge (credit) to amounts added to policyholder account balances
for separate account liabilities. Such income (loss) and related charge (credit)
fluctuated in relationship to total separate account assets and the return
earned on such assets.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading security accounts established on August 31,
2003, which are designed to act as a hedge for embedded derivatives related to:
(i) our equity-indexed products; and (ii) certain modified coinsurance
agreements. In addition, such income includes the income on investments backing
the market strategies of our multibucket annuity products. The income on our
trading account securities are designed to substantially offset: (i) the change
in value of embedded derivatives related to modified coinsurance agreements
described below; and (ii) certain amounts included in insurance policy benefits.
Change in value of embedded derivatives related to modified coinsurance
agreements are described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We have transferred the specific block of
investments related to these agreements to our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
trading account income. The change in the value of the embedded derivatives
should largely be offset by the change in value of the trading securities.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. In the three and nine months ended September 30,
2002, this amount included $4.6 million and $14.5 million, respectively, of
affiliated fee revenue earned by our subsidiary in India. Such revenue is
eliminated in consolidation. Excluding such affiliated income, fee revenue and
other income decreased in the 2003 periods primarily as a result of a decrease
in the market value of investments managed for others, upon which these fees are
based. The Company sold its India subsidiary in the fourth quarter of 2002 and
has substantially eliminated the customer service and backroom operations
conducted there.
Insurance policy benefits fluctuated as a result of the factors summarized
in the explanations for loss ratios related to specific products which follow
and, in the two month period ended August 31, 2003, as a result of a change in
estimates of future losses on certain policies. Loss ratios are calculated by
taking the related insurance product's: (i) policy benefits; divided by (ii)
policy income.
The loss ratios on our Medicare supplement products increased slightly in
the 2003 periods, although they have generally been within our range of
expectations. Governmental regulations generally require us to attain and
maintain a loss ratio, after three years, of not less than 65 percent on these
products.
Our loss experience on long-term care products issued by independent agents
has been worse than we expected. Although we anticipated a higher level of
benefits to be paid out on these products as the policies age, the paid claims
have exceeded our projections. We are experiencing adverse developments on home
health care policies issued in certain areas of Florida and other states
(primarily policies issued by certain of our subsidiaries prior to their
acquisitions). This adverse experience is reflected in the higher loss ratios in
2003. We are aggressively seeking rate increases and pursuing other actions on
certain long-term care policies. We hired an actuarial consulting firm to help
evaluate the adequacy of our long-term care reserves given our recent adverse
experience and claim reserve deficiencies. Based on the results of their study
and our internal evaluations, we modified our claim continuance tables to
reflect longer benefit payment periods consistent with our current estimate of
future loss experience. Accordingly, claim reserves increased by $95.3 million
in the two months ended August 31, 2003, most of which was due to the new
continuance tables.
The net cash flows from our long-term care products generally result in the
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the loss ratio will
typically increase, but the increase in the change in reserve will be partially
offset by investment income earned on the assets which have accumulated. The
interest-adjusted loss ratio for long-term care products is calculated by taking
the insurance product's (i) policy benefits less interest income on the
accumulated assets which back the insurance liabilities; divided by (ii) policy
income.
The loss ratio for our specified disease products reflects higher than
expected incurred claims on certain cancer insurance policies during the first
eight months of 2003. These policies generally provide fixed or limited
benefits. Payments under cancer insurance policies are generally made directly
to, or at the direction of, the policyholder following diagnosis of, or
treatment for a covered type of cancer. We had favorable claims experience in
the one month ended September 30, 2003.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
The loss ratios on our other products fluctuate due to the smaller size of
these blocks of business. The loss ratios on this business have generally been
within our expectations.
In August 2003, the Company decided to change a non-guaranteed element of
certain policies. This element was not required by the policy and the change
will eliminate the former practice of reducing the cost of insurance charges to
amounts below the level permitted under the provisions of the policies. As a
result of this decision, our estimates of future expected gross profits on these
products used as a basis for amortization of cost of policies purchased and cost
of policies produced and the establishment of insurance liabilities has changed.
We adjusted the total amortization and reserve charge we had recorded since the
acquisition of these policies as a result of the change to our earlier estimates
in accordance with Statement of Financial Accounting Standards No. 97,
"Accounting and Reporting by Insurance Enterprises of Certain Long-Duration
Contracts and for Realized Gains and Losses from the Sale of Investments." The
effect of the change in estimate was a $220.2 million reduction to insurance
policy benefits and a $39.8 million reduction in amortization recorded in the
two months ended August 31, 2003.
Amounts added to policyholder account balances for annuity products were
$38.1 million in the one month ended September 30, 2003; $77.7 million in the
two months ended August 31, 2003; $311.6 million in the eight months ended
August 31, 2003; $120.8 million in the three months ended September 30, 2002;
and $377.3 million in the nine months ended September 30, 2002. This decrease is
primarily due to: (i) a smaller block of annuity business inforce; and (ii) a
decrease in the weighted average crediting rates. The weighted average crediting
rates for these products were 4.2 percent for the one month ended September 30,
2003; 4.3 percent for the eight months ended August 31, 2003; and 4.3 percent
for the nine months ended September 30, 2002.
Amounts added to equity-indexed products and separate account liabilities
correspond to the related investment income accounts described above.
Amortization related to operations includes amortization of the cost of
policies produced and the cost of policies purchased. Amortization recorded in
the two months ended August 31, 2003 was affected by the change in estimates of
future losses on certain policies described above under "insurance policy
benefits." Policyholder redemptions of annuity and, to a lesser extent, life
products have increased in recent periods. We have experienced additional
redemptions following the downgrade of our A.M. Best financial strength rating
to "B (Fair)" in August of 2002. When redemptions are greater than our previous
assumptions, we are required to accelerate the amortization of our cost of
policies produced and cost of policies purchased to write off the balance
associated with the redeemed policies. Amortization in recent periods has
fluctuated as a result of the acceleration of the amortization of our cost of
policies produced and cost of policies purchased associated with policy
redemptions and changes in future lapse assumptions with respect to the policies
in force. In 2002, we changed the lapse assumptions used to determine the
amortization of the cost of policies produced and the cost of policies purchased
related to certain universal life products and our annuities to reflect our then
current estimates of future lapses. For certain universal life products, we
changed the ultimate lapse assumption from: (i) a range of 6 percent to 7
percent; to (ii) a tiered assumption based on the level of funding of the policy
of a range of 2 percent to 10 percent. We recorded additional amortization
related to higher redemptions and changes to our lapse assumptions of $48
million and $122 million in the three and nine months ended September 30, 2002.
Policyholder redemptions during the 2003 periods have generally been consistent
with our revised lapse assumptions.
Interest expense on investment borrowings fluctuates along with our
investment borrowing activities and the interest rates thereon. Average
investment borrowings (excluding borrowings related to the GM building) were
$531.5 million during the one month ended September 30, 2003; $689.1 million
during the eight months ended August 31, 2003; and $1,226.4 million in the nine
months ended September 30, 2002. The weighted average interest rates on such
borrowings (excluding borrowings related to the GM building) were 1.3 percent
during the one month ended September 30, 2003; 1.8 percent during the eight
months ended August 31, 2003; and 1.3 percent during the nine months ended
September 30, 2002.
Other operating costs and expenses were $47.0 million in the one month
ended September 30, 2003; $100.7 million in the two months ended August 31,
2003; $380.6 million in the eight months ended August 31, 2003; $133.6 million
in the three months ended September 30, 2002; and $378.7 million in the nine
months ended September 30, 2002. Such increase is primarily related to increased
policy acquisition costs which were non-deferrable. The ratio of operating
expenses (excluding amortization of cost of policies produced and cost of
policies purchased) as a percentage of average liabilities for insurance and
asset accumulation products was 2.41 percent in the one month ended September
30, 2003; 2.85 percent in the two
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
months ended August 31, 2003; 3.03 percent in the eight months ended August 31,
2003; 2.46 percent in the three months ended September 30, 2002; and 2.29
percent in the nine months ended September 30, 2002.
Net investment gains (losses), including related costs and amortization
fluctuate from period to period. During the one month ended September 30, 2003,
we recognized net investment gains of $6.7 million related to the net gains from
the sales of investments (primarily fixed maturities). There were no writedowns
of fixed maturity investments in the one month period. During the first eight
months of 2003, we recognized net investment losses of $5.4 million. During the
first eight months of 2003, the net investment losses included: (i) $40.5
million of net gains from the sales of investments (primarily fixed maturities);
net of (ii) $45.9 million of writedowns of fixed maturity investments as a
result of conditions which caused us to conclude a decline in fair value of the
investment was other than temporary. The net investment losses during the first
nine months of 2002 included: (i) $489.8 million of writedowns of fixed maturity
investments, equity securities and other invested assets as a result of
conditions which caused us to conclude a decline in fair value of the investment
was other than temporary; and (ii) $4.1 million of net losses from the sales of
investments (primarily fixed maturities). The facts and circumstances resulting
in the other-than-temporary losses are described in "Investments with
Other-Than-Temporary Losses" included in this "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
When we sell securities at a gain (loss) and reinvest the proceeds at a
different yield, we increase (reduce) the amortization of cost of policies
purchased and cost of policies produced in order to reflect the change in future
yields. Sales of fixed maturity investments resulted in a decrease in the
amortization of the cost of policies purchased and the cost of policies produced
of nil in the one month ended September 30, 2003; $.6 million in the two months
ended August 31, 2003; $.4 million in the eight months ended August 31, 2003;
$22.4 million in the three months ended September 30, 2002; and $24.5 million in
the nine months ended September 30, 2002.
Special charges in 2002 include: (i) losses of $34.5 million on reinsurance
and asset sale transactions entered into as part of our cash raising initiatives
(all recognized in the second quarter of 2002); and (ii) other items totaling
$7.5 million ($2.3 million of which was recognized in the third quarter of 2002)
primarily related to severance benefits and costs incurred with the transfer of
certain customer service and backroom operations to our India subsidiary. These
charges are described in greater detail in the note to the accompanying
consolidated financial statements entitled "Special Charges".
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
Corporate operations (dollars in millions)
Successor Predecessor
------------- -----------------------------
One month Two months Three months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Corporate operations:
Interest expense on corporate debt, net of investment income............... $ (6.3) $ (50.3) $ (79.0)
Provision for losses and interest expense related to stock
purchase plan............................................................ - (24.5) (59.9)
Venture capital income (loss) related to investment in
AWE, net of related expenses............................................. (2.7) 2.0 (6.6)
Other items................................................................ (2.5) (1.7) (27.4)
Special charges............................................................ - - (32.6)
Reorganization items....................................................... - 2,163.0 -
------ -------- -------
Income (loss) before income taxes and minority interest................ $(11.5) $2,088.5 $(205.5)
====== ======== =======
Successor Predecessor
------------- -----------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Corporate operations:
Interest expense on corporate debt, net of investment income............... $ (6.3) $ (181.7) $(227.7)
Provision for losses and interest expense related to stock
purchase plan............................................................ - (55.6) (199.9)
Venture capital income (loss) related to investment in
AWE, net of related expenses............................................. (2.7) 10.5 (106.6)
Other items................................................................ (2.5) (28.4) (72.7)
Special charges............................................................ - - (61.1)
Extraordinary gain on extinguishment of debt............................... - - 1.8
Reorganization items....................................................... - 2,130.5 -
------ -------- -------
Income (loss) before income taxes and minority interest................ $(11.5) $1,875.3 $(666.2)
====== ======== =======
Interest expense on corporate debt, net of investment income in the one
month ended September 30, 2003, includes interest expense on the New Credit
Facility. Interest expense decreased in the 2003 Predecessor periods primarily
as a result of our ceasing to accrue interest on notes payable (excluding Old
Conseco's senior credit facility, the guaranteed senior notes and certain
secured senior notes).
Provision for losses and interest expense related to stock purchase plan
represents the non-cash provision we established in connection with our
guarantees of bank loans to former directors and current and former officers and
key employees and our related loans for interest. The funds from the bank loans
were used by the participants to purchase approximately 18.0 million shares of
Old Conseco common stock. In the eight months ended August 31, 2003, and the
nine months ended September 30, 2002, we increased our reserve by $55.6 million
and $199.9 million, respectively, in connection with these guarantees and loans.
We determined the reserve based upon the value of the collateral held by the
banks (primarily the purchased stock). At August 31, 2003, the reserve for
losses on the loan guarantees totaled $715.7 million. The outstanding principal
balance on the bank loans was $481.3 million. In addition, Conseco has provided
loans to participants for interest on the bank loans totaling $219.0 million.
During 2002, Conseco purchased $55.5 million of loans from the banks utilizing
cash held in a segregated cash account as collateral for our guarantee of the
bank loans (including accrued interest, the balance on these loans was $60.3
million at August 31, 2003). The guarantees of the bank loans are discussed in
greater detail in the note to the accompanying consolidated financial statements
entitled "Guarantees".
Venture capital income (loss) relates to our investment in AWE, a company
in the wireless communication business. Our investment in AWE is carried at
estimated fair value, with changes in fair value recognized as investment
income.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other items include general corporate expenses, net of amounts charged to
subsidiaries for services provided by the corporate operations. During the first
eight months of 2003, disputes with certain of our insurance carriers were
resolved and a previously established liability of $40 million was released
which was substantially offset by increases to various litigation reserves of
$30 million (none of which occurred in the two months ended August 31, 2003).
Special charges in corporate operations for 2002 include: (i) an impairment
charge of $20.0 million (recognized in the third quarter of 2002) associated
with the value of a subsidiary which we had entered into an agreement to sell;
(ii) $17.7 million related to refinancing transactions (of which $.3 million was
recognized in the third quarter of 2002); (iii) restructuring expenses of $12.1
million (all of which was recognized in the third quarter of 2002); (iv) other
items totaling $18.8 million (of which $.2 million was recognized in the third
quarter of 2002); partially offset by (v) net gains of $7.5 million related to
the sale of certain non-core assets. These charges are described in greater
detail in the note to the accompanying consolidated financial statements
entitled "Special Charges".
Reorganization items in the two months ended August 31, 2003 included: (i)
$3,151.4 million related to the gain on the discharge of prepetition
liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii)
$(38.4) million related to professional fees associated with our bankruptcy
proceedings which are expensed as incurred in accordance with SOP 90-7. The
reorganization items in the eight months ended August 31, 2003 included: (i)
$3,151.4 million related to the gain on the discharge of prepetition
liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii)
$(70.9) million related to professional fees.
PREMIUM AND ASSET ACCUMULATION PRODUCT COLLECTIONS
In accordance with GAAP, insurance policy income as shown in our
consolidated statement of operations consists of premiums earned for policies
that have life contingencies or morbidity features. For annuity and universal
life contracts without such features, premiums collected are not reported as
revenues, but as deposits to insurance liabilities. We recognize revenues for
these products over time in the form of investment income and surrender or other
charges.
Agents, insurance brokers and marketing companies who market our products
and prospective purchasers of our products use the ratings of our insurance
subsidiaries as an important factor in determining which insurer's products to
market or purchase. Ratings have the most impact on our annuity and
interest-sensitive life insurance products. In July 2002, A.M. Best downgraded
the financial strength ratings of our primary insurance subsidiaries from "A-
(Excellent)" to "B++ (Very Good)" and placed the ratings "under review with
negative implications." On August 14, 2002, A.M. Best lowered the financial
strength ratings of our primary insurance subsidiaries from "B++ (Very Good)" to
"B (Fair)". A.M. Best ratings for the industry currently range from "A++
(Superior)" to "F (In Liquidation)" and some companies are not rated. An "A++"
rating indicates superior overall performance and a superior ability to meet
ongoing obligations to policyholders. The "B" rating is assigned to companies
which have, on balance, fair balance sheet strength, operating performance and
business profile, when compared to the standards established by A.M. Best, and a
fair ability in A.M. Best's opinion to meet their current obligations to
policyholders, but are financially vulnerable to adverse changes in underwriting
and economic conditions. The rating reflected A.M. Best's view of the
uncertainty surrounding our restructuring initiatives and the potential adverse
financial impact on our subsidiaries. On September 11, 2003, A.M. Best affirmed
its financial strength ratings of our primary insurance companies ("B (Fair)")
and removed the ratings from under review, indicating that the ratings outlook
is positive. On October 3, 2003, A.M. Best assigned a positive outlook to all of
our ratings. The assignment of a positive outlook to Conseco's ratings reflects
A.M. Best's favorable view of our bankruptcy reorganization and a number of
management initiatives including the sale of the GM building, restructuring of
our investment portfolios, expense reductions, merging of certain subsidiaries,
stabilization of surrenders and a commitment in the near-to medium-term to focus
on selling higher margin products with lower capital requirements.
On September 11, 2003, S&P assigned a "B+" counterparty credit and
financial strength rating of our primary insurance companies and placed each
company on positive CreditWatch, with the exception of Conseco Senior Health
Insurance Company, which was placed on CreditWatch developing. Rating categories
from "BB" to "CCC" are classified as "vulnerable", and pluses and minuses show
the relative standing within a category. In S&P's view, an insurer rated "B" has
weak financial security characteristics and adverse business conditions will
likely impair its ability to meet financial commitments. On September 12, 2003,
Moody's affirmed the B3 rating of our insurance companies and placed each
insurance company on review for possible upgrade, with the exception of Conseco
Senior Health Insurance Company, which had a developing outlook. Rating
categories from "Ba" to "C" are classified as "vulnerable" by Moody's, and may
be
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
supplemented with numbers "1", "2", or "3" to show relative standing within a
category. In Moody's view, an insurer rated "B" offers poor financial security
and cannot offer assurance of punctual payment of claims over a long period of
time.
The ratings downgrades have generally caused sales of our insurance
products to decline and policyholder redemptions and lapses to increase. In some
cases, the downgrades have also caused defections among our independent agent
sales force and increases in the commissions we must pay in order to retain
them. These events have had a material adverse effect on our financial results.
Further downgrades by A.M. Best or S&P would likely have further material and
adverse effects on our financial results and liquidity, and will constitute a
default under our New Credit Facility.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. In setting premium rates, we consider historical
claims information, industry statistics, the rates of our competitors and other
factors. If our actual claims experience proves to be less favorable than we
assumed and we are unable to raise our premium rates, our financial results may
be adversely affected. Our estimates of insurance liabilities assume we will be
able to raise rates if future experience results in blocks of our health
insurance business becoming unprofitable. We generally cannot raise our health
insurance premiums in any state unless we first obtain the approval of the
insurance regulator in that state. We review the adequacy of our premium rates
regularly and file rate increases on our products when we believe existing
premium rates are too low. It is possible that we will not be able to obtain
approval for premium rate increases from currently pending requests or requests
filed in the future. If we are unable to raise our premium rates because we fail
to obtain approval for a rate increase in one or more states, our net income may
decrease. If we are successful in obtaining regulatory approval to raise premium
rates due to unfavorable actual claims experience, the increased premium rates
may reduce the volume of our new sales and cause existing policyholders to allow
their policies to lapse. This could result in anti-selection if healthier
policyholders allow their policies to lapse. This would reduce our premium
income and profitability in future periods. Increased lapse rates also could
require us to expense all or a portion of the deferred policy costs relating to
lapsed policies in the period in which those policies lapse, adversely affecting
our financial results in that period.
We sell our insurance products through three primary distribution channels
- - career agents, independent producers and direct marketing. Our career agency
force sells primarily Medicare supplement and long-term care insurance policies,
senior life insurance and annuities. These agents visit the customer's home,
which permits one-on-one contact with potential policyholders and promotes
strong personal relationships with existing policyholders. Our independent
producer distribution channel consists of a general agency and insurance
brokerage distribution system comprised of independent licensed agents doing
business in all fifty states, the District of Columbia, and certain
protectorates of the United States. Independent producers are a diverse network
of independent agents, insurance brokers and marketing organizations. Our direct
marketing distribution channel is engaged primarily in the sale of "graded
benefit life" insurance policies which are sold directly from the Company to the
policyholder.
62
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premiums and accumulation product collections were as follows
(dollars in millions):
Successor Predecessor
-------------- -------------------------------
One month Two months Three months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Premiums collected by our insurance subsidiaries:
Annuities:
Equity-indexed (first-year)..................................... $ 2.0 $ 9.2 $ 43.6
Equity-indexed (renewal)........................................ .9 2.1 4.6
------ ------ --------
Subtotal - equity-indexed annuities........................... 2.9 11.3 48.2
------ ------ --------
Other fixed (first-year)........................................ 63.3 147.9 216.2
Other fixed (renewal)........................................... 2.5 3.0 6.0
------ ------ --------
Subtotal - other fixed annuities.............................. 65.8 150.9 222.2
------ ------ --------
Total annuities............................................... 68.7 162.2 270.4
------ ------ --------
Supplemental health:
Medicare supplement (first-year)................................ 8.7 17.7 38.6
Medicare supplement (renewal)................................... 74.1 148.2 211.7
------ ------ --------
Subtotal - Medicare supplement................................ 82.8 165.9 250.3
------ ------ --------
Long-term care (first-year)..................................... 6.2 12.7 23.4
Long-term care (renewal)........................................ 66.5 139.7 204.1
------ ------ --------
Subtotal - long-term care..................................... 72.7 152.4 227.5
------ ------ --------
Specified disease (first-year).................................. 2.4 4.8 8.6
Specified disease (renewal)..................................... 27.1 51.6 81.8
------ ------ --------
Subtotal - specified disease.................................. 29.5 56.4 90.4
------ ------ --------
Other health (first-year)....................................... 1.9 3.2 2.2
Other health (renewal).......................................... 4.8 8.7 17.7
------ ------ --------
Subtotal - other health....................................... 6.7 11.9 19.9
------ ------ --------
Total supplemental health..................................... 191.7 386.6 588.1
------ ------ --------
Life insurance:
First-year...................................................... 5.6 12.8 27.9
Renewal......................................................... 40.9 87.9 131.1
------ ------ --------
Total life insurance.......................................... 46.5 100.7 159.0
------ ------ --------
Group major medical:
Renewal......................................................... 17.4 28.9 83.8
------ ------ --------
Total group major medical..................................... 17.4 28.9 83.8
------ ------ --------
Collections on insurance products from continuing lines of business:
Total first-year premium collections on insurance products...... 90.1 208.3 360.5
Total renewal premium collections on insurance products......... 234.2 470.1 740.8
------ ------ --------
Total collections on insurance products....................... $324.3 $678.4 $1,101.3
====== ====== ========
Deposit type contracts............................................... $ 30.8 $ 57.5 $ 78.3
====== ====== ========
(continued)
63
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
-------------- ---------------------------------
One month Two months Three months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Premiums collected from discontinued businesses and products in run-off:
Major medical............................................... $ .5 $1.6 $16.6
Annuities (primarily variable).............................. - - 72.1
Other ...................................................... - - .1
---- ---- -----
Total collections on insurance products from discontinued
operations and products in run-off...................... $ .5 $1.6 $88.8
==== ==== =====
Deposit type contracts - discontinued operations............... $ - $ - $ 1.3
==== ==== =====
(continued)
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
---------------- ---------------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Premiums collected by our insurance subsidiaries:
Annuities:
Equity-indexed (first-year)..................................... $ 2.0 $ 42.8 $ 167.0
Equity-indexed (renewal)........................................ .9 12.1 22.2
------ -------- --------
Subtotal - equity-indexed annuities........................... 2.9 54.9 189.2
------ -------- --------
Other fixed (first-year)........................................ 63.3 699.7 591.6
Other fixed (renewal)........................................... 2.5 17.8 23.3
------ -------- --------
Subtotal - other fixed annuities.............................. 65.8 717.5 614.9
------ -------- --------
Total annuities............................................... 68.7 772.4 804.1
------ -------- --------
Supplemental health:
Medicare supplement (first-year)................................ 8.7 74.1 122.6
Medicare supplement (renewal)................................... 74.1 595.4 636.4
------ -------- --------
Subtotal - Medicare supplement................................ 82.8 669.5 759.0
------ -------- --------
Long-term care (first-year)..................................... 6.2 51.9 74.1
Long-term care (renewal)........................................ 66.5 547.6 606.3
------ -------- --------
Subtotal - long-term care..................................... 72.7 599.5 680.4
------ -------- --------
Specified disease (first-year).................................. 2.4 19.7 28.0
Specified disease (renewal)..................................... 27.1 216.7 248.4
------ -------- --------
Subtotal - specified disease.................................. 29.5 236.4 276.4
------ -------- --------
Other health (first-year)....................................... 1.9 10.5 9.3
Other health (renewal).......................................... 4.8 37.0 69.3
------ -------- --------
Subtotal - other health....................................... 6.7 47.5 78.6
------ -------- --------
Total supplemental health..................................... 191.7 1,552.9 1,794.4
------ -------- --------
Life insurance:
First-year...................................................... 5.6 45.7 75.9
Renewal......................................................... 40.9 337.7 407.9
------ -------- --------
Total life insurance.......................................... 46.5 383.4 483.8
------ -------- --------
Group major medical:
First-year...................................................... - - .4
Renewal......................................................... 17.4 152.4 247.8
------ -------- --------
Total group major medical..................................... 17.4 152.4 248.2
------ -------- --------
Collections on insurance products from continuing lines of business:
Total first-year premium collections on insurance products...... 90.1 944.4 1,068.9
Total renewal premium collections on insurance products......... 234.2 1,916.7 2,261.6
------ -------- --------
Total collections on insurance products....................... $324.3 $2,861.1 $3,330.5
====== ======== ========
Deposit type contracts............................................... $ 30.8 $ 260.1 $ 237.6
====== ======== ========
(continued)
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Successor Predecessor
--------------- ----------------------------------
One month Eight months Nine months
ended ended ended
September 30, August 31, September 30,
2003 2003 2002
---- ---- ----
Premiums collected from discontinued businesses and products in run-off:
Major medical............................................... $ .5 $4.0 $ 89.2
Annuities (primarily variable annuities).................... - - 260.4
Other....................................................... - - .4
---- ---- ------
Total collections on insurance products from discontinued
operations and products in run-off...................... $ .5 $4.0 $350.0
==== ==== ======
Deposit type contracts - discontinued operations................. $ - $ - $ 5.8
==== ==== ======
Continuing operations
Annuities include equity-indexed annuities and other fixed annuities sold
through both career agents and professional independent producers. Pursuant to
our initiatives to increase capital and focus on the sale of products that
result in less strain on our statutory capital and surplus, we took actions to
de-emphasize the sales of annuity products through professional independent
producers. Total annuity sales through professional independent producers
totaled $5.3 million in the one month ended September 30, 2003; $73.9 million in
the eight months ended August 31, 2003; and $307.3 million in the nine months
ended September 30, 2002. For annuity sales through career agents, we provided
certain sales inducements to purchasers and sales incentives to our agents.
These programs ended at various times during the second quarter of 2003. Total
annuity collections from career agents totaled $63.4 million in the one month
ended September 30, 2003; $698.5 million in the eight months ended August 31,
2003; and $496.8 million in the nine months ended September 30, 2002.
We introduced our first equity-indexed annuity product in 1996. The
accumulation value of these annuities is credited with interest at an annual
guaranteed minimum rate of 3 percent (or, including the effect of applicable
sales loads, a 1.7 percent compound average interest rate over the term of the
contracts). These annuities provide for potentially higher returns based on a
percentage of the change in the S&P 500 Index during each year of their term. We
purchase S&P 500 Call Options in an effort to hedge increases to policyholder
benefits resulting from increases in the S&P 500 Index. Total collected premiums
for this product were $2.9 million in the one month ended September 30, 2003;
$11.3 million in the two months ended August 31, 2003; $54.9 million in the
eight months ended August 31, 2003; $48.2 million in the three months ended
September 30, 2002; and $189.2 million in the nine months ended September 30,
2002. The decreases can be attributed to: (i) the general stock market
performance in recent years which has made other investment products more
attractive to certain customers; and (ii) the effect of the A.M. Best ratings
downgrade to "B (Fair)."
Other fixed rate annuity products include single-premium deferred annuities
("SPDAs"), flexible-premium deferred annuities ("FPDAs") and single-premium
immediate annuities ("SPIAs"), which are credited with a declared rate. The
demand for traditional fixed-rate annuity contracts has increased as such
products became more attractive than equity-indexed or variable annuity products
to certain customers after the general stock market performance in recent years.
SPDA and FPDA policies typically have an interest rate that is guaranteed for
the first policy year, after which we have the discretionary ability to change
the crediting rate to any rate not below a guaranteed minimum rate. The interest
rate credited on SPIAs is based on market conditions existing when a policy is
issued and remains unchanged over the life of the SPIA. Annuity premiums on
these products were $65.8 million in the one month ended September 30, 2003;
$150.9 million in the two months ended August 31, 2003; $717.5 million in the
eight months ended August 31, 2003; $222.2 million in the three months ended
September 30, 2002; and $614.9 million in the nine months ended September 30,
2002. The annuity premiums collected in 2003 were primarily from sales through
our career agency force, which were favorably impacted by the sales inducements
and incentives discussed above. In addition, the minimum guaranteed crediting
rates on certain of our annuity
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
products were very attractive. We recently introduced new annuity products which
have lower minimum guaranteed crediting rates. Given the elimination of the
sales inducements and incentives and the lower minimum guaranteed crediting
rates, sales of fixed rate annuity products have declined.
Supplemental health products include Medicare supplement, long-term care,
specified disease and other insurance products distributed through a career
agency force and professional independent producers. Our profits on supplemental
health policies depend on the overall level of sales, the length of time the
business remains inforce, investment yields, claim experience and expense
management.
Collected premiums on Medicare supplement policies were $82.8 million in
the one month ended September 30, 2003; $165.9 million in the two months ended
August 31, 2003; $669.5 million in the eight months ended August 31, 2003;
$250.3 million in the three months ended September 30, 2002; and $759.0 million
in the nine months ended September 30, 2002. Collected premiums have been
affected by the decrease in new sales.
Premiums collected on long-term care policies totaled $72.7 million in the
one month ended September 30, 2003; $152.4 million in the two months ended
August 31, 2003; $599.5 million in the eight months ended August 31, 2003;
$227.5 million in the three months ended September 30, 2002; and $680.4 million
in the nine months ended September 30, 2002. Collected premiums have been
affected by the decrease in new sales. We ceased selling new long-term care
policies through professional independent producers in the second quarter of
2003.
Premiums collected on specified disease products totaled $29.5 million in
the one month ended September 30, 2003; $56.4 million in the two months ended
August 31, 2003; $236.4 million in the eight months ended August 31, 2003; $90.4
million in the three months ended September 30, 2002; and $276.4 million in the
nine months ended September 30, 2002. Collected premiums have been affected by
the decrease in new sales.
Other health products include disability income, dental and various other
health insurance products. We have discontinued the sale of most of these
products. The disability income and dental products have been marketed to school
systems located in nearly all states. Premiums collected totaled $6.7 million in
the one month ended September 30, 2003; $11.9 million in the two months ended
August 31, 2003; $47.5 million in the eight months ended August 31, 2003; $19.9
million in the three months ended September 30, 2002; and $78.6 million in the
nine months ended September 30, 2002.
Life products are sold through career agents, professional independent
producers and direct response distribution channels. Life premiums collected
totaled $46.5 million in the one month ended September 30, 2003; $100.7 million
in the two months ended August 31, 2003; $383.4 million in the eight months
ended August 31, 2003; $159.0 million in the three months ended September 30,
2002; and $483.8 million in the nine months ended September 30, 2002. The A.M.
Best ratings downgrade to "B (Fair)" has negatively affected our sales of life
products. We have recently discontinued the sale of certain life products
through the professional independent producer channel.
Group major medical premiums totaled $17.4 million in the one month ended
September 30, 2003; $28.9 million in the two months ended August 31, 2003;
$152.4 million in the eight months ended August 31, 2003; $83.8 million in the
three months ended September 30, 2002; and $248.2 million in the nine months
ended September 30, 2002. We no longer actively market new sales of these
products.
Deposit type contracts include guaranteed interest contracts, supplemental
contracts without life contingencies and short-term deposit funds. Amounts
collected from deposit type contracts were $30.8 million in the one month ended
September 30, 2003; $57.5 million in the two months ended August 31, 2003;
$260.1 million in the eight months ended August 31, 2003; $78.3 million in the
three months ended September 30, 2002; and $237.6 million in the nine months
ended September 30, 2002. Such amounts often fluctuate from period-to-period.
67
CONSECO, INC. AND SUBSIDIARIES
-------------------
Major medical business in run-off and discontinued operations
Major medical in run-off includes major medical health insurance products
sold to individuals and small groups. In the second half of 2001, we stopped
renewing a large portion of our major medical lines of business. In early 2002,
we decided to stop renewing all inforce individual and small group business and
discontinue new sales. Individual health premiums collected were $.5 million in
the one month ended September 30, 2003; $1.6 million in the two months ended
August 31, 2003; $4.0 million in the eight months ended August 31, 2003; $16.6
million in the three months ended September 30, 2002; and $89.2 million in the
nine months ended September 30, 2002.
Variable annuities offer contract holders the ability to direct premiums
into specific investment portfolios; rates of return are based on the
performance of the portfolio. Profits on variable annuities are earned from the
fees charged to contract holders. We sold our variable annuity business in the
fourth quarter of 2002.
Life product premiums from discontinued operations represent the life
business of CVIC, which was sold in the fourth quarter of 2002.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between September 30, 2003 and
December 31, 2002, reflect: (i) the reorganization of our capital structure
pursuant to the Plan; and (ii) the effect of the sale of CFC.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' deficit. At September 30, 2003, we increased the
carrying value of such investments by $470.6 million as a result of this fair
value adjustment.
The Company's capital structure was determined in accordance with the terms
of the Plan and consists of: (i) a $1.3 billion secured bank credit agreement;
(ii) Preferred Stock with an aggregate liquidation preference of $859.7 million;
(iii) warrants to purchase six million shares of common stock; and (iv) 100
million shares of new common stock. The Company's capital structure as of
September 30, 2003, is as follows (dollars in millions):
Total capital:
Corporate notes payable................................................ $1,300.0
Shareholders' equity:
Preferred stock..................................................... 865.0
Common stock and additional paid-in capital......................... 1,640.3
Accumulated other comprehensive income.............................. 273.2
Retained earnings................................................... 18.9
--------
Total shareholders' equity....................................... 2,797.4
--------
Total capital.................................................... $4,097.4
========
68
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following table summarizes certain financial ratios as of and for the
one month ended September 30, 2003:
Book value per common share..................................................................... $19.31
Ratio of earnings to fixed charges.............................................................. 1.82x
Ratio of earnings to fixed charges and preferred dividends...................................... 1.54x
Debt to total capital ratios (a):
Corporate debt to total capital.............................................................. 34%
Corporate debt and preferred stock to total capital.......................................... 57%
<FN>
- ---------------
(a) Excludes accumulated other comprehensive income.
</FN>
Liquidity for insurance and fee-based operations
Our insurance operating companies generally receive adequate cash flow from
premium collections and investment income to meet their obligations. Life
insurance and annuity liabilities are generally long-term in nature.
Policyholders may, however, withdraw funds or surrender their policies, subject
to any applicable surrender and withdrawal penalty provisions. We seek to
balance the duration of our invested assets with the estimated duration of
benefit payments arising from contract liabilities.
On August 14, 2002, A.M. Best lowered the financial strength ratings of our
primary insurance subsidiaries from "B++ (Very Good)" to "B (Fair)". A.M. Best
ratings for the industry currently range from "A++ (Superior)" to "F (In
Liquidation)" and some companies are not rated. An "A++" rating indicates
superior overall performance and a superior ability to meet ongoing obligations
to policyholders. The "B" rating is assigned to companies which have, on
balance, fair balance sheet strength, operating performance and business
profile, when compared to the standards established by A.M. Best, and a fair
ability in A.M. Best's opinion to meet their current obligations to
policyholders, but are financially vulnerable to adverse changes in underwriting
and economic conditions. The rating reflected A.M. Best's view of the
uncertainty surrounding our restructuring initiatives and the potential adverse
financial impact on our subsidiaries. On September 11, 2003, A.M. Best affirmed
its financial strength ratings of our primary insurance companies ("B (Fair)")
and removed the ratings from under review, indicating that the ratings outlook
is positive. On October 3, 2003, A.M. Best assigned a positive outlook to all of
our ratings. The assignment of a positive outlook to Conseco's ratings reflects
A.M. Best's favorable view of our bankruptcy reorganization and a number of
management initiatives including the sale of the GM building, sale of CFC,
restructuring of our investment portfolios, expense reductions, merging of
certain subsidiaries, stabilization of surrenders and a commitment in the
near-to medium-term to focus on selling higher margin products with lower
capital requirements. On September 11, 2003, S&P assigned a "B+" counterparty
credit and financial strength rating of our primary insurance companies and
placed each company on positive CreditWatch, with the exception of Conseco
Senior Health Insurance Company, which was placed on CreditWatch developing.
Rating categories from "BB" to "CCC" are classified as "vulnerable", and pluses
and minuses show the relative standing within a category. In S&P's view, an
insurer rated "B" has weak financial security characteristics and adverse
business conditions will likely impair its ability to meet financial
commitments. On September 12, 2003, Moody's affirmed the B3 rating of our
insurance companies and placed each insurance company on review for possible
upgrade, with the exception of Conseco Senior Health Insurance Company, which
had a developing outlook. Rating categories from "Ba" to "C" are classified as
"vulnerable" by Moody's, and may be supplemented with numbers "1", "2", or "3"
to show relative standing within a category. In Moody's view, an insurer rated
"B" offers poor financial security and cannot offer assurance of punctual
payment of claims over a long period of time.
The ratings downgrades have generally caused sales of our insurance
products to decline and policyholder redemptions and lapses to increase. In some
cases, the downgrades have also caused defections among our independent agent
sales force and increases in the commissions we must pay. These events have had
a material adverse effect on our financial results. Further downgrades by A.M.
Best, S & P or Moody's would likely have further material and adverse effects on
our financial results and liquidity. Further downgrades by A.M. Best will also
constitute a default under our New Credit Facility.
69
CONSECO, INC. AND SUBSIDIARIES
-------------------
As more fully described under the caption "Statutory Information" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", our two insurance subsidiaries domiciled in Texas entered into
consent orders with the Texas Department of Insurance. We expect the consent
orders to be released in the near future. The consent orders applied to all of
our insurance subsidiaries and, among other things, restricted the ability of
our insurance subsidiaries to pay dividends and other amounts to the parent
company without regulatory consent. State laws generally provide state insurance
regulatory agencies with broad authority to protect policyholders in their
jurisdictions. Accordingly, we cannot assure you that the regulators will not
seek to assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs. We have agreed with the Texas Department of
Insurance to provide prior notice of certain transactions, including up to 30
days prior notice for the payment of dividends by an insurance subsidiary to any
non-insurance company parent, and periodic reporting of information concerning
our financial performance and condition.
Our insurance subsidiaries experienced increased lapse rates on annuity
policies during 2002. Aggregate annuity surrenders have declined in 2003. We
believe that the diversity of the investment portfolios of our insurance
subsidiaries and the concentration of investments in high-quality, liquid
securities provide sufficient liquidity to meet foreseeable cash requirements of
our insurance subsidiaries. Our insurance subsidiaries could readily liquidate
portions of their investments, if lapses continue at current levels.
Liquidity of the Holding Companies
Pursuant to the Plan, we entered into the New Credit Facility. The New
Credit Facility consists of two tranches: Tranche A - $1.0 billion; and Tranche
B - $.3 billion. See the note to the consolidated financial statements for
further discussion related to the New Credit Facility. Principal repayments are
due as follows (dollars in millions):
Tranche A Tranche B
June 30, 2004......................................................... $ 50.0 $ 3.0
June 30, 2005......................................................... 50.0 3.0
June 30, 2006......................................................... 50.0 1.5
December 31, 2006..................................................... 50.0 1.5
June 30, 2007......................................................... 75.0 1.5
December 31, 2007..................................................... 75.0 1.5
June 30, 2008......................................................... 75.0 1.5
December 31, 2008..................................................... 75.0 1.5
June 30, 2009......................................................... - 1.5
September 10, 2009.................................................... 500.0 -
December 31, 2009..................................................... - 1.5
September 10, 2010.................................................... - 282.0
-------- ------
$1,000.0 $300.0
======== ======
At September 30, 2003, CNO and CDOC held unrestricted cash of $12.7 million
and additional restricted cash of $22.1 million held in trust for the payment of
bankruptcy-related professional fees. In addition, our other non-life insurance
companies held unrestricted cash of approximately $69.6 million.
CNO and CDOC are holding companies with no business operations of their
own; they depend on their operating subsidiaries for cash to make principal and
interest payments on debt, and to pay administrative expenses and income taxes.
The cash CNO and CDOC receive from insurance subsidiaries consists of dividends
and distributions, principal and interest payments on surplus debentures, fees
for services, tax-sharing payments, and from our non-insurance subsidiaries,
loans and advances. A further deterioration in the financial condition, earnings
or cash flow of the material subsidiaries of CNO or CDOC for any reason could
further limit such subsidiaries' ability to pay cash dividends or other
disbursements to CNO and/or CDOC, which, in turn, would limit CNO's and/or
CDOC's ability to meet debt service requirements and satisfy other financial
obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid from earned surplus of the insurance company for any
12-month period in amounts equal to the greater of (or in a few states, the
lesser of): (i) net gain from operations or net income for the prior year;
70
CONSECO, INC. AND SUBSIDIARIES
-------------------
or (ii) 10 percent of capital and surplus as of the end of the preceding year.
Any dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department. Also, we have agreed
with the Texas Department of Insurance to provide up to 30 days prior notice of
the payment of dividends by an insurance subsidiary to any non-insurance company
parent. As described under the caption "Statutory Information" within
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", we recently were subject to consent orders with the Commissioner of
Insurance for the State of Texas that, among other things, limited the ability
of our insurance subsidiaries to pay dividends. If our financial condition were
to deteriorate, we may be required to enter into similar orders in the future.
In addition, we may need to contribute additional capital to improve the ACLRBC
ratios of our insurance subsidiaries and this could affect the ability of our
top tier insurance subsidiary to pay dividends.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
assure you that we will possess sufficient income and liquidity to meet all of
our liquidity requirements and other obligations. Although we believe that
amounts required for us to meet our financial and operating obligations will be
available from our subsidiaries and from funds currently held by CNO and CDOC,
our results for future periods are subject to numerous uncertainties. We may
encounter liquidity problems, which could affect our ability to meet our
obligations while attempting to meet competitive pressures or adverse economic
conditions.
Because our operations are conducted through subsidiaries, claims of the
creditors of those subsidiaries (including policyholders) will rank senior to
our claims to distributions from the subsidiaries, which we depend on to make
payments on our obligations. CDOC's subsidiaries had indebtedness for borrowed
money (excluding indebtedness to affiliates), policy reserves and other
liabilities of approximately $25.6 billion at September 30, 2003. The
obligations of CNO and CDOC, as parent holding companies, will rank effectively
junior to these liabilities.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted under the insurance law of its state of domicile by such
state's insurance regulator as the receiver with respect to such insurer's
property and business. In the event of a default on our debt or our insolvency,
liquidation or other reorganization, our creditors and stockholders will not
have the right to proceed against the assets of our insurance subsidiaries or to
cause their liquidation under federal and state bankruptcy laws.
Even following our emergence from bankruptcy, we have substantial
indebtedness. At September 30, 2003, we had indebtedness for borrowed money
(excluding indebtedness to affiliates), policy reserves and other liabilities of
approximately $27.1 billion. Further, our historical capital requirements have
been significant and our future capital requirements could vary significantly
and may be affected by general economic conditions, industry trends,
performance, and many other factors that are not within our control. We cannot
assure you that we will be able to obtain financing or that we will not continue
to experience losses in the future. Our profitability and ability to generate
cash flow will likely depend upon our ability to successfully implement our
business strategy. However, we cannot assure you that we will be able to
accomplish these results.
Under our New Credit Facility, we have agreed to a number of covenants and
other provisions that restrict our ability to engage in various financing
transactions and pursue certain operating activities without the prior consent
of the lenders under the New Credit Facility. We have also agreed to meet or
maintain various financial ratios and minimum financial strength ratings for our
insurance subsidiaries. For instance, if we experience another A.M. Best ratings
downgrade, if we fail to achieve an "A-" rating from A.M. Best by August 15,
2005 (or December 31, 2005 if we meet certain financial ratios) or if we
experience a ratings downgrade from A.M. Best after achieving an "A-" rating, we
will suffer an event of default under the New Credit Facility. Our ability to
meet these financial and ratings covenants may be affected by events beyond our
control. These requirements represent significant restrictions on the manner in
which we may operate our business. If we default under any of these
requirements, the lenders could declare all outstanding borrowings, accrued
interest and fees to be due and payable. If that were to occur, we cannot assure
you that we would have sufficient liquidity to repay or refinance this
indebtedness or any of our other debts.
71
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At September 30, 2003, the amortized cost and estimated fair value of
actively managed fixed maturities and equity securities were as follows (dollars
in millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities................................................ $10,868.2 $345.3 $12.3 $11,201.2
United States Treasury securities and obligations of
United States government corporations and agencies................ 812.6 16.4 .1 828.9
States and political subdivisions................................... 564.5 12.0 .2 576.3
Debt securities issued by foreign governments....................... 84.9 2.3 - 87.2
Structured securities .............................................. 5,767.9 99.2 4.0 5,863.1
Below-investment grade (primarily corporate securities)................ 787.4 12.0 3.4 796.0
--------- ------ ----- ---------
Total actively managed fixed maturities............................. $18,885.5 $487.2 $20.0 $19,352.7
========= ====== ===== =========
Equity securities...................................................... $ 104.6 $ 2.9 $ - $ 107.5
========= ====== ===== =========
Concentration of Corporate Securities
At September 30, 2003, our corporate securities (including below-investment
grade) were concentrated in the following industries:
Percent of Percent of
amortized estimated
cost fair value
---------- ----------
Media and communications......................................................... 12.0% 12.1%
Bank/savings and loan............................................................ 11.3 11.4
Electric utility................................................................. 9.5 9.4
Energy........................................................................... 8.2 8.2
Insurance ....................................................................... 7.7 7.7
Real estate and real estate investment trusts.................................... 7.3 7.3
Financial institutions........................................................... 6.2 6.2
With respect to our corporate securities, no other industry accounted for
more than 5.0 percent of amortized cost or estimated fair value.
Below-Investment Grade Securities
At September 30, 2003, the amortized cost of the Company's fixed maturity
securities in below-investment grade securities was $787.4 million, or 4.2
percent of the Company's fixed maturity portfolio. The estimated fair value of
the below-investment grade portfolio was $796.0 million, or 101 percent of the
amortized cost. The value of these securities varies based on the economic terms
of the securities, structural considerations and the creditworthiness of the
issuer of the securities. Recently a number of large, highly leveraged issuers
have experienced significant financial difficulties, which resulted in our
recognition of significant other-than-temporary impairments.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of loss upon default by the
borrower is significantly greater with respect to below-investment grade
securities than with other corporate debt securities. Below-investment grade
securities are generally unsecured and are often subordinated to other creditors
of the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and are more
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CONSECO, INC. AND SUBSIDIARIES
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sensitive to adverse economic conditions, such as recession or increasing
interest rates, than are investment grade issuers. The Company attempts to
reduce the overall risk in the below-investment grade portfolio, as in all
investments, through careful credit analysis, strict investment policy
guidelines, and diversification by issuer and/or guarantor and by industry.
Net Realized Investment Gains (Losses)
During the one month ended September 30, 2003, we recognized net realized
investment gains of $6.7 million resulting from the sales of investments
(primarily fixed maturities) which generated proceeds of $2.1 billion. There
were no writedowns of fixed maturity investments as a result of conditions which
caused us to conclude a decline in fair value of the investment was other than
temporary. During the first eight months of 2003, we recognized net realized
investment losses of $5.4 million. The net realized investment losses during the
first eight months of 2003 included: (i) $40.5 million of net gains from the
sales of investments (primarily fixed maturities) which generated proceeds of
$5.4 billion; net of (ii) $45.9 million of writedowns of fixed maturity
investments as a result of conditions which caused us to conclude a decline in
fair value of the investment was other than temporary. At September 30, 2003,
fixed maturity securities in default as to the payment of principal or interest
had an aggregate amortized cost of $21.4 million and a carrying value of $21.5
million. Net realized investment losses during the first nine months of 2002
included: (i) $489.8 million of writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which caused us
to conclude a decline in fair value of the investment was other than temporary;
and (ii) $4.1 million of net losses from the sales of investments (primarily
fixed maturities).
During the one month ended September 30, 2003, we sold $50.9 million of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $.8 million. During the first eight months of 2003, we sold
$2.7 billion of fixed maturity investments which resulted in gross investment
losses (before income taxes) of $59.4 million. Securities sold at a loss are
sold for a number of reasons including: (i) changes in the investment
environment; (ii) expectation that the market value could deteriorate further;
(iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in
credit quality; and (v) our analysis indicating there is a high probability that
the security is other-than-temporarily impaired.
The following summarizes the investments sold at a loss during the first
eight months of 2003 which had been continuously in an unrealized loss position
exceeding 20 percent of the amortized cost basis prior to the sale for the
period indicated (there were no such investments sold at a loss during the one
month ended September 30, 2003) (dollars in millions):
At date of sale
-----------------
Number Amortized Fair
Period of issuers cost value
------ ---------- ---- -----
Less than 6 months prior to sale.................... 16 $32.0 $24.0
Greater than or equal to 6 and less than 12 months
prior to sale.................................... 8 40.6 25.7
Greater than 12 months prior to sale................ 20 39.8 23.7
Investments with Other-Than-Temporary Losses
During the one month ended September 30, 2003, we did not record any
writedowns of fixed maturity investments. During the eight months ended August
31, 2003, we recorded writedowns of fixed maturity investments totaling $45.9
million as further described in the following paragraphs:
During the eight months ended August 31, 2003, we recognized a loss of
$11.1 million to record certain commercial loans at their estimated fair value
as we intended to liquidate them and use the proceeds to repay the senior
financing used to acquire the loans. No additional gain or loss was recognized
upon the ultimate disposition of the loans.
During the eight months ended August 31, 2003, we recorded writedowns of
$8.4 million related to our holdings of fixed maturity investments in a major
airline that has filed bankruptcy. Although our investments are backed by
collateral,
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CONSECO, INC. AND SUBSIDIARIES
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our analysis of the value of the underlying collateral indicated that the
decline in fair value of the investment is other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$3.7 million related to our holdings of fixed maturity investments in a
fertilizer company that has filed for bankruptcy. A significant portion of its
production capacity was rendered unprofitable due to high raw material costs and
was temporarily idled. Accordingly, we concluded that the decline in fair value
was other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$1.8 million related to holdings in a health care company that has had financial
problems due to financial misstatements, substantial regulatory and litigation
exposure and its failure to meet debt service requirements. The adverse effect
on liquidity and access to capital may force this issuer to file for bankruptcy.
Accordingly, we concluded the decline in fair value was other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$1.5 million related to holdings of a fixed income security of a finance company
that has had significant financial and liquidity problems. Accordingly, we
concluded the decline in fair value was other than temporary.
During the eight months ended August 31, 2003, we recorded writedowns of
$9.6 million related to holdings of a fixed income security in a trust which
leases airplanes and related equipment. We believe that the collateral
supporting these investments has eroded and, therefore, we concluded the decline
in fair value was other than temporary.
In addition to the specific investments discussed above, we recorded $9.8
million of writedowns related to various other fixed maturity investments. No
other writedown of a single issuer exceeded $1.5 million.
Recognition of Losses
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that is other than temporary, the decline is recognized as a
realized loss and the cost basis of the security is reduced to its estimated
fair value.
Our evaluation of investments for impairment requires significant judgments
to be made including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) assessment of
whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of an investment
loss at that time.
Our periodic assessment of whether unrealized losses are "other than
temporary" requires significant judgment. Factors considered include: (i) the
extent to which market value is less than the cost basis; (ii) the length of
time that the market value has been less than cost; (iii) whether the unrealized
loss is event driven, credit-driven or a result of changes in market interest
rates; (iv) the near-term prospects for improvement in the issuer and/or its
industry; (v) whether the investment is investment-grade and our view of the
investment's rating and whether the investment has been downgraded since its
purchase; (vi) whether the issuer is current on all payments in accordance with
the contractual terms of the investment and is expected to meet all of its
obligations under the terms of the investment; (vii) our ability and intent to
hold the investment for a period of time sufficient to allow for any anticipated
recovery; and (viii) the underlying current and prospective asset and enterprise
values of the issuer and the extent to which our investment may be affected by
changes in such values.
If a decline in value is determined to be other than temporary and the cost
basis of the security is written down to fair value, we review the circumstances
which caused us to believe that the decline was other than temporary with
respect to other investments in our portfolio. If such circumstances exist with
respect to other investments, those investments are also written down to fair
value. Future events may occur, or additional or updated information may become
available, which may necessitate future realized losses of securities in our
portfolio. Significant losses in the carrying value of our investments could
have a material adverse effect on our earnings in future periods.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at September
30, 2003, by contractual maturity. Actual maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties. Most of the structured
securities shown below provide for periodic payments throughout their lives.
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CONSECO, INC. AND SUBSIDIARIES
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Estimated
Amortized fair
cost value
--------- ---------
(Dollars in millions)
Due in one year or less................................................................... $ 11.3 $ 11.3
Due after one year through five years..................................................... 119.7 117.6
Due after five years through ten years.................................................... 165.7 163.6
Due after ten years....................................................................... 336.5 324.6
-------- --------
Subtotal............................................................................... 633.2 617.1
Structured securities..................................................................... 753.9 750.0
-------- --------
Total.................................................................................. $1,387.1 $1,367.1
======== ========
Investments in fixed maturities rated below-investment grade or classified
as equity-type securities in an unrealized loss position exceeding 20 percent of
the cost basis as of September 30, 2003 had a cost basis of $.2 million.
Our investment strategy is to maximize over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change. While we have both the ability and intent to hold
securities with unrealized losses until they mature or recover in value, we may
sell securities at a loss in the future because of actual or expected changes in
our view of the particular investment, its industry, its type or the general
investment environment.
Based on management's current assessment of these securities and other
investments with unrealized losses at September 30, 2003, the Company believes
the issuers of the securities will continue to meet their obligations (or with
respect to equity-type securities, the investment value will recover to its cost
basis). The Company has no current plans to sell these securities and has the
ability to hold them to maturity. The recognition of an other-than-temporary
impairment through a charge to earnings may be recognized in future periods if
management later concludes that the decline in market value below the cost basis
is other than temporary.
Investment in General Motors Building
During the summer of 2003, we successfully enforced our contractual right
to buy out our 50 percent equity partner in the GM building, a landmark 50-story
office tower in New York City. After obtaining an award in arbitration, and
confirming that award in the New York court system, we finally settled our
differences with our equity partner, thus permitting us to put the building up
for sale. On September 26, 2003, we sold our investment in the GM building. We
received cash of $636.8 million, which was approximately equal to the value
established upon the adoption of fresh start accounting.
Our investment in the GM building was made through a partnership which
acquired the building in 1998 for $878 million. The initial capital structure of
the partnership consisted of: (i) a $700 million senior mortgage; (ii) $200
million of subordinated debt with a stated fixed return of 12.7 percent
payable-in-kind, and the opportunity to earn an additional residual return; and
(iii) $30 million of partnership equity, owned 50 percent by Conseco and 50
percent by an affiliate of Donald Trump. A Trump affiliate also served as
general manager of the acquired building. We owned 100 percent of the
subordinated debt.
The $30 million of partnership equity represented less than 10 percent of
the total capital of the partnership. In addition, the subordinated debt was
intended to absorb virtually all expected losses and receive a significant
portion of expected residual returns. Based on our 100 percent ownership of the
subordinated debt, we were the primary beneficiary of the GM building. The
partnership was consolidated in our financial statements effective August 31,
2003 in accordance with the requirements of FIN 46, which was implemented in
conjunction with fresh start accounting. The August 31, 2003 fresh start balance
sheet reflected the following balances of the partnership: the GM building at
$1,336.3 million; cash of $28.4 million; and a non-recourse loan of $700 million
(classified as an investment borrowing). Our income statement for the
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CONSECO, INC. AND SUBSIDIARIES
-------------------
month of September reflected investment income of $2.9 million related to this
investment (representing our equity interest in the income from the building for
the 26 days prior to the sale).
Structured Securities
At September 30, 2003, fixed maturity investments included $5.9 billion of
structured securities (or 30 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations, asset-backed securities and commercial mortgage-backed
securities. The yield characteristics of structured securities differ from those
of traditional fixed-income securities. Interest and principal payments for
mortgage-backed securities occur more frequently, often monthly. Mortgage-backed
securities are subject to risks associated with variable prepayments. Prepayment
rates are influenced by a number of factors that cannot be predicted with
certainty, including: the relative sensitivity of the underlying mortgages
backing the assets to changes in interest rates; a variety of economic,
geographic and other factors; and the repayment priority of the securities in
the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities
backed by these loans increase when prevailing interest rates decline
significantly relative to the interest rates on such loans. The yields on
mortgage-backed securities purchased at a discount to par will increase when the
underlying mortgages prepay faster than expected. The yields on mortgage-backed
securities purchased at a premium will decrease when the underlying mortgages
prepay faster than expected. When interest rates decline, the proceeds from the
prepayment of mortgage-backed securities may be reinvested at lower rates than
we were earning on the prepaid securities. When interest rates increase,
prepayments on mortgage-backed securities decrease as fewer underlying mortgages
are refinanced. When this occurs, the average maturity and duration of the
mortgage-backed securities increase, which decreases the yield on
mortgage-backed securities purchased at a discount, because the discount is
realized as income at a slower rate, and increases the yield on those purchased
at a premium as a result of a decrease in the annual amortization of the
premium.
Pursuant to fresh start reporting, we were required to mark all of our
investments to market value. The current interest rate environment is much lower
than when most of our investments were purchased. Accordingly, the fresh start
values of our investments generally exceed the par values of such investments.
The amount of value exceeding par is referred to as a "purchase premium" which
is amortized against future income. If prepayments in any period are higher than
expected, premium amortization is increased. In periods of unexpectedly high
prepayment activity, the increased amortization will reduce net investment
income.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral at September 30, 2003 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 5 percent..................................................................... $ 798.4 $ 773.7 $ 796.0
5 percent - 6 percent............................................................... 945.3 939.2 964.0
6 percent - 7 percent............................................................... 3,158.5 3,264.9 3,303.2
7 percent - 8 percent............................................................... 658.9 690.9 700.4
8 percent and above................................................................. 97.2 102.8 103.1
-------- -------- --------
Total structured securities (a).............................................. $5,658.3 $5,771.5 $5,866.7
======== ======== ========
<FN>
- -----------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $3.4 million.
</FN>
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CONSECO, INC. AND SUBSIDIARIES
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The amortized cost and estimated fair value of structured securities at
September 30, 2003, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
--------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs and sequential and targeted amortization classes............ $3,816.4 $3,863.0 20%
Planned amortization classes and accretion-directed bonds................. 656.5 673.5 4
Commercial mortgage-backed securities..................................... 1,018.7 1,050.5 5
Subordinated classes and mezzanine tranches............................... 276.2 276.0 1
Other..................................................................... 3.7 3.7 -
-------- -------- --
Total structured securities (a).................................... $5,771.5 $5,866.7 30%
======== ======== ==
<FN>
- ------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $3.4 million.
</FN>
Pass-throughs and sequential and targeted amortization classes have similar
prepayment variability. Pass-throughs historically provide the best liquidity in
the mortgage-backed securities market. Pass-throughs are also used frequently in
the dollar roll market and can be used as the collateral when creating
collateralized mortgage obligations. Sequential classes are a series of tranches
that return principal to the holders in sequence. Targeted amortization classes
offer slightly better structure in return of principal than sequentials when
prepayment speeds are close to the speed at the time of creation.
Planned amortization classes and accretion-directed bonds are some of the
most stable and liquid instruments in the mortgaged-backed securities market.
Planned amortization class bonds adhere to a fixed schedule of principal
payments as long as the underlying mortgage collateral experiences prepayments
within a certain range. Changes in prepayment rates are first absorbed by
support or companion classes. This insulates the planned amortization class from
the consequences of both faster prepayments (average life shortening) and slower
prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are bonds secured by
commercial real estate mortgages. Commercial real estate encompasses income
producing properties that are managed for economic profit. Property types
include multi-family dwellings including apartments, retail centers, hotels,
restaurants, hospitals, nursing homes, warehouses, and office buildings. The
CMBS market currently offers high yields, strong credits, and call protection
compared to similar-rated corporate bonds. Most CMBS have strong call protection
features where borrowers are locked out from prepaying their mortgages for a
stated period of time. If the borrower does prepay any or all of the loan, they
will be required to pay prepayment penalties.
Subordinated and mezzanine tranches are classes that provide credit
enhancement to the senior tranches. The rating agencies require that this credit
enhancement not deteriorate due to prepayments for a period of time, usually
five years of complete lockout, followed by another period of time where
prepayments are shared pro rata with senior tranches. Subordinated and mezzanine
tranches bear a majority of the risk of loss due to property owner defaults.
Subordinated bonds are generally rated "AA" or lower; we typically do not hold
securities rated lower than "BB".
Mortgage Loans
At September 30, 2003, the mortgage loan balance was primarily comprised of
commercial loans. Less than one percent of the mortgage loan balance was
noncurrent (loans with two or more scheduled payments past due) at September 30,
2003.
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Investment Borrowings
Our investment borrowings (excluding borrowings related to the GM building)
averaged approximately $531.5 million during the one month ended September 30,
2003; $689.1 million during the eight months ended August 31, 2003; and $1,226.4
million during the nine months ended September 30, 2002 and were collateralized
by investment securities with fair values approximately equal to the loan value.
The weighted average interest rates on such borrowings (excluding borrowings
related to the GM building) were 1.3 percent during the one month ended
September 30, 2003; 1.8 percent during the eight months ended August 31, 2003;
and 1.3 percent during the nine months ended September 30, 2002, respectively.
STATUTORY INFORMATION
Statutory accounting practices prescribed or permitted by regulatory
authorities for the Company's insurance subsidiaries differ from GAAP. The
statutory net income (loss) of our insurance subsidiaries was $255.6 million and
$(273.3) million in the first nine months of 2003 and 2002, respectively
(including realized investment gains (losses) of $33.3 million and $(315.4)
million, respectively). The Company's insurance subsidiaries reported the
following amounts to regulatory agencies at September 30, 2003, after
appropriate eliminations of intercompany accounts among such subsidiaries
(dollars in millions):
Statutory capital and surplus .................................. $1,412.4
Asset valuation reserve......................................... 78.4
Interest maintenance reserve.................................... 358.5
--------
Total........................................................ $1,849.3
========
The statutory capital and surplus shown above included investments in the
preferred stock of CDOC of $159.0 million, all of which were eliminated in the
consolidated financial statements prepared in accordance with GAAP.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations. These regulations generally permit
dividends to be paid from earned surplus of the insurance company for any
12-month period in amounts equal to the greater of (or in a few states, the
lesser of): (i) net gain from operations or net income for the prior year; or
(ii) 10 percent of capital and surplus as of the end of the preceding year. Any
dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department.
On October 30, 2002, Bankers National Life Insurance Company and Conseco
Life Insurance Company of Texas (on behalf of itself and all other Conseco
insurance subsidiaries), our insurance subsidiaries domiciled in Texas, each
entered into consent orders with the Commissioner of Insurance for the State of
Texas whereby they agreed: (i) not to request any dividends or other
distributions before January 1, 2003 and, thereafter, not to pay any dividends
or other distributions to parent companies outside of the insurance system
without the prior approval of the Texas Insurance Commissioner; (ii) to continue
to maintain sufficient capitalization and reserves as required by the Texas
Insurance Code; (iii) to request approval from the Texas Insurance Commissioner
before making any disbursements not in the ordinary course of business; (iv) to
complete any pending transactions previously reported to the proper insurance
regulatory officials prior to and during Conseco's restructuring, unless not
approved by the Texas Insurance Commissioner; (v) to obtain a commitment from
Conseco and CIHC to maintain their infrastructure, employees, systems and
physical facilities prior to and during Conseco's restructuring; and (vi) to
continue to permit the Texas Insurance Commissioner to examine its books,
papers, accounts, records and affairs. The consent orders are expected to be
released in the near future. We have agreed with the Texas Insurance
Commissioner to provide prior notice of certain transactions, including 30 days
prior notice of the payment of dividends by an insurance subsidiary to any
non-insurance company parent, and periodic reporting of information concerning
the financial performance and condition of Conseco, Inc. and its subsidiaries.
The National Association of Insurance Commissioners' Risk-Based Capital for
Life and/or Health Insurers Model Act (the "Model Act") provides a tool for
insurance regulators to determine the levels of statutory capital and surplus an
insurer must maintain in relation to its insurance and investment risks and
whether there is a need for possible regulatory attention. The Model Act
provides four levels of regulatory attention, varying with the ratio of the
insurance company's total adjusted capital (defined as the total of its
statutory capital and surplus, asset valuation reserve and certain other
adjustments) to its ACLRBC: (i) if a company's total adjusted capital is less
than or equal to 200 percent but greater than 150 percent of its
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CONSECO, INC. AND SUBSIDIARIES
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ACLRBC (the "Company Action Level"), the company must submit a comprehensive
plan to the regulatory authority proposing corrective actions aimed at improving
its capital position; (ii) if a company's total adjusted capital is less than or
equal to 150 percent but greater than 100 percent of its ACLRBC (the "Regulatory
Action Level"), the regulatory authority will perform a special examination of
the company and issue an order specifying the corrective actions that must be
followed; (iii) if a company's total adjusted capital is less than or equal to
100 percent but greater than 70 percent of its ACLRBC (the "Authorized Control
Level"), the regulatory authority may take any action it deems necessary,
including placing the company under regulatory control; and (iv) if a company's
total adjusted capital is less than or equal to 70 percent of its ACLRBC (the
"Mandatory Control Level"), the regulatory authority must place the company
under its control. In addition, the Model Law provides for an annual trend test
if a company's total adjusted capital is between 200 percent and 250 percent of
its ACLRBC at the end of the year. The trend test calculates the greater of the
decrease in the margin of total adjusted capital over ACLRBC: (i) between the
current year and the prior year; and (ii) for the average of the last 3 years.
It assumes that such decrease could occur again in the coming year. Any company
whose trended total adjusted capital is less than 190 percent of its ACLRBC
would trigger a requirement to submit a comprehensive plan as described above
for the Company Action Level.
The 2002 statutory annual statements filed with the state insurance
regulators of each of our insurance subsidiaries reflected total adjusted
capital in excess of the levels subjecting the subsidiary to any regulatory
action. The 2002 audited financial statements of our insurance subsidiaries were
completed in June 2003. Two of our subsidiaries' ACLRBC ratios, based on the
capital balances reflecting audit adjustments, were less than 250 percent. As a
result of an additional adjustment that we made in the amended 2002 Annual
Statement relating to one such subsidiary's investment in the General Motors
building, its ACLRBC ratio exceeded 250 percent. As a result of the sale of the
General Motors building, the ACLRBC ratio for the other such subsidiary has
increased to a level above 250 percent. However, as a result of losses on the
long-term care business within Conseco Insurance Group during the third quarter
of 2003, including long-term care claim reserve strengthening of $87 million, we
will need to contribute additional capital to one subsidiary to enable its
ACLRBC ratio to equal or exceed 250 at December 31, 2003.
The combined ACLRBC ratio for our insurance subsidiaries was 332 percent at
December 31, 2002. At December 31, 2002, the ratios for our insurance
subsidiaries that are subject to the four levels of regulatory attention
described above ranged from 250 percent to 563 percent. We are taking actions
intended to improve the ACLRBC ratios of our insurance subsidiaries. Such
actions include: (i) discontinuing or reducing sales of products that create
initial reductions in statutory surplus because of the costs of selling the
products; (ii) reducing operating expenses; (iii) merging some of our insurance
subsidiaries with other insurance subsidiaries; and (iv) restructuring our
investment portfolio to better match the risk profile of the portfolio with each
insurance subsidiary's earnings and capital requirements. We have discussed
these actions with insurance regulators in each of the states in which our
insurance subsidiaries are domiciled.
NEW ACCOUNTING STANDARDS
See "Recently Issued Accounting Standards" in the notes to consolidated
financial statements for a discussion of recently issued accounting standards.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our market risks, and the ways we manage them, are summarized in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", included in Old Conseco's Form 10-K for the year ended December 31,
2002. There have been no material changes in the first nine months of 2003 to
such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Conseco's management, under the supervision and with the participation of
the Chief Executive Officer and the Chief Financial Officer, evaluated the
effectiveness of Conseco's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended). Based on this evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of September 30, 2003, Conseco's disclosure
controls and procedures were effective to ensure that information required to be
disclosed by Conseco in reports that it files or submits under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission's rules and forms.
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CONSECO, INC. AND SUBSIDIARIES
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There were no significant changes in Conseco's internal controls over
financial reporting that occurred during the quarter ended September 30, 2003,
that have materially affected, or are reasonably likely to materially affect,
Conseco's internal controls over financial reporting.
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PART II - OTHER INFORMATION
ITEM 1. LITIGATION AND OTHER LEGAL PROCEEDINGS.
LITIGATION AND OTHER LEGAL PROCEEDINGS
We are involved on an ongoing basis in lawsuits (including purported class
actions) relating to our operations, including with respect to sales practices,
and we and current and former officers and former directors are defendants in
pending class action lawsuits asserting claims under the securities laws and
derivative lawsuits. The ultimate outcome of these lawsuits cannot be predicted
with certainty and we have estimated the potential exposure for each of the
matters and have recorded a liability if a loss is deemed probable.
Securities Litigation
Since we announced our intention to restructure our capital on August 9,
2002, a total of eight purported securities fraud class action lawsuits have
been filed in the United States District Court for the Southern District of
Indiana. The complaints name us as a defendant, along with certain current and
former officers of Old Conseco. These lawsuits were filed on behalf of persons
or entities who purchased Old Conseco's common stock on various dates between
October 24, 2001 and August 9, 2002. In each case Plaintiffs allege claims under
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and allege
material omissions and dissemination of materially misleading statements
regarding, among other things, the liquidity of Conseco and alleged problems in
CFC's manufactured housing division, allegedly resulting in the artificial
inflation of Old Conseco's stock price. On March 13, 2003, all of these cases
were consolidated into one case in the United States District Court for the
Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco,
Inc., et al., File No. 02-CV-1332 DFH-TAB. The lawsuits were stayed as to all
defendants by order of the United States Bankruptcy Court for the Northern
District of Illinois. The stay was lifted on October 15, 2003. It is expected
that plaintiffs will file a consolidated class action complaint with respect to
the individual defendants in November 2003. Our liability with respect to these
lawsuits was discharged in the Plan and our obligation to indemnify certain
individual defendants is limited by the Plan. We believe these lawsuits are
without merit and intend to defend them vigorously. The ultimate outcome of
these lawsuits cannot be predicted with certainty.
Derivative Litigation
Nine shareholder derivative suits were filed in 2000 in the United States
District Court for the Southern District of Indiana. The complaints named as
defendants the then current directors, certain former directors, certain
non-director officers of Old Conseco (in one case), and, alleging aiding and
abetting liability, certain banks that made loans in relation to Old Conseco's
"Stock Purchase Plan" (in three cases). Old Conseco is also named as a nominal
defendant in each complaint. Plaintiffs allege that the defendants breached
their fiduciary duties by, among other things, intentionally disseminating false
and misleading statements concerning the acquisition, performance and proposed
sale of CFC, and engaged in corporate waste by causing Old Conseco to guarantee
loans that certain officers, directors and key employees of Old Conseco used to
purchase stock under the Stock Purchase Plan. These cases have now been
consolidated into one case in the United States District Court for the Southern
District of Indiana, captioned: In Re Conseco, Inc. Derivative Litigation, Case
Number IP00655-C-Y/S. An amended complaint was filed on April 12, 2001, making
generally the same allegations and allegations of violation of the Federal
Reserve Board's margin rules. Three similar cases have been filed in the
Hamilton County Superior Court in Indiana. Schweitzer v. Hilbert, et al., Case
No. 29D01-0004CP251; Evans v. Hilbert, et al., Case No. 29D01-0005CP308 (both
Schweitzer and Evans name as defendants certain non-director officers); Gintel
v. Hilbert, et al., Case No. 29003-0006CP393 (naming as defendants, and alleging
aiding and abetting liability as to, banks that allegedly made loans in relation
to the Stock Purchase Plan). We believe that these lawsuits are without merit
and intend to defend them vigorously. The cases filed in Hamilton County have
been stayed pending resolution of the derivative suits filed in the United
States District Court. We have asserted that these lawsuits are assets of the
estate pursuant to section 541(a) of the Bankruptcy Code and do not intend to
pursue them following emergence from bankruptcy because they are meritless. In
October and November 2003, CNO filed motions to dismiss all the pending
derivative matters. The ultimate outcome of these lawsuits cannot be predicted
with certainty.
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Other Litigation
Collection efforts by the Company and Conseco Services, LLC related to the
1996-1999 director and officer loan programs have been commenced against various
past board members and executives/officers with outstanding loan balances. In
addition, certain former officers and directors have sued the companies for
declaratory relief concerning their liability for the loans. Currently, we are
involved in litigation with Stephen C. Hilbert, James D. Massey, Dennis E.
Murray, Sr., Rollin Dick and Bruce Crittenden. The specific lawsuits include:
Hilbert v. Conseco, Case No. 03A 04283 (Bankr. N.D. Ill.); Conseco Services v.
Hilbert, Case No.29C01-0310 MF 1296 (Cir. Ct. Hamilton Cty, Ind.); Murray and
Massey v. Conseco, Case No.1:03-CV-1482 LJM-WTL (S.D. Ind.); Dick v. Conseco
Services, Case No. 29 D01-0207-PL-549 (Sup. Ct. Hamilton Cty, Ind.); and
Crittenden v. Conseco, Case No.IP02-1823-C B/S (S.D. Ind.). The Company and
Conseco Services, LLC believe that all amounts due under the director and
officer loan programs, including all applicable interest, are valid obligations
owed to the companies. We intend to prosecute these claims to obtain the maximum
recovery possible. Further, with regard to the various claims brought against
the Company and Conseco Services, LLC by certain former directors and officers,
we believe that these claims are without merit and intend to defend them
vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
In October 2002, Roderick Russell, on behalf of himself and a class of
persons similarly situated, and on behalf of the ConsecoSave Plan filed an
action in the United States District Court for the Southern District of Indiana
against Old Conseco, Conseco Services, LLC and certain current and former
officers of Old Conseco (Roderick Russell, et al. v Conseco, Inc., et al., Case
No. 1:02-CV-1639 LJM). The purported class action consists of all individuals
whose 401(k) accounts held common stock of Old Conseco at any time since April
28, 1999. The complaint alleges, among other things, breaches of fiduciary
duties under ERISA by continuing to permit employees to invest in Old Conseco's
common stock without full disclosure of the Company's true financial condition.
Old Conseco filed a motion to dismiss the complaint in December 2002. This
lawsuit was stayed as to all defendants by order of the Bankruptcy Court. The
stay was lifted on October 15, 2003. It is expected that there will be a ruling
on the motion to dismiss before further proceedings occur in this matter. We
believe the lawsuit is without merit and intend to defend it vigorously. The
ultimate outcome of the lawsuit cannot be predicted with certainty.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced
an action against Old Conseco, Conseco Services, LLC, and two former officers in
the Boone Circuit Court (Inlow et al. v. Conseco, Inc., et al., Cause No.
06C01-0206-CT-244). The heirs assert that unvested options to purchase 756,248
shares of Old Conseco common stock should have been vested at Mr. Inlow's death.
The heirs further claim that if such options had been vested, they would have
been exercised, and that the resulting shares of common stock would have been
sold for a gain of approximately $30 million based upon a stock price of $58.125
per share, the highest stock price during the alleged exercise period of the
options. We believe the heirs' claims are without merit and will defend the
action vigorously. The maximum exposure to the Company for this lawsuit is
estimated to be $33 million. The heirs did not file a proof of claim with the
Bankruptcy Court. Subject to dispositive motions which are yet to be filed, the
matter will continue to trial against Conseco Services, LLC and the other
co-defendants on September 13, 2004. The ultimate outcome cannot be predicted
with certainty.
On June 27, 2001, two suits against the Company's subsidiary, Philadelphia
Life Insurance Company (now known as Conseco Life Insurance Company), both
purported nationwide class actions seeking unspecified damages, were
consolidated in the U.S. District Court, Middle District of Florida (In Re PLI
Sales Litigation, Cause No. 01-MDL-1404), alleging among other things,
fraudulent sales and a "vanishing premium" scheme. Philadelphia Life filed a
motion for summary judgment against both named plaintiffs, which motion was
granted in June 2002. Plaintiffs appealed to the 11th Circuit. The 11th Circuit,
in July 2003, affirmed in part and reversed in part, allowing two fraud counts
with respect to one plaintiff to survive. The plaintiffs' request for a
rehearing with respect to this decision has been denied. Philadelphia Life has
filed a summary judgment motion with respect to the remaining claims.
Philadelphia Life believes this lawsuit is without merit and intends to defend
it vigorously. The ultimate outcome of the lawsuit cannot be predicted with
certainty.
On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company, was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New Mexico
(Robert Atencio and Theresa Atencio, for themselves and all other similarly
situated v. Manhattan National Life Insurance Company, an Ohio corporation,
Cause No. D-0101-CV-2000-2817), alleging among other things fraud by
non-disclosure of additional charges for those policyholders wishing to pay
premium modes other than annual. We retained liability for this litigation in
connection with the sale of Manhattan National Life in June 2002. We believe
this lawsuit is without merit and intend to defend it vigorously. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
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On December 19, 2001, four of the Company's subsidiaries were named in a
purported nationwide class action seeking unspecified damages in the District
Court of Adams County, Colorado (Jose Medina and others similarly situated v.
Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers
National Life Insurance Company and Bankers Life and Casualty Company, Cause No.
01-CV-2465), alleging among other things breach of contract regarding alleged
non-disclosure of additional charges for those policy holders wishing to pay
premium modes other than annual. On July 14 and 15, 2003 the plaintiff's motion
for class certification was heard and the Court took the matter under
advisement. On November 10, 2003, the Court denied the motion for class
certification. The defendants believe this lawsuit is without merit and intend
to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted
with certainty.
On July 31, 2001, the Company's subsidiary, Conseco Senior Health Insurance
Company, was named in an action filed by the State of Texas in the District
Court of Travis County, Texas (State of Texas v. Conseco Senior Health Insurance
Company, Cause No. GV102103), alleging among other things a violation of the
Deceptive Trade Practices Act related to allegations of failure to adequately
notify policyholders that premium rates could increase. Conseco Senior has
reached a tentative settlement with the State of Texas, however in the event a
settlement is not consummated, Conseco Senior intends to defend this matter
vigorously as it believes the lawsuit is without merit. The ultimate outcome of
this lawsuit cannot be predicted with certainty.
On December 30, 2002 and December 31, 2002, five suits were filed in
various Mississippi counties against the Company's subsidiary, Conseco Life
Insurance Company (Kathie Allen, et al. v. Conseco Life Insurance Company, et
al., Circuit Court of Jones County, Mississippi, Cause No. 2002-448-CV12;
Malcolm Bailey, et al. v. Conseco Life Insurance Company, et al., Circuit Court
of Claiborne County, Mississippi, Cause No. CV-2002-371; Anthony Cascio, et al.
v. Conseco Life Insurance Company, et al, Circuit Court of LeFlore County,
Mississippi, Cause No. CV-2002-0242-CICI; William Garrard, et al. v. Conseco
Life insurance Company, et al., Circuit Court of Sunflower County, Mississippi,
Cause No. CV-2002-0753-CRL; and William Weaver, et al. v. Conseco Life Insurance
Company, et al., Circuit Court of LeFlore County, Mississippi, Cause No.
CV-2002-0238-CICI), alleging among other things, a "vanishing premium" scheme.
Conseco Life removed all of the cases to the U.S. District Courts in
Mississippi. In September 2003, plaintiffs' Motion to Remand was denied in the
Garrard and Weaver matters, but granted in the Cascio matter. Conseco Life
awaits the court's ruling on Plaintiff's Motion to Remand in the Allen matter.
In Bailey the parties have agreed to stay in Federal court. Conseco Life
believes the lawsuits are without merit and intends to defend them vigorously.
The ultimate outcome of the lawsuits cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits and arbitrations (including purported class actions)
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
Other Proceedings
The Company has been notified that the staff of the SEC has obtained a
formal order of investigation in connection with an inquiry that relates to
events in and before the spring of 2000, including CFC's accounting for its
interest-only securities and servicing rights. These issues were among those
addressed in the Company's write-down and restatement in the spring of 2000, and
were the subject of shareholder class action litigation, which was settled in
the second quarter of 2003. The Company is cooperating fully with the SEC staff
in this matter.
The deadline to file administrative claims in the bankruptcy proceeding was
October 9, 2003. The Plan provides that all such claims must be paid in full, in
cash. We are reviewing all timely filed administrative claims and may resolve
disputes regarding allowance of such claims in the Bankruptcy Court. If
significant administrative claims are allowed, our cash flow would be negatively
affected.
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ITEM 5. OTHER INFORMATION
Directors and Executive Officers of Conseco
Directors. As a result of the reorganization, Conseco made significant
changes to its Board of Directors. The Board of Directors now consists of the
following seven members:
R. Glenn Hilliard, age 60, became the non-executive chairman of Conseco's
board of directors in September 2003. From 1999 until his retirement in April
2003, Mr. Hilliard served as chairman and CEO of ING Americas. From 1994 to 1999
he was chairman and CEO of ING North America.
Philip Roberts, age 61, joined Conseco's board of directors in September
2003. He is principal of Roberts Ventures L.L.C., consultant for merger and
acquisition and product development for investment management firms. From 1990
until 2000, Mr. Roberts served as chief investment officer of trust business for
Mellon Financial Corporation and headed its institutional asset management
businesses from 1990 to 1996.
Neal Schneider, age 59, joined Conseco's board of directors in September
2003. Until June 2000, he was managing partner in the New York office of Smart
and Associates, LLP, a business advisory and accounting firm. Mr. Schneider
previously spent 34 years with Arthur Andersen & Co., including service as
partner in charge of the Worldwide Insurance Industry Practice and the North
American Financial Service Practice.
Michael Shannon, age 45, joined Conseco's board of directors in September
2003. He is co-founder and current president and chief executive officer of KSL
Recreation Corporation (owner and operator of golf courses and destination
resorts in the U.S.).
William Shea, age 55, has served as a director of Conseco and its
predecessor since September 2002. He has served as president and chief executive
officer of Conseco since October 2002 and was president and chief operating
officer from September 2001 until October 2002. Before joining Conseco Mr. Shea
served as CEO of View Tech, Inc. (integrated video-conferencing solutions) from
1999 until 2000. From 1993 to 1998, he was vice chairman and chief financial
officer of Bank Boston Corporation.
Michael Tokarz, age 53, joined Conseco's board of directors in September
2003. He is managing member of the Tokarz Group, LLC (venture capital
investments). Mr. Tokarz was a general partner with Kohlberg Kravis Roberts &
Co. until he retired in 2002.
John Turner, age 63, joined Conseco's board of directors in September 2003.
He is chairman of Hillcrest Capital Partners, a private equity investment firm.
Mr. Turner served as chairman and CEO of ReliaStar Financial Corp. from 1991
until it was acquired by ING in 2000. After the acquisition he became vice
chairman and a member of the executive committee for ING Americas until his
retirement in 2002.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a) Exhibits.
10.4 Guarantee and Security Agreement dated as of September 10,
2003, among Conseco, Inc., the Subsidiary Guarantors Party
Thereto and Bank of America, N.A., as Agent.
10.5 Employment Agreement by and between William J. Shea and
Conseco, Inc. dated as of May 27, 2003.
10.6 Agreement by and between R. Glenn Hilliard and Conseco,
Inc. dated as of June 18, 2003.
12.1 Computation of Ratio of Earnings to Fixed Charges and
Preferred Dividends.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
b) Reports on Form 8-K.
A report on Form 8-K dated July 15, 2003, was filed with the
Commission to report under Item 5, the Company's filing with the
United States Bankruptcy Court of the Fourth Amended Joint Plan of
Reorganization of the Filing Entities.
A report on Form 8-K dated August 15, 2003, was filed with the
Commission to report under Item 5, the Company's filing with the
United States Bankruptcy Court of the Fifth Amended Joint Plan of
Reorganization of the Filing Entities.
A report on Form 8-K dated September 9, 2003, was filed with the
Commission to report under Item 3, the United States Bankruptcy
Court's confirmation of the Sixth Amended Joint Plan of
Reorganization and to report under Item 5, the registration of the
common stock of the Company.
A report on Form 8-K dated September 26, 2003, was filed with the
Commission to report under Item 5, the Company's completed sale of
the General Motors Building in New York City.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: November 19, 2003 By: /s/ William J. Shea
------------------------------------
William J. Shea, President and
Chief Executive Officer
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