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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 June 30, 2005
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ -------
Commission File Number 001-31792
Conseco, Inc.
Delaware 75-3108137
---------------------- -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
----------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act): Yes [X] No [ ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court: Yes [X] No [ ]
Shares of common stock outstanding as of August 1, 2005: 151,066,487
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of June 30, 2005 and December 31, 2004.................................. 3
Consolidated Statement of Operations for the three and six months ended June 30, 2005 and 2004........ 5
Consolidated Statement of Shareholders' Equity for the six months ended June 30, 2005 and 2004........ 6
Consolidated Statement of Cash Flows for the six months ended June 30, 2005 and 2004.................. 7
Notes to Consolidated Financial Statements............................................................ 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements............................................. 26
Overview ............................................................................................. 27
Critical Accounting Policies ......................................................................... 27
Risk Factors ......................................................................................... 28
Results of Operations................................................................................. 39
Premium Collections................................................................................... 52
Liquidity and Capital Resources....................................................................... 58
Investments........................................................................................... 62
New Accounting Standards ............................................................................. 67
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................................... 67
Item 4. Controls and Procedures............................................................................... 67
PART II - OTHER INFORMATION
Item 1. Litigation and Other Legal Proceedings ............................................................... 68
Item 6. Exhibits ............................................................................................. 68
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
June 30, December 31,
2005 2004
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
June 30, 2005 - $21,599.8; December 31, 2004 - $21,015.4)............................ $22,441.7 $21,633.4
Equity securities at fair value (cost: June 30, 2005 - $32.4;
December 31, 2004 - $32.7)........................................................... 33.8 33.9
Mortgage loans......................................................................... 1,121.7 1,123.8
Policy loans........................................................................... 435.2 448.5
Trading securities..................................................................... 735.1 902.3
Other invested assets ................................................................. 131.4 164.4
--------- ---------
Total investments.................................................................. 24,898.9 24,306.3
Cash and cash equivalents:
Unrestricted........................................................................... 774.3 776.6
Restricted............................................................................. 16.1 18.9
Accrued investment income................................................................. 316.9 308.4
Value of policies in force at the Effective Date.......................................... 2,485.8 2,629.6
Cost of policies produced................................................................. 562.5 409.1
Reinsurance receivables................................................................... 897.0 975.7
Income tax assets......................................................................... 788.1 967.2
Assets held in separate accounts.......................................................... 30.1 32.9
Other assets.............................................................................. 312.7 330.8
--------- ---------
Total assets....................................................................... $31,082.4 $30,755.5
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
June 30, December 31,
2005 2004
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $12,524.7 $12,508.2
Traditional products................................................................... 11,782.4 11,741.3
Claims payable and other policyholder funds............................................ 863.7 879.8
Liabilities related to separate accounts............................................... 30.1 32.9
Other liabilities........................................................................ 476.1 498.3
Investment borrowings.................................................................... 452.1 433.9
Notes payable - direct corporate obligations............................................. 758.8 758.9
--------- ---------
Total liabilities.................................................................. 26,887.9 26,853.3
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Preferred stock.......................................................................... 667.8 667.8
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: June 30, 2005 - 151,066,487; December 31, 2004 - 151,057,863)......... 1.5 1.5
Additional paid-in capital............................................................... 2,603.0 2,597.8
Accumulated other comprehensive income................................................... 473.5 337.3
Retained earnings........................................................................ 448.7 297.8
--------- ---------
Total shareholders' equity......................................................... 4,194.5 3,902.2
--------- ---------
Total liabilities and shareholders' equity......................................... $31,082.4 $30,755.5
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
--------------------- ---------------------
2005 2004 2005 2004
---- ---- ---- ----
Revenues:
Insurance policy income................................ $ 728.5 $ 737.0 $1,456.2 $1,485.4
Net investment income (loss):
General account assets............................... 348.0 318.4 685.8 630.4
Policyholder and reinsurer accounts.................. (1.6) (14.8) (24.9) .9
Net realized investment gains (loss)................. 7.9 (5.6) 9.5 21.5
Fee revenue and other income........................... 3.9 4.5 8.1 11.9
-------- -------- -------- --------
Total revenues..................................... 1,086.7 1,039.5 2,134.7 2,150.1
-------- -------- -------- --------
Benefits and expenses:
Insurance policy benefits.............................. 703.4 666.5 1,374.4 1,386.2
Interest expense....................................... 16.1 23.1 30.8 52.2
Amortization........................................... 88.0 82.3 182.7 180.5
Gain on extinguishment of debt......................... - (2.8) - (2.8)
Other operating costs and expenses..................... 139.3 163.6 279.7 314.8
-------- -------- -------- --------
Total benefits and expenses........................ 946.8 932.7 1,867.6 1,930.9
-------- -------- -------- --------
Income before income taxes......................... 139.9 106.8 267.1 219.2
Income tax expense on period income....................... 51.8 38.5 97.2 78.1
-------- -------- -------- --------
Net income......................................... 88.1 68.3 169.9 141.1
Preferred stock dividends................................. 9.5 23.7 19.0 46.6
-------- -------- -------- --------
Net income applicable to common stock.............. $ 78.6 $ 44.6 $ 150.9 $ 94.5
======== ======== ======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding.................. 151,058,000 127,048,000 151,058,000 113,582,000
=========== =========== =========== ===========
Net income........................................... $.52 $.35 $1.00 $.83
==== ==== ===== ====
Diluted:
Weighted average shares outstanding.................. 185,002,000 146,992,000 185,883,000 123,790,000
=========== =========== =========== ===========
Net income........................................... $.48 $.34 $.91 $.81
==== ==== ==== ====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income(loss) earnings
----- ----- --------------- ------------ --------
Balance, January 1, 2005............................. $3,902.2 $667.8 $2,599.3 $337.3 $297.8
Comprehensive income, net of tax:
Net income...................................... 169.9 - - - 169.9
Change in unrealized appreciation of
investments (net of applicable income tax
expense of $76.2)............................. 136.2 - - 136.2 -
--------
Total comprehensive income.................. 306.1
Stock option and restricted stock plans......... 5.2 - 5.2 - -
Dividends on preferred stock.................... (19.0) - - - (19.0)
-------- ------ -------- ------ ------
Balance, June 30, 2005............................... $4,194.5 $667.8 $2,604.5 $473.5 $448.7
======== ====== ======== ====== ======
Balance, January 1, 2004............................. $2,817.6 $887.5 $1,642.9 $218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 141.1 - - - 141.1
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
expense of nil)............................... (407.6) - - (407.6) -
--------
Total comprehensive loss.................... (266.5)
Stock option and restricted stock plans......... 7.7 - 7.7 - -
Issuance of mandatorily convertible
preferred stock, net.......................... 667.8 667.8 - - -
Redemption of cumulative convertible
exchangeable preferred stock.................. (928.9) (928.9) - - -
Issuance of common stock, net................... 882.2 - 882.2 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................. 41.4 41.4 - - -
Dividends on preferred stock.................... (46.6) - - - (46.6)
-------- ------ -------- ------- ------
Balance, June 30, 2004............................... $3,174.7 $667.8 $2,532.8 $(188.9) $163.0
======== ====== ======== ======= ======
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Six months ended
June 30,
2005 2004
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $1,273.1 $1,288.5
Net investment income................................................................. 707.7 743.8
Fee revenue and other income.......................................................... 8.1 11.9
Net sales of trading securities....................................................... 162.6 .5
Insurance policy benefits............................................................. (991.6) (1,049.5)
Interest expense...................................................................... (24.5) (49.7)
Policy acquisition costs.............................................................. (206.3) (174.4)
Other operating costs................................................................. (278.8) (317.6)
Taxes................................................................................. 5.6 9.2
-------- --------
Net cash provided by operating activities........................................... 655.9 462.7
-------- --------
Cash flows from investing activities:
Sales of investments.................................................................. 7,440.7 5,486.8
Maturities and redemptions of investments............................................. 770.0 1,103.7
Purchases of investments.............................................................. (8,771.6) (7,530.0)
Change in restricted cash............................................................. 2.8 19.0
Other................................................................................. (15.0) (.3)
-------- --------
Net cash used by investing activities .............................................. (573.1) (920.8)
-------- --------
Cash flows from financing activities:
Issuance of notes payable, net........................................................ - 790.0
Issuance of preferred stock, net...................................................... - 667.8
Issuance of common stock, net......................................................... .2 882.2
Payments on notes payable............................................................. (.9) (1,300.0)
Redemption of preferred stock......................................................... - (928.9)
Amounts received for deposit products................................................. 822.0 782.1
Withdrawals from deposit products..................................................... (905.6) (956.5)
Investment borrowings................................................................. 18.2 161.4
Dividends paid on preferred stock..................................................... (19.0) -
Other................................................................................. - (3.6)
-------- --------
Net cash provided (used) by financing activities.................................. (85.1) 94.5
-------- --------
Net decrease in cash and cash equivalents......................................... (2.3) (363.6)
Cash and cash equivalents, beginning of period........................................... 776.6 1,228.7
-------- --------
Cash and cash equivalents, end of period................................................. $ 774.3 $ 865.1
======== ========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2004 Form 10-K of Conseco,
Inc.
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO is the successor to
Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"), in
connection with its bankruptcy reorganization which became effective on
September 10, 2003 (the "Effective Date"). The terms "Conseco", the "Company",
"we", "us", and "our" as used in this report refer to CNO and its subsidiaries
or, when the context requires otherwise, Old Conseco and its subsidiaries. We
focus on serving the senior and middle-income markets, which we believe are
attractive, high growth markets. We sell our products through three distribution
channels: career agents, professional independent producers (some of whom sell
one or more of our product lines exclusively) and direct marketing.
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary for a fair statement of 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 (the "SEC") 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 2005 presentation. These
reclassifications have no effect on net income or shareholders' equity. Results
for interim periods are not necessarily indicative of the results that may be
expected for a full year.
The balance sheet at December 31, 2004, presented herein, has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by GAAP in the United States for complete
financial statements.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect reported
amounts of various 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 to calculate values for the cost of policies produced, the value
of policies in force at the Effective Date, certain investments, assets and
liabilities related to income taxes, liabilities for insurance and asset
accumulation products, liabilities related to litigation, guaranty fund
assessment accruals and amounts recoverable from loans to certain former
directors and former 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.
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); and (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
Our trading security accounts are designed to act as hedges for embedded
derivatives related to our equity-indexed annuity products and 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 investments backing the market
strategies of our multibucket annuity products. The change in market value of
these securities, which is recognized currently in income from policyholder and
reinsurer accounts (a component of investment income), is substantially offset
by the change in insurance policy benefits for these products. Our trading
securities totaled $735.1 million and $902.3 million at June 30, 2005 and
December 31, 2004, respectively.
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Accumulated other comprehensive income is comprised of the net effect of
unrealized appreciation on our investments. These amounts, included in
shareholders' equity as of June 30, 2005 and December 31, 2004, were as follows
(dollars in millions):
June 30, December 31,
2005 2004
---- ----
Net unrealized appreciation on investments............................................ $ 848.1 $ 621.6
Adjustment to value of policies inforce at the Effective Date......................... (87.3) (85.7)
Adjustment to cost of policies produced............................................... (22.7) (10.2)
Deferred income tax liability......................................................... (264.6) (188.4)
------- -------
Accumulated other comprehensive income........................................... $ 473.5 $ 337.3
======= =======
AMORTIZATION OF THE VALUE OF POLICIES INFORCE AT THE EFFECTIVE DATE
The value assigned to the right to receive future cash flows from contracts
existing at August 31, 2003 (the effective date of the reorganization of our
Predecessor) 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. For universal life or
investment products, we amortize these costs using the interest rate credited to
the underlying policies in relation to the established gross profits. For other
products, we amortize these costs using the projected investment earnings rate
in relation to future anticipated premium revenue.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect of the event on future investment yields. We also adjust the value of
policies inforce at the Effective Date for the change in amortization that would
have been recorded if actively managed fixed maturity securities had been sold
at their stated aggregate fair value and the proceeds reinvested at current
yields. We include the impact of this adjustment in accumulated other
comprehensive income within shareholders' equity.
In accordance with Statement of Financial Accounting Standards No. 97
"Accounting and Reporting by Insurance Enterprises for Certain Long-Duration
Contracts and Realized Gains and Losses from the Sale of Investments" ("SFAS
97"), we are required to amortize the value of policies inforce in relation to
estimated gross profits for universal life-type products and investment-type
products. SFAS 97 also requires that estimates of expected gross profits used as
a basis for amortization be evaluated regularly, and that the total amortization
recorded to date be adjusted by a charge or credit to the statement of
operations, if actual experience or other evidence suggests that earlier
estimates should be revised.
9
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 (dollars in millions and shares in
thousands):
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2005 2004 2005 2004
---- ---- ---- ----
Net income...................................................... $88.1 $ 68.3 $169.9 $141.1
Preferred stock dividends....................................... (9.5) (23.7) (19.0) (46.6)
----- ------ ------ ------
Net income applicable to common stock
for basic earnings per share............................. 78.6 44.6 150.9 94.5
Effect of dilutive securities:
Preferred stock dividends.................................... 9.5 5.3 19.0 5.3
----- ------ ------ ------
Net income applicable to common stock and assumed
conversions for diluted earnings per share............... $88.1 $ 49.9 $169.9 $ 99.8
===== ====== ====== ======
Shares:
Weighted average shares outstanding
for basic earnings per share............................... 151,058 127,048 151,058 113,582
Effect of dilutive securities on weighted average shares:
Class B mandatorily convertible preferred stock............ 33,076 19,352 34,052 9,676
Stock option and restricted stock plans.................... 868 592 773 532
------- ------- ------- -------
Dilutive potential common shares........................... 33,944 19,944 34,825 10,208
------- ------- ------- -------
Weighted average shares outstanding for diluted earnings
per share.................................................. 185,002 146,992 185,883 123,790
======= ======= ======= =======
For the three and six months ended June 30, 2004, equivalent common shares
of 35.3 million and 39.7 million, respectively, related to the assumed
conversion of convertible exchangeable preferred stock (which was redeemed in
the second quarter of 2004) were not included in the computation of diluted
earnings per share because doing so would have been antidilutive.
Basic earnings per common share is computed by dividing net income
applicable to common stock by the weighted average number of common shares
outstanding for the period. Restricted shares are not included in basic earnings
per share until vested. Diluted earnings per share reflects the potential
dilution that could occur if outstanding stock options were exercised and
restricted stock was vested. The dilution from options and restricted shares is
calculated using the treasury stock method. Under this method, we assume the
proceeds from the exercise of the options (or the unrecognized compensation
expense with respect to restricted stock) will be used to purchase shares of our
common stock at the average market price during the period, reducing the
dilutive effect of the exercise of the options (or the vesting of the restricted
stock).
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR STOCK OPTIONS
We measure compensation cost for our stock option plans using the intrinsic
value method pursuant to Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" and related interpretations ("APB 25"). Under
this method, compensation cost is recorded when the quoted market price at the
grant date exceeds the amount an employee must pay to acquire the stock. When
the Company issues employee stock options with the exercise price equal to or
greater than the market price of our stock on the grant date, no compensation
cost is recorded. Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS 123") and Statement of
Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation
- - Transition and Disclosure" require disclosures of the pro forma effects of
using the fair value method of accounting for stock options.
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123 (revised 2004) "Share-Based
Payment" ("SFAS 123R"), which revises SFAS 123 and supersedes APB 25. SFAS 123R
provides additional guidance on accounting for share-based payments and will
require all such awards to be measured at fair value with the related
compensation cost recognized in the statement of operations over the related
service period. In April 2005, the SEC delayed the implementation date of SFAS
123R. Conseco will implement SFAS 123R using the modified prospective method on
January 1, 2006. Under this method, the Company will begin recognizing
compensation cost for all awards granted, modified, repurchased or cancelled on
and after January 1, 2006. In addition, we will be required to recognize
compensation cost over the remaining vesting period for the portion of
outstanding awards that are not vested as of January 1, 2006. SFAS 123R also
requires the benefits of tax deductions in excess of recognized compensation
cost to be reported as a financing cash flow rather than as an operating cash
flow, as currently required. The aggregate value of unvested options at June 30,
2005, as determined using the Black-Scholes option valuation model at the date
of grant, was $13.9 million, of which $10.9 million will be recognized as
compensation cost over the remaining vesting period after January 1, 2006. If
compensation cost had been determined based on the fair value at the grant dates
for all awards issued after the Effective Date, the Company's pro forma net
income and pro forma earnings per share would have been as follows (dollars in
millions, except per share amounts):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Net income, as reported ......................................... $88.1 $68.3 $169.9 $141.1
Less stock-based employee compensation expense determined
under the fair value method for all awards, net of
income taxes................................................ .9 .8 1.5 1.1
----- ----- ------ ------
Pro forma net income............................................. $87.2 $67.5 $168.4 $140.0
===== ===== ====== ======
Earnings per share:
Basic, as reported.......................................... $.52 $.35 $1.00 $.83
Basic, pro forma............................................ .51 .34 .99 .82
Diluted, as reported........................................ $.48 $.34 $.91 $.81
Diluted, pro forma.......................................... .47 .33 .91 .80
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
BUSINESS SEGMENTS
We manage our business through the following: two primary operating
segments, Bankers Life and Conseco Insurance Group, which are defined on the
basis of product distribution; a third segment comprised of other business in
run-off; and corporate operations, which consists of holding company activities
and certain noninsurance businesses.
Operating information by segment was as follows (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities................................. $ 13.2 $ 13.6 $ 25.5 $ 25.8
Supplemental health....................... 304.4 293.9 606.1 586.3
Life...................................... 52.9 36.3 95.1 74.0
Other..................................... 3.1 2.8 6.2 5.6
Net investment income (a)...................... 120.0 103.5 233.5 202.6
Fee revenue and other income (a)............... (.2) .2 .4 .5
Net realized investment gains (a).............. .5 .4 2.5 11.4
-------- -------- -------- --------
Total Bankers Life revenues........... 493.9 450.7 969.3 906.2
-------- -------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities................................. 5.1 5.6 10.7 11.0
Supplemental health....................... 164.0 185.4 335.7 371.7
Life...................................... 92.8 94.5 189.0 198.3
Other..................................... 3.2 4.2 6.6 8.7
Net investment income (a)...................... 178.3 158.9 335.6 347.0
Fee revenue and other income (a)............... .6 1.5 1.1 3.3
Net realized investment gains (losses) (a)..... 6.3 (5.1) 3.8 11.1
-------- -------- -------- --------
Total Conseco Insurance Group
revenues.......................... 450.3 445.0 882.5 951.1
-------- -------- -------- --------
Other Business in Run-Off:
Insurance policy income - supplemental health.. 89.8 100.7 181.3 204.0
Net investment income (a)...................... 44.8 40.9 88.0 81.2
Fee revenue and other income (a)............... .2 .2 .3 .5
Net realized investment gains (losses) (a)..... 2.4 (.9) 4.5 1.8
-------- -------- -------- --------
Total Other Business in Run-Off
revenues.......................... 137.2 140.9 274.1 287.5
-------- -------- -------- --------
Corporate:
Net investment income.......................... 3.3 .3 3.8 .5
Fee and other income........................... 3.3 2.6 6.3 7.6
Net realized investment losses................. (1.3) - (1.3) (2.8)
-------- -------- -------- --------
Total corporate revenues.............. 5.3 2.9 8.8 5.3
-------- -------- -------- --------
Total revenues........................ 1,086.7 1,039.5 2,134.7 2,150.1
-------- -------- -------- --------
(continued on next page)
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2005 2004 2005 2004
---- ---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits........................... $341.2 $308.2 $ 670.6 $ 614.7
Amortization........................................ 45.0 43.6 91.9 89.3
Interest expense on investment borrowings........... .8 .7 1.5 1.1
Other operating costs and expenses.................. 38.0 44.1 75.7 79.6
------ ------ -------- --------
Total Bankers Life expenses.................... 425.0 396.6 839.7 784.7
------ ------ -------- --------
Conseco Insurance Group:
Insurance policy benefits........................... 274.5 262.4 529.6 574.3
Amortization........................................ 38.2 34.0 80.2 81.7
Interest expense on investment borrowings........... 2.2 1.2 4.2 2.1
Other operating costs and expenses.................. 64.1 81.9 133.7 158.2
------ ------ -------- --------
Total Conseco Insurance Group expenses......... 379.0 379.5 747.7 816.3
------ ------ -------- --------
Other Business in Run-Off:
Insurance policy benefits........................... 87.7 95.9 174.2 197.2
Amortization........................................ 4.8 4.7 10.6 9.5
Interest expense on investment borrowings........... - .1 - .1
Other operating costs and expenses.................. 20.9 25.5 41.9 48.4
------ ------ -------- --------
Total Other Business in Run-Off expenses....... 113.4 126.2 226.7 255.2
------ ------ -------- --------
Corporate:
Interest expense on corporate debt.................. 13.1 21.1 25.1 48.9
Gain on extinguishment of debt...................... - (2.8) - (2.8)
Other operating costs and expenses.................. 16.3 12.1 28.4 28.6
------ ------ -------- --------
Total corporate expenses....................... 29.4 30.4 53.5 74.7
------ ------ -------- --------
Total expenses................................. 946.8 932.7 1,867.6 1,930.9
------ ------ -------- --------
Income (loss) before income taxes:
Bankers Life................................... 68.9 54.1 129.6 121.5
Conseco Insurance Group........................ 71.3 65.5 134.8 134.8
Other Business in Run-Off...................... 23.8 14.7 47.4 32.3
Corporate operations........................... (24.1) (27.5) (44.7) (69.4)
------ ------ -------- --------
Income before income taxes................. $139.9 $106.8 $ 267.1 $ 219.2
====== ====== ======== ========
<FN>
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return plus a higher potential return that is based on a percentage (the
"participation rate") of a particular index, such as the Standard & Poor's 500
Index, 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 one-year call options
on the applicable indices in an effort to hedge potential increases to
policyholder benefits resulting from increases in the particular index to which
the product's return is linked. We include the cost of the options in the
pricing of these products. Policyholder account balances for these annuities
fluctuate in relation to changes in the values of these options. We reflect
changes in the estimated market value of these options in net investment income
(classified as investment income from policyholder accounts). Option costs that
are attributable to benefits provided were $20.5 million and $23.2 million in
the first six months of 2005 and 2004, respectively, and were included in
investment income. Net investment income (loss) related to equity-indexed
products before these option costs were $(.1) million and $28.0 million in the
first six months of 2005 and 2004, respectively. These amounts were
substantially offset by the corresponding charges to insurance policy benefits.
The estimated fair values of the options were $40.1 million and $50.4 million at
June 30, 2005 and December 31, 2004, respectively. We classify these instruments
as other invested assets.
The Company accounts for the options attributed to the policyholder for the
estimated life of the annuity contract as embedded derivatives as defined by
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", as amended by Statement of Financial
Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement
No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities" (collectively
referred to as "SFAS 138"). We record the changes in the fair values of the
embedded derivatives in current earnings as a component of policyholder
benefits. The fair value of these derivatives, which are classified as
"liabilities for interest-sensitive products", was $203.3 million and $236.7
million at June 30, 2005 and December 31, 2004, respectively. We have
transferred a specific 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 that 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 June 30, 2005, all of our counterparties were rated "A" or
higher by Standard & Poor's Corporation ("S&P").
Certain of our reinsurance payable balances contain embedded derivatives as
defined in 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". Such derivatives had an
estimated fair value of $35.9 million and $32.1 million at June 30, 2005 and
December 31, 2004, 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
We hold bank loans made to certain former directors and employees that
enabled them to purchase common stock of Old Conseco. These loans, with a
principal amount of $481.3 million, had been guaranteed by our Predecessor. 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 exceed $255 million. The former bank loans and the interest
loans are collectively referred to as the "D&O loans." We regularly evaluate the
collectibility of these loans in light of the collateral we hold, the credit
worthiness of the participants and the current status of various legal actions
we have taken to collect the D&O loans. At June 30, 2005, we have estimated that
approximately $38 million of the D&O loan 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.
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 net proceeds from the collection of certain D&O loans in an
aggregate amount not to exceed $30 million. We have established a liability of
$19 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 employment agreements of two of the
Company's former chief executive officers, certain wholly-owned subsidiaries of
the Company are the guarantors of the former executives' nonqualified
supplemental retirement benefits. The liability for such benefits at June 30,
2005 and December 31, 2004 was $25.1 million and $22.0 million, respectively,
and is included in the caption "Other liabilities" in the consolidated balance
sheet.
REINSURANCE
The cost of reinsurance ceded totaled $121.0 million and $133.5 million in
the first six months of 2005 and 2004, respectively. We deduct 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
$127.1 million and $158.0 million in the first six months of 2005 and 2004,
respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced. Reinsurance premiums
assumed totaled $28.9 million and $35.8 million in the first six months of 2005
and 2004, respectively.
See the note entitled "Accounting for Derivatives" for a discussion of the
derivatives embedded in the payable related to certain modified coinsurance
agreements.
INCOME TAXES
The components of income tax expense were as follows (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ----------------------
2005 2004 2005 2004
---- ---- ---- ----
Current tax provision......................................... $ - $ 1.2 $ - $ 3.0
Deferred tax provision........................................ 51.8 37.3 97.2 75.1
----- ----- ----- -----
Income tax expense on period income.................. $51.8 $38.5 $97.2 $78.1
===== ===== ===== =====
15
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:
Six months ended
June 30,
----------------------
2005 2004
---- ----
U.S. statutory corporate rate........................................................ 35.0% 35.0%
Other nondeductible expenses......................................................... 1.2 .5
State taxes.......................................................................... .6 .1
Other deductible expenses............................................................ (.4) -
---- ----
Effective tax rate.......................................................... 36.4% 35.6%
==== ====
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
June 30, December 31,
2005 2004
---- ----
Deferred tax assets:
Net operating loss carryforwards:
Portion attributable to worthless investment in Conseco Finance Corp........... $ 1,452.4 $ 1,452.4
Other.......................................................................... 112.4 99.9
Capital loss carryforwards........................................................ 366.6 388.6
Deductible temporary differences:
Insurance liabilities.......................................................... 1,505.7 1,598.0
Reserve for loss on loan guarantees............................................ 198.5 207.3
--------- ---------
Gross deferred tax assets.................................................... 3,635.6 3,746.2
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (50.5) (79.7)
Value of policies in force at the Effective Date and cost of policies produced. (738.9) (732.1)
Unrealized appreciation of investments......................................... (264.6) (188.4)
Other.......................................................................... (178.0) (169.4)
--------- ---------
Gross deferred tax liabilities............................................... (1,232.0) (1,169.6)
--------- ---------
Net deferred tax assets before valuation allowance........................... 2,403.6 2,576.6
Valuation allowance................................................................... (1,629.6) (1,629.6)
--------- ---------
Net deferred tax assets...................................................... 774.0 947.0
Current income taxes prepaid.......................................................... 14.1 20.2
--------- ---------
Net income tax assets........................................................ $ 788.1 $ 967.2
========= =========
Conseco and its affiliates are currently under examination by the Internal
Revenue Service (the "IRS") for tax years ending December 31, 2002 through
December 31, 2003. The outcome of this examination (including any appeals
thereof) is not expected to have a material adverse affect on our operating
results, but may result in utilization or adjustment of the income tax loss
carryforwards reported below, and is expected to resolve the Section 382
limitation and the life insurance limitation issues more fully discussed below.
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss
carryforwards. The net deferred tax assets before valuation allowance totaled
$2.4 billion at June 30, 2005. In evaluating our deferred income tax
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
assets, we consider whether it is more likely than not that the deferred income
tax assets will be realized. The ultimate realization of our deferred income tax
assets depends upon generating future taxable income during the periods in which
our temporary differences become deductible and before our capital loss
carryforwards and net operating loss carryforwards expire. In addition, the use
of the Company's net ordinary loss carryforwards is dependent, in part, on
whether the IRS ultimately agrees with the tax position we have taken and plan
to take in our current and future tax returns. We evaluate the realizability of
our deferred income tax assets and assess the need for a valuation allowance on
an ongoing basis.
As of June 30, 2005, we believe that it is necessary to have a valuation
allowance on a portion of our deferred tax assets. This determination was made
by evaluating each component of the deferred tax assets and assessing the
effects of limitations or issues on such component's ability to be fully
recognized in the future. Two significant issues include whether Section 382 of
the Internal Revenue Code (the "Code") is applicable, which would limit the
amount of net operating losses arising from the worthlessness of our previous
subsidiary, Conseco Finance Corp. ("CFC"), and whether such net operating losses
are eligible to offset life insurance income without limitation. We intend to
maintain a sufficient valuation allowance against our deferred tax assets until
objective evidence exists to further reduce or eliminate it.
Based upon our projections of future income that we completed in early
2005, we believe that we will more likely than not recover $774.0 million of our
deferred tax assets through reductions of our tax liabilities in future periods.
However, recovery is dependent on achieving such projections and failure to do
so would result in an increase in the valuation allowance in a future period.
Any future increase in the valuation allowance would result in additional income
tax expense and reduce shareholders' equity, and such an increase could have a
significant impact upon our earnings in the future. There was no change in our
valuation allowance during the first six months of 2005.
As of June 30, 2005, we had $4.5 billion of net operating loss
carryforwards and $1.0 billion of capital loss carryforwards (including the loss
resulting from the worthlessness of CFC discussed below), which expire as
follows (dollars in millions):
Net operating loss carryforwards Capital loss carryforwards
------------------------------------------- -----------------------------------------
Year of expiration Subject to ss.382 Not subject to ss.382 Subject to ss.382 Not subject to ss.382
------------------ ----------------- --------------------- ----------------- ---------------------
2005........................... $ .2 $ - $ - $ -
2006........................... .1 - - -
2007........................... 5.8 - 429.7 -
2008 .......................... .1 - 583.7 -
2009........................... 10.5 - - 34.1
2010........................... 3.5 - - -
2011........................... .5 - - -
2016........................... 29.2 - - -
2017........................... 51.1 - - -
2018........................... 53.9 4,182.3 (a) - -
2019........................... .7 - - -
2020........................... 2.5 33.8 - -
2022........................... .6 - - -
2023........................... 84.0 - - -
2024........................... - 10.0 - -
2025........................... - 2.0 - -
------ -------- -------- -----
Total.......................... $242.7 $4,228.1 $1,013.4 $34.1
====== ======== ======== =====
<FN>
- -------------
(a) We have taken the position in our tax returns that the $4.1 billion tax
loss on the worthlessness of CFC included in this amount will not be
subject to Section 382 of the Code. Although we believe our position is
consistent with the Code, it is subject to interpretation and remains an
uncertainty with respect to the future utilization of this operating loss
carryforward. If the IRS disagrees with our position, the $4.1 billion tax
loss would be subject to Section 382 of the Code and the maximum
carryforward that could be utilized would be $2.7 billion (subject to our
ability to generate sufficient future taxable income in the relevant
carryforward period). See additional discussion below.
</FN>
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The timing and manner in which we will utilize the net operating loss
carryforwards and capital loss carryforwards in any year or in total may be
limited by various provisions of the Code (and interpretation thereof) and our
ability to generate sufficient future taxable income in the relevant
carryforward period.
The following paragraphs summarize some of the unresolved issues regarding
the future utilization of our net operating loss carryforwards, which, when
resolved, could cause a reassessment of the need for a portion of the valuation
allowance.
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 of the non-life entities. There is no
limitation on 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 Code limitations described above. However,
if the IRS were to disagree with our conclusion and such determination
ultimately prevailed, the loss related to CFC would be subject to such
limitation. The IRS has informed the Company that it will address this matter
during its examination of our tax returns for calendar years 2002-2003. We have
had, and continue to have, discussions with the IRS as part of the audit in
process. These discussions indicate that the IRS is tentatively adverse to the
Company's conclusion that the loss related to CFC should be treated as a life
insurance loss. The IRS's determination will not be known until the completion
of the audit, which is expected by the end of the year. The Company believes
that it has strong legal arguments for its position, and, if the IRS ultimately
challenges the Company's position, then the Company may exercise all of its
appeal rights, including litigation if necessary. Such an appeal could take a
significant amount of time to resolve.
The timing and manner in which the Company will be able to utilize some or
all of its net operating loss carryforwards may be limited by Section 382 of the
Code. Section 382 imposes limitations on a corporation's ability to use its net
operating loss carryforwards when the company undergoes an ownership change.
Because the Company underwent an ownership change pursuant to its
reorganization, this limitation applies to the Company. In order to determine
the amount of this limitation, we must determine the amount of our net operating
loss carryforwards related to the period prior to our emergence from bankruptcy
(such amount will be subject to the 382 limitation) and the amount related to
the period after emergence (such amount will not be subject to the 382
limitation). When the Company filed its 2003 federal income tax return, it
elected to specifically identify transactions in each period and record them in
the period they actually occurred. As a result, we believe the loss related to
CFC will be treated as post emergence and therefore not subject to the Section
382 limitation. Any losses that are subject to the Section 382 limitation will
only be utilized by the Company up to approximately $140 million per year with
any unused amounts carried forward to the following year. The IRS has informed
the Company that it will address this matter during its examination of our tax
returns for calendar years 2002-2003. We have had, and continue to have,
discussions with the IRS as part of the audit in process. These discussions
indicate that the IRS is no longer reviewing the Section 382 issue and is not at
this time adverse to the Company's position. Such a determination will not be
known until the completion of the audit, which is expected by the end of the
year.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of June 30, 2005 and December 31, 2004 (dollars in millions):
June 30, December 31,
2005 2004
---- ----
$800.0 million secured credit agreement ("Credit Facility")............................. $767.1 $768.0
Unamortized issuance costs.............................................................. (8.3) (9.1)
------ ------
Direct corporate obligations....................................................... $758.8 $758.9
====== ======
On June 22, 2004, we entered into the Credit Facility. The Credit Facility
is a six-year term loan, the proceeds of which were used: (i) to refinance in
full all indebtedness, including accrued interest, under our previous $1.3
billion credit agreement (the "Previous Credit Facility"); (ii) to repurchase
$106.6 million of certain affiliated preferred stock; and (iii) for other
general corporate purposes.
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
We are required to make: (i) a principal payment of $1.1 million on
December 31, 2005; and (ii) quarterly principal payments of $2.0 million
commencing March 31, 2006, and continuing until March 31, 2010. The remaining
principal balance is due on June 22, 2010. The Company made an optional
prepayment of $28.0 million in December 2004. The Company made a mandatory
prepayment of $.9 million (after consideration of the $28.0 million prepayment)
on March 31, 2005, based on the Company's excess cash flows at December 31,
2004, as defined in the Credit Facility. The borrowing bears interest, payable
at least quarterly, based on either a eurodollar rate or a base rate. The
eurodollar rate is equal to LIBOR plus 3.5 percent. The base rate is equal to
2.5 percent plus the greater of: (i) the Federal funds rate plus .50 percent; or
(ii) Bank of America's prime rate. On June 30, 2005, the interest rate on our
Credit Facility was 6.83 percent.
Pursuant to the Credit Facility, as long as the interest coverage ratio (as
defined in the Credit Facility) is less than 4.0:1.0, the Company is required to
make mandatory prepayments with all or a portion of the proceeds from the
following transactions or events including: (i) the issuance of certain
indebtedness; (ii) equity issuances; (iii) certain asset sales or casualty
events; and (iv) excess cash flows as defined in the Credit Facility. The
Company may make optional prepayments at any time in minimum amounts of $3.0
million.
The Credit Facility requires the Company to maintain various financial
ratios and balances, as defined in the agreement, including: (i) a debt to total
capitalization ratio of not more than 25 percent at all times (such ratio was 17
percent at June 30, 2005); (ii) an interest coverage ratio greater than or equal
to 2.0:1.0 for each rolling four quarters ending (or, if less, the number of
full quarters commencing after June 22, 2004) during the period October 1, 2004
through June 30, 2007, and 2.5:1.0 for the four quarters ending September 30,
2007 and for each rolling four quarters thereafter (such ratio exceeded 2.10:1.0
for the four quarters ending June 30, 2005); (iii) EBITDA, as defined in the
Credit Facility, greater than or equal to $725.0 million for each rolling four
quarters ending during the period July 1, 2004 through December 31, 2005, $775.0
million for each rolling four quarters ending during the period January 1, 2006
through December 31, 2006, and $825.0 million for each rolling four quarters
thereafter (such amount was greater than $1.0 billion for the four quarters
ended June 30, 2005); (iv) an aggregate risk-based capital ratio, as defined in
the Credit Facility, greater than or equal to 245 percent for each quarter
ending during the period June 30, 2005 through June 30, 2006, and 250 percent
for each quarter ending thereafter (such ratio exceeded the minimum risk-based
capital requirements at June 30, 2005); (v) a combined statutory capital and
surplus level, as defined in the Credit Facility of greater than $1,270.0
million (combined statutory capital and surplus at June 30, 2005 exceeded such
requirement); and (vi) specified investment portfolio requirements (such
investment portfolio requirements were met at June 30, 2005).
The Credit Facility prohibits or restricts, among other things: (i) the
payment of cash dividends on the Company's common stock; (ii) the repurchase of
our common stock; (iii) the issuance of additional debt or capital stock; (iv)
liens; (v) asset dispositions; (vi) affiliate transactions; (vii) certain
investment activities; (viii) change in business; and (ix) prepayment of
indebtedness (other than the Credit Facility). The obligations under our Credit
Facility are guaranteed by Conseco's current and future domestic subsidiaries,
other than: (i) its insurance companies; (ii) subsidiaries of the insurance
companies; or (iii) certain immaterial subsidiaries as defined in the Credit
Facility. This guarantee was secured by granting liens on substantially all the
assets of the guarantors, including the capital stock of our top tier insurance
company, Conseco Life Insurance Company of Texas.
SALES INDUCEMENTS
Our annuity products include contracts that offer enhanced crediting rates
or bonus payments. These enhanced rates are considered sales inducements under
Statement of Position 03-01 "Accounting and Reporting by Insurance Enterprises
for Certain Nontraditional Long-Duration Contracts and for Separate Accounts".
Such amounts are deferred and amortized in the same manner as the cost of
policies produced. Sales inducements deferred totaled $10.0 million and $6.8
million during the six months ended June 30, 2005 and 2004, respectively.
Amounts amortized totaled $2.4 million and $.9 million during the six months
ended June 30, 2005 and 2004, respectively. The unamortized balance of deferred
sales inducements at June 30, 2005 and December 31, 2004 was $23.4 million and
$15.8 million, respectively. Our reserve for persistency bonus benefits was
$307.8 million at June 30, 2005 and $313.2 million at December 31, 2004.
RECENTLY ISSUED ACCOUNTING STANDARDS
The FASB issued SFAS 123R in December 2004. SFAS 123R revises SFAS 123
"Accounting for Stock-Based Compensation" and supersedes APB 25. SFAS 123R
provides additional guidance on accounting for share-based payments and will
require all such awards to be measured at fair value with the related
compensation cost recognized in the statement of
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
operations over the related service period. SFAS 123R is effective for all
awards granted, modified, repurchased or cancelled in the interim period
beginning after June 15, 2005 and requires the recognition of compensation cost
over the remaining vesting period for the portion of outstanding awards that are
not vested as of the effective date. In April 2005, the SEC amended the
compliance date to implement SFAS 123R at the beginning of the next fiscal year,
instead of the next reporting period that begins after June 15, 2005. SFAS 123R
also requires the benefits of tax deductions in excess of recognized
compensation cost to be reported as a financing cash flow rather than as an
operating cash flow, as currently required. The Company's net income would have
been reduced by $.9 million and $1.5 million in the three and six months ended
June 30, 2005, respectively, if we had recognized stock-based employee
compensation as determined under the fair value method, net of income taxes.
In May 2005, the FASB issued Statement of Financial Accounting Standards
No. 154, Accounting Changes and Error Corrections, a replacement of Accounting
Principles Board ("APB") Opinion No. 20 and SFAS No. 3 ("SFAS 154"). The
statement is a result of a broader effort by the FASB to converge standards with
the International Accounting Standards Board ("IASB"). The statement requires
retrospective application to prior periods' financial statements for a voluntary
change in accounting principle unless it is impracticable. It also requires that
a change in method of depreciation, amortization, or depletion for long-lived,
non-financial assets be accounted for as a change in accounting estimate rather
than a change in accounting principle. SFAS 154 is effective for accounting
changes and corrections of errors made in fiscal years beginning after December
15, 2005. SFAS 154 is not expected to have a material impact on the Company's
unaudited interim consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards No. 153,
"Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29" ("SFAS
153") in December 2004. SFAS 153 amends prior guidance to eliminate the
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of SFAS 153 are effective for nonmonetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005 and shall be
applied prospectively. SFAS 153 is not expected to have a material impact on the
Company's consolidated financial statements at the date of adoption.
In March 2004, the Emerging Issues Task Force issued Emerging Issues Task
Force Topic No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments" ("EITF 03-01"). EITF 03-01 provides
additional guidance for determining whether an impairment of an investment is
other than temporary. EITF 03-01 also includes guidance for accounting for an
investment subsequent to an other-than-temporary impairment and requires certain
disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments. Certain guidance in EITF 03-01 was effective
beginning the quarter ended September 30, 2004; however, such guidance did not
significantly change our procedures for evaluating impairments. The FASB will
issue FASB Staff Position Paper ("FSP") 115-1, The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments ("FSP
115-1"), superseding EITF 03-1 and EITF Topic D-44, Recognition of
Other-Than-Temporary Impairment on the Planned Sale of a Security Whose Cost
Exceeds Fair Value ("Topic D-44"). FSP 115-1 will nullify the accounting
guidance on the determination of whether an investment is other-than-temporarily
impaired as set forth in EITF 03-1. FSP 115-1 will be effective for
other-than-temporary impairment analysis conducted in periods beginning after
September 15, 2005. The Company has complied with the disclosure requirements of
EITF 03-1, which were effective December 31, 2003 and remain in effect.
LITIGATION AND OTHER LEGAL PROCEEDINGS
The Company and its subsidiaries are involved in various legal actions in
the normal course of business, in which claims for compensatory and punitive
damages are asserted, some for substantial amounts. Some of the pending matters
have been filed as purported class actions and some actions have been filed in
certain jurisdictions that permit punitive damage awards that are
disproportionate to the actual damages incurred. Although there can be no
assurances, at the present time the Company does not anticipate that the
ultimate liability from either pending or threatened legal actions, after
consideration of existing loss provisions, will have a material adverse effect
on the financial condition, operating results or cash flows of the Company.
Nonetheless, given the large or indeterminate amounts sought in certain of these
actions, and the inherent unpredictability of litigation, it is possible that an
adverse outcome in certain matters could, from time to time, have a material
adverse effect on the Company's consolidated results of operations or cash flows
in particular quarterly or annual periods.
In the cases described below, we have disclosed any specific dollar amounts
sought in the complaints. In our experience, such monetary demands bear little
relation to the ultimate loss, if any, to the Company. However, for the reasons
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
stated above, it is not possible to make meaningful estimates of the amount or
range of loss that could result from some of these matters at this time. The
Company reviews these matters on an ongoing basis and follows the provisions of
Statement of Financial Accounting Standards No. 5, "Accounting for
Contingencies", when making accrual and disclosure decisions. When assessing
reasonably possible and probable outcomes, the Company bases its decisions on
its assessment of the ultimate outcome following all appeals.
Securities Litigation
After our Predecessor announced its intention to restructure on August 9,
2002, eight purported securities fraud class action lawsuits were filed in the
United States District Court for the Southern District of Indiana. The
complaints named us as a defendant, along with certain of our former officers.
These lawsuits were filed on behalf of persons or entities who purchased our
Predecessor's common stock on various dates between October 24, 2001 and August
9, 2002. The plaintiffs allege claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended (the "Exchange Act") and allege
material omissions and dissemination of materially misleading statements
regarding, among other things, the liquidity of Conseco and alleged problems in
CFC's manufactured housing division, allegedly resulting in the artificial
inflation of our Predecessor's stock price. On March 13, 2003, all of these
cases were consolidated into one case in the United States District Court for
the Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco,
Inc., Gary Wendt, William Shea, Charles Chokel and James Adams, et al., Case No.
02-CV-1332 DFH-TAB. The complaint seeks an unspecified amount of damages. The
plaintiffs have filed a consolidated class action complaint with respect to the
individual defendants. Our liability with respect to this lawsuit was discharged
in our Predecessor's plan of reorganization and our obligation to indemnify
individual defendants who were not serving as an officer or director on the
Effective Date is limited to $3 million in the aggregate under such plan. This
limit was reached in May of 2005. Our liability to indemnify individual
defendants who were serving as an officer or director on the Effective Date, of
which there is one such defendant, is not limited by such plan. A motion to
dismiss was filed on behalf of defendants Shea, Wendt and Chokel and on July 14,
2005, this matter was dismissed. Plaintiffs were given until August 24, 2005 to
amend their complaint. James S. Adams filed for bankruptcy on July 29, 2005,
Case No. 1:02-cv-1332-DFH-TAB (Southern District, Indiana). We believe this
lawsuit is without merit and intend to defend it vigorously; however, the
ultimate outcome cannot be predicted with certainty. Our current estimate of the
maximum loss that we could reasonably incur on this case is approximately $1.5
million. We do not believe that the potential loss related to the individual
defendant who served as an officer on the Effective Date is material.
Other Litigation
The Company and certain subsidiaries, including principally Conseco Life
Insurance Company ("Conseco Life"), have been named in numerous purported class
action and individual lawsuits alleging, among other things, breach of contract,
fraud and misrepresentation with regard to a change made in 2003 and 2004 in the
way cost of insurance charges are calculated for life insurance policies sold
primarily under the names "Lifestyle" and "Lifetime". Approximately 86,500 of
these policies were subject to the change, which resulted in increased monthly
charges to the policyholders' accounts. Many of the purported class action
lawsuits were filed in Federal courts across the United States. On or about June
23, 2004, the Judicial Panel on Multidistrict Litigation consolidated these
lawsuits into the action now referred to as In Re Conseco Life Insurance Co.
Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California).
On or about September 23, 2004, plaintiffs in the multi-district action filed an
amended consolidated complaint and, at that time, added Conseco, Inc. as a
defendant. The amended complaint alleges, among other things, that the change
enabled Conseco, Inc. to add $360 million to its balance sheet. The amended
complaint seeks unspecified compensatory, punitive and exemplary damages as well
as an injunction that would require the Company to reinstate the prior method of
calculating cost of insurance charges and refund any increased charges that
resulted from the change. On April 26, 2005, the Judge in the multi-district
action certified a nationwide class on the claims for breach of contract and
injunctive relief. On April 27, 2005, the Judge certified a statewide California
class for injunctive and restitutionary relief pursuant to California Business
and Professions Code Section 17200 and breach of the duty of good faith and fair
dealing, but denied certification on the claims for fraud and intentional
misrepresentation and fraudulent concealment. Trial is currently set to begin on
or about May 9, 2006. Other cases now pending include purported nationwide class
actions in Indiana and California state courts. Those cases filed in Indiana
state courts have been consolidated into the case now referred to as Alene P.
Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211
(Superior Court, Hamilton County, Indiana). Four putative nationwide and/or
statewide class-action lawsuits filed in California state courts have been
consolidated and are being coordinated in the Superior Court of San Francisco
County under the new caption Cost of Insurance Cases, Judicial Council
Coordination Proceeding No. 4384 (Judicial Council of California). On January
25, 2005 an Amended Complaint making similar allegations was filed in the case
captioned William Schwartz v. Jeffrey Landerman, Diann P. Urbanek, Metro
Insurance, Inc.,
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Samuels Jacky Insurance Agency, Conseco Life Insurance Company, Successor to
Philadelphia Life Insurance Company, Case No. GD 00-011432 (Court of Common
Pleas, Allegheny County, Pennsylvania). Additionally, Schwartz filed a purported
nationwide class action captioned William Schwartz and Rebecca R. Frankel,
Trustee of the Robert M. Frankel Irrevocable Insurance Trust v. Conseco Life
Ins. Co. et al., Case No. GD 05-3742 (Court of Common Pleas, Allegheny County,
Pennsylvania). On May 16, 2005 an individual lawsuit was filed in Illinois
captioned Sidney Bark, Shirley Bark, Marla Bark Dembitz, Caryn Bark and Toni
Bark v. Conseco Life Insurance Company, Massachusetts General Life Insurance
Company, Brown, Brown and Gomberg, LTD; and Gerald R. Gomberg, Case No.
2005L005353 (Circuit Court of Cook County, Illinois, County Department, Law
Division), which has been removed to the United States District Court for the
Northern District of Illinois. On May 24, 2005 a lawsuit was filed in Illinois
on behalf of a putative statewide class captioned William J. Harte, individually
and on behalf of all others similarly situated v. Conseco Life Insurance
Company, Case No. 05CH08925 (Circuit Court of Cook County, Illinois, Chancery
Division), which has been removed to the United States District Court for the
Northern District of Illinois. On May 25, 2005 an individual lawsuit was filed
in California captioned Leslie C. Garland, M.D., and the Leslie C. Garland
Irrevocable Trust v. Conseco Life Insurance Company, successor to Massachusetts
General Life Insurance Company and DOES 1 through 50 inclusive, Case No.
BC330898 (Superior Court, County of Los Angeles, California), which has been
removed to the United States District Court for the Central District of
California and consolidated and coordinated with MDL 1610. We believe these
lawsuits are without merit and intend to defend them vigorously. However, the
ultimate outcome of the lawsuits cannot be predicted with certainty and an
adverse decision could have a material impact on the Company's consolidated
financial condition, cash flows or results of operations.
In October 2002, Roderick Russell, on behalf of himself and purportedly on
behalf of a class of persons similarly situated, and on behalf of the
ConsecoSave Plan, filed an action in the United States District Court for the
Southern District of Indiana against our Predecessor, our subsidiary Conseco
Services, LLC ("Conseco Services") and certain of our current and former
officers, Roderick Russell, et al. v. Conseco, Inc., et al., Case No.
1:02-CV-1639 LJM. The complaint seeks an unspecified amount of damages. The
purported class action consists of all individuals whose 401(k) accounts held
common stock of our Predecessor at any time since April 28, 1999. The complaint
alleges, among other things, breaches of fiduciary duties under ERISA by
continuing to permit employees to invest in our Predecessor's common stock
without full disclosure of the Company's true financial condition. We reached a
tentative settlement with the Russell plaintiffs for $10 million in February
2005, subject to the negotiation of a final settlement agreement. A final
settlement agreement has been reached. The class action settlement must now be
approved by the district court, after a fairness hearing is conducted. We have
established a liability of $10 million for the cost of this settlement.
The Company will pursue recovery of any settlement in the Russell matter,
from its fiduciary insurance carrier, RLI Insurance Company ("RLI"). However, on
February 13, 2004, RLI filed a declaratory judgment action asking the court to
find no liability under its policy for the claims made in the Russell matter due
to certain releases provided to them pursuant to RLI's agreement to settle a
case involving the Predecessor related to a different policy coverage, RLI
Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No.
1:04-CV-0310DFH-TAB (Southern District, Indiana). On March 15, 2004, RLI filed
an amended complaint adding Conseco Services as an additional defendant. On
March 30, 2004, RLI filed a second amended complaint adding certain individual
plan fiduciaries as defendants. On May 24, 2004, we filed our answer to the
second amended complaint and counterclaims for declaratory judgment and breach
of contract. On September 2, 2004, RLI filed a motion for judgment on all
counterclaims. The court has stayed this matter until the Russell matter is
resolved. We believe RLI's position is without merit because the previous
release is not applicable to the Russell matter. We plan to vigorously pursue
all claims against RLI, but the ultimate outcome of the lawsuit cannot be
predicted with certainty. We expect to ultimately recover a substantial portion
of the $10 million we expect to pay in settlement of the Russell matter from
RLI.
On July 9, 1999, a complaint was filed in the Supreme Court of the State of
New York, County of New York, PRG Planning & Development, LLC v. LateNite Magic,
Inc., Daurio & Russo & Sons Construction Co., Inc., Specialized Audio Visual,
Inc., Farmore Realty, Inc. f/k/a Sweetheart Theatres, Inc., The City of New York
and the State of New York Cause No: 114077/99. The complaint seeks damages in
the amount of $3.9 million with interest thereon from January 20, 1998. This is
a lien foreclosure suit that is the result of an April 1996 lease agreement
entered into by LateNite Magic and Farmore Realty, Inc. to develop a theme
restaurant based on the magic of David Copperfield. A former subsidiary of the
Company, Conseco Variable Insurance Company ("CVIC"), and our subsidiary Conseco
Annuity Assurance Company (now known as Conseco Insurance Company) purchased
preferred stock of LateNite and acquired the right to an assignment of the April
1996 lease. An amended complaint was filed on December 2, 1999 naming CVIC and
Conseco Annuity Assurance Company as co-defendants. The trial in this case
commenced on March 10, 2005 and concluded on May 20, 2005. The post trial briefs
have been submitted and a decision could come at any time. We retained liability
for CVIC's involvement in this litigation in
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
connection with the sale of CVIC. We believe that we have established adequate
reserves in the event we are found liable under this lawsuit. The ultimate
outcome of the lawsuit cannot be predicted with certainty.
On December 10, 2004, an arbitration award was issued by the American
Arbitration Association finding for American Worldwide Insurance, Inc. ("AWI")
and Todd Green ("Green"), individually, and against Conseco Life. The arbitrated
dispute arises from a marketing agreement initially entered into in 1994. AWI
and Green alleged breach of contract and bad faith and sought $4.3 million
actual damages and unspecified punitive damages. The award resulted in total
actual damages of $2.1 million, as well as future payments of $.9 million due on
September 9, 2005, $.8 million due on September 9, 2006, and $.6 million due on
September 9, 2007. The panel also found that AWI and Green failed to prove that
either Conseco Life or Conseco Marketing, LLC acted in bad faith and refused an
award of punitive damages. We have filed an application in Federal court in the
case captioned, Conseco Life Insurance Company and Conseco Marketing, LLC v.
American Worldwide Insurance, Inc. and Todd Green, Cause No.
1:04-CV-2035-DFH-TAB (Southern District, Indiana) requesting, among other
things, to vacate the arbitration award because it is contrary to applicable law
and order a new arbitration proceeding. AWI and Green have filed a motion in
opposition and a motion to confirm the arbitration award. On August 4, 2005, our
application to vacate the arbitration award was denied and judgment was entered
consistent with the award as set forth above. Adequate reserves have been
established with respect to the judgment.
On June 27, 2001, two suits against Conseco Life, both purported nationwide
class actions seeking unspecified compensatory and punitive damages, were
consolidated in the U.S. District Court, Middle District of Florida, In Re PLI
Sales Litigation, Cause No. 01-MDL-1404. The complaint alleges, among other
things, fraudulent sales and a "vanishing premium" scheme. Conseco Life filed a
motion for summary judgment against both named plaintiffs, which motion was
granted in June 2002. Plaintiffs appealed to the 11th Circuit Court of Appeals.
The 11th Circuit, in July 2003, affirmed in part and reversed in part, allowing
two fraud counts with respect to one plaintiff to survive. The plaintiffs'
request for a rehearing with respect to this decision has been denied. Conseco
Life filed a summary judgment motion with respect to the remaining claims. This
summary judgment was denied in February 2004. On April 23, 2004, a similar case
was filed. Harold R. Arthur, individually and as Trustee of the Harold A. Arthur
Revocable Living Trust, on behalf of himself and all others similarly situated
v. Conseco Life Insurance Company, Case No. 6:04-CV-587-ORL-31KRS (U.S. District
Court, Middle District of Florida). The case was consolidated with the PLI Sales
Practices Litigation in May 2004. The plaintiff's motion for class certification
was denied. Conseco Life's motion for summary judgment on Plaintiff Arthur's
claim was denied. Trial of Arthur's claim and one claim of co-plaintiff Siegel
is scheduled for the period beginning September 6, 2005. We believe that we have
established adequate reserves in the event we are found liable under this
lawsuit. The ultimate outcome of this lawsuit cannot be predicted with
certainty.
On December 1, 2000, the Company's former subsidiary, Manhattan National
Life Insurance Company, was named in a purported nationwide class action seeking
unspecified damages in the First Judicial District Court of Santa Fe, New
Mexico, Robert Atencio and Theresa Atencio, for themselves and all other
similarly situated v. Manhattan National Life Insurance Company, an Ohio
corporation, Cause No. D-0101-CV-2000-2817, alleging among other things fraud by
non-disclosure of additional charges for those policyholders paying via premium
modes other than annual. We retained liability for this litigation in connection
with the sale of Manhattan National Life in June 2002. We believe this lawsuit
is without merit and intend to defend it vigorously. Given the uncertainties
regarding the outcome of these proceedings, we are unable to estimate the
possible range of loss that may result from this pending litigation.
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 policyholders paying via premium
modes other than annual. On November 10, 2003, the court denied the plaintiff's
motion for class certification. On January 26, 2004, the plaintiff appealed the
trial court's ruling denying class certification. Oral argument was heard on
July 26, 2005, and we are waiting for the appellate court's decision. All
further proceedings have been stayed pending the outcome of the appeal. The
defendants believe this lawsuit is without merit and intend to defend it
vigorously. Given the uncertainties regarding the outcome of these proceedings,
we are unable to estimate the possible range of loss that may result from this
pending litigation.
On October 8, 2003, a complaint was filed in the United States District
Court for South Carolina, Greenville Division, Consolidated Insured Benefits,
Inc. and Ronald F. English v. Conseco Medical Insurance Company, Cause No.
6:03-3211-20. Plaintiffs are a former Conseco Medical Insurance Company ("CMIC")
field marketing organization and its president and
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
chief executive officer, and they allege in the complaint that they were damaged
by CMIC's exit from the individual medical insurance market claiming damages in
an unnamed amount for fraud, negligent misrepresentation and breach of fiduciary
duty. CMIC has filed a motion for summary judgment, and the case is set for
trial on or after September 7, 2005. We believe the action is without merit, and
intend to defend it vigorously. The ultimate outcome of the action cannot be
predicted with certainty.
In October 1997, an action was filed against CVIC and general agent Glenn
H. Guffey by nine South Carolina agents, who alleged that they had suffered
losses as a result of defendants' breach of contract, fraud and misleading
conduct relating to the sale of Flex II annuities. In the action, Thomas Allen
et al v. Great American Reserve Insurance Company, Glenn H. Guffey and American
Home Assurance Company, Case Number 29C01-9709-CP751 in the Circuit Court of
Hamilton County, Indiana, plaintiffs claim that Mr. Guffey told them that the
annuities would have no initial administrative fees charged to the owner of the
annuity (when in fact they did) and that as a result, they had been selling the
annuities on that basis. Plaintiffs demanded unspecified compensatory and
punitive damages, and allege that they have lost commissions and renewals and
that their business reputations have been damaged as a result of Mr. Guffey's
misrepresentations. They further contend that CVIC should be held liable as it
negligently supervised Mr. Guffey and knew about his fraudulent conduct.
Defendants were granted a Summary Judgment on February 9, 2000, but plaintiffs
appealed the judgment, and the Indiana Supreme Court overturned it on April 2,
2002. Mr. Guffey has settled with plaintiffs, and the case against CVIC is now
set for a jury trial commencing October 24, 2005. We retained liability for
CVIC's involvement in this litigation in connection with the sale of CVIC. We
believe this action is without merit, and intend to defend it vigorously. The
ultimate outcome of the action cannot be predicted with certainty.
Collection efforts by the Company and Conseco Services related to the
1996-1999 director and officer loan programs have been commenced against various
past board members and executives with outstanding loan balances. In addition,
certain former officers and directors have sued the companies for declaratory
relief concerning their liability for the loans. Currently, we are involved in
litigation with Stephen C. Hilbert, James D. Massey, Dennis E. Murray, Sr.,
James S. Adams, Maxwell E. Bublitz, Ngaire E. Cuneo and David R. Decatur. The
specific lawsuits now pending include: Hilbert v. Conseco, Case No. 03CH 15330
(Circuit Court, Cook County, Illinois); Conseco Services v. Hilbert, Case No.
29C01-0310-MF-1296 (Circuit Court, Hamilton County, Indiana); Murray and Massey
v. Conseco, Case No. 1:03-CV-1701-LJM-VSS (Southern District, Indiana); Stephen
C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026
(Superior Court, Hamilton County, Indiana); Conseco Services v. Adams, Case No.
29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton
County, Indiana); Conseco Services v. Cuneo, et al., Case No.
1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray,
Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County,
Indiana); Conseco Inc. v. Adams, et al., Case No. 04 L 012974 (Circuit Court,
Cook County, Illinois); Conseco Inc. v. Cuneo, et al., Case No. 04 C 7469
(Northern District, Illinois). David Decatur filed for bankruptcy on May 12,
2004, Case No. 04-08772-JKC-11 (Southern District, Indiana). Maxwell E. Bublitz
filed for bankruptcy on May 2, 2005, Case No. 05-08168-7 (Southern District,
Indiana). James S. Adams filed for bankruptcy on July 29, 2005, Case No.
1:02-cv-1332-DFH-TAB (Southern District, Indiana).
On October 20, 2004, the judge in the Conseco Services v. Hilbert case
granted partial final summary judgment in favor of Conseco Services in the
amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of appeal.
The matter is fully briefed and pending a decision by the Indiana Court of
Appeals. The Court of Appeals has set the matter for oral argument on September
8, 2005. We filed an objection to Dr. Decatur's bankruptcy on December 9, 2004.
On July 9, 2004, Conseco Services filed a motion for partial summary judgment in
the Cuneo Indiana matter. On June 24, 2005, the Company filed a motion for
summary judgment in the Cuneo Illinois matter. The Company and Conseco Services
believe that all amounts due under the director and officer loan programs,
including all applicable interest, are valid obligations owed to the companies.
As part of our Predecessor's plan of reorganization, we have agreed to pay 45
percent of any net proceeds recovered in connection with these lawsuits, in an
aggregate amount not to exceed $30 million, to former holders of our
Predecessor's trust preferred securities that did not opt out of a settlement
reached with the committee representing holders of these securities. We intend
to prosecute these claims to obtain the maximum recovery possible. Further, with
regard to the various claims brought against the Company and Conseco Services by
certain former directors and officers, we believe that these claims are without
merit and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty. At June 30, 2005, we estimated that
approximately $38 million, net of collection costs, of the remaining amounts due
under the loan program will be collected and that $19 million will be paid to
the former holders of our Predecessor's trust preferred securities.
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other arbitrations and lawsuits, including purported class actions,
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Six months ended
June 30,
-----------------------
2005 2004
---- ----
Cash flows from operating activities:
Net income........................................................................... $ 169.9 $ 141.1
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization and depreciation.................................................... 191.6 197.6
Income taxes..................................................................... 102.9 87.3
Insurance liabilities............................................................ 199.7 139.8
Accrual and amortization of investment income.................................... 46.8 112.5
Deferral of policy acquisition costs............................................. (206.3) (174.4)
Net realized investment gains.................................................... (9.5) (21.5)
Net sales (purchases) of trading securities...................................... 162.6 .5
Gain on extinguishment of debt................................................... - (2.8)
Other............................................................................ (1.8) (17.4)
------- -------
Net cash provided by operating activities...................................... $ 655.9 $ 462.7
======= =======
Non-cash items not reflected in the investing and financing activities sections
of the consolidated statement of cash flows:
Stock option and restricted stock plans............................................ $5.0 $ 7.7
Issuance of convertible preferred shares........................................... - 41.4
At June 30, 2005, restricted cash consisted of: (i) $15.2 million held in
an escrow account pursuant to a settlement with the Securities and Exchange
Commission and the New York Attorney General concerning their joint
investigation into market timing in variable annuities issued by a former
subsidiary of Old Conseco; (ii) $.7 million held in trust for the payment of
bankruptcy-related professional fees; and (iii) $.2 million of segregated cash
held for the benefit of the former holders of TOPrS.
SUBSEQUENT EVENTS
In July 2005, we announced that we are seeking to raise, subject to market
and other conditions, $300 million through a private offering of convertible
debentures ($330 million if the initial purchasers' option is exercised in
full). The offering will be made only to qualified institutional buyers in
compliance with Rule 144A under the Securities Act of 1933. The Company intends
to use the proceeds of the debentures to repay debt under its Credit Facility.
The debentures to be offered will not be registered under the Securities Act of
1933 or any state securities laws, and may not be offered or sold in the United
States absent registration or an applicable exemption from registration
requirements.
In July 2005, we announced that we have engaged Banc of America Securities
LLC and J.P. Morgan Securities Inc. to act as lead arrangers and joint
bookrunners in connection with the amendment of our existing Credit Facility.
The amendment is expected to provide for, among other things, a reduction in the
principal amount of the Credit Facility to $475 million through the application
of proceeds of the convertible debentures, a reduction in the interest spread on
the term loan, relaxed financial covenants and increased flexibility to enter
into capital markets transactions.
25
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at June 30, 2005, and the consolidated results of operations for the three and
six months ended June 30, 2005 and 2004, and, where appropriate, factors that
may affect future financial performance. Please read this discussion in
conjunction with the accompanying consolidated financial statements and notes.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Our statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the Securities and
Exchange Commission, press releases, presentations by Conseco or its management
or oral statements) relative to markets for Conseco's products and trends in
Conseco's operations or financial results, as well as other statements, contain
forward-looking statements within the meaning of the federal securities law and
the Private Securities Litigation Reform Act of 1995. Forward-looking statements
typically are identified by the use of terms such as "anticipate," "believe,"
"plan," "estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" section of our 2004 Annual
Report on Form 10-K provides examples of risks, uncertainties and events that
could cause our actual results to differ materially from the expectations
expressed in our forward-looking statements. Assumptions and other important
factors that could cause our actual results to differ materially from those
anticipated in our forward-looking statements include, among other things:
o our ability to achieve an upgrade of the financial strength ratings of
our insurance company subsidiaries and the impact of prior rating
downgrades on our business;
o the ultimate outcome of lawsuits filed against us and other legal and
regulatory proceedings to which we are subject;
o our ability to obtain adequate and timely rate increases on our
supplemental health products including our long-term care business;
o mortality, morbidity, usage of health care services, persistency and
other factors which may affect the profitability of our insurance
products;
o our ability to achieve anticipated expense reductions and levels of
operational efficiencies;
o the adverse impact of our Predecessor's bankruptcy proceedings on our
business operations, and relationships with our customers, employees,
regulators, distributors and agents;
o performance of our investments;
o customer response to new products, distribution channels and marketing
initiatives;
o the risk factors or uncertainties listed from time to time in our
filings with the Securities and Exchange Commission;
o general economic conditions and other factors, including prevailing
interest rate levels, stock and credit market performance and health
care inflation, which may affect (among other things) our ability to
sell products and access capital on acceptable terms, the returns on
and the market value of our investments, and the lapse rate and
profitability of policies;
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products; and
26
CONSECO, INC. AND SUBSIDIARIES
-------------------
o regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, such as the
payment of dividends to us, regulation of financial services affecting
(among other things) bank sales and underwriting of insurance
products, regulation of the sale, underwriting and pricing of
products, and health care regulation affecting health insurance
products.
Other factors and assumptions not identified above are also relevant to the
forward-looking statements, and, if they prove incorrect, could also cause
actual results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
We conduct our business operations through two primary operating segments,
which are defined primarily on method of product distribution, and a third
segment comprised of businesses in run-off, as follows:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty Company ("Bankers Life and Casualty") and Colonial Penn Life
Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets
and distributes Medicare supplement insurance, life insurance,
long-term care insurance and annuities to the senior market through
exclusive career agents and sales managers. Colonial Penn markets
graded benefit and simplified issue life insurance directly to
consumers through television advertising, direct mail, the internet
and telemarketing. Both Bankers Life and Casualty and Colonial Penn
market their products under their own brand names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through
independent marketing organizations that represent independent agents.
This segment markets its products under the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold through independent agents and major medical insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company business that are not related to our
operating segments.
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2004 Annual Report on
Form 10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements.
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CONSECO, INC. AND SUBSIDIARIES
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RISK FACTORS
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors could
have a material adverse effect on the business, financial condition or results
of operations of Conseco. In addition, please refer to the "Cautionary Statement
Regarding Forward-Looking Statements" above.
Certain purported class action lawsuits could harm our financial strength
and reduce our profitability.
We and several of our present and former subsidiaries have been named as
defendants in various purported class action lawsuits. Our former subsidiary,
Manhattan National Life Insurance Company, is a defendant in a purported
nationwide class action lawsuit which seeks unspecified damages in New Mexico
state court for alleged fraud by non-disclosure of additional charges to
policyholders who desired to pay premiums on other than an annual basis. Four of
our subsidiaries have also been named in a purported nationwide class action
lawsuit which seeks unspecified damages in Colorado state court for alleged
claims similar to those aforementioned in the New Mexico suit.
In addition, our subsidiary, Conseco Life Insurance Company, or Conseco
Life, has also been named as a defendant in multiple purported class actions and
individual cases alleging, among other things, breach of contract, violation of
California Business and Professions Code Section 17200, fraud and
misrepresentation regarding a change made in 2003 and 2004 in the way cost of
insurance charges and related monthly deductions were calculated for
approximately 86,500 life insurance policies. In April 2005, a nationwide class
was certified with respect to the breach of contract claim and, in California, a
statewide class was certified for injunctive and restitutionary relief pursuant
to California Business and Professions Code Section 17200 and breach of the duty
of good faith and fair dealing. These claims allege that the change to the
calculation of cost of insurance charges allowed us to add $360 million to our
balance sheet. They seek, among other things, an injunction that would require
the reinstatement of the prior method for calculating monthly cost of insurance
charges, and a refund of any additional charges that resulted from the change.
In addition, state insurance departments have inquired about this change to the
calculation of monthly deductions.
The ultimate outcome of these lawsuits cannot be predicted with certainty.
In addition, we and our subsidiaries may become subject to similar litigation in
other jurisdictions. These lawsuits and any future lawsuits could, individually
or in the aggregate, have a material adverse effect on our financial condition,
and it is possible that an adverse determination in pending litigation could,
from time to time, have a material adverse effect on our consolidated results of
operations or cash flows in particular quarterly or annual periods. Because our
insurance subsidiaries were not part of the bankruptcy proceedings underwent by
our predecessor company and some of its non-insurance subsidiaries, those
proceedings did not result in the discharge of any claims, including claims
asserted in litigation, against our insurance subsidiaries.
The 2002 bankruptcy of our predecessor company and some of its subsidiaries
disrupted our operations and damaged the "Conseco" brand. As a result, we
may continue to experience lower sales, increased agent attrition and
policyholder lapses and redemptions.
The announcement of our predecessor's intention to seek a restructuring of
its capital in August 2002 and the subsequent filing of bankruptcy petitions by
our predecessor company and some of its non-insurance subsidiaries in December
2002 caused significant disruptions in our predecessor's operations. We believe
that adverse publicity in national and local media concerning our predecessor's
distressed financial condition and its disputes with former members of
management caused sales of our insurance products to decline and policyholder
lapses and redemptions to increase. For example, our total premium collections
decreased by 7.2 percent to $3,881.4 million and 8.4 percent to $4,180.9 million
for the years ended December 31, 2004 and 2003, respectively, compared to the
prior year. In addition, withdrawals from annuities and other investment-type
products exceeded deposits by $147.4 million and $615.4 million during the years
ended December 31, 2004 and 2003, respectively.
We also experienced increased agent attrition, which, in some cases, led us
to increase agents' commissions or sales incentives in order to retain agents.
For example, the number of producing agents and sales managers selling products
through the Conseco Insurance Group segment decreased by approximately 29
percent to 6,200 at December 31, 2004, compared to December 31, 2003. The number
of career agents selling products through the Bankers Life segment remained at
approximately 4,600 throughout 2004. We implemented sales incentive programs for
our agents to retain them during the period when we experienced much negative
publicity, lower ratings and increased activity from competitor agents. The
total cost for the agent incentive programs during 2003 and 2002 was $17
million.
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CONSECO, INC. AND SUBSIDIARIES
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While we cannot precisely quantify the damage to the Conseco brand caused
by the negative publicity of our predecessor's distressed financial condition,
we believe these events contributed significantly to the trends indicated above.
The successful completion of the bankruptcy and capital restructuring in 2003
and 2004, respectively, have begun to reverse some of these trends; however, we
do not expect our sales to return to pre-bankruptcy levels in the near-term.
A failure to improve the financial strength ratings of our insurance
subsidiaries could cause us to experience decreased sales, increased agent
attrition and increased policyholder lapses and redemptions.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. Agents,
insurance brokers and marketing companies who market our products, and
prospective policyholders view ratings as an important factor in evaluating an
insurers' products. This is especially true for annuity, interest-sensitive life
insurance and long-term care products. Our insurance companies' financial
strength ratings were downgraded by all of the major rating agencies beginning
in July 2002 in connection with the financial distress that ultimately led to
our predecessor company's bankruptcy. This ratings decline was a primary factor
in the decreased sales of our insurance products and the increased policyholder
redemptions and lapses beginning in 2002. We also experienced increased agent
attrition, which, in some cases, led us to increase commissions or sales
incentives in an effort to retain them. These events have hindered our ability
to market our products and to recruit and retain agents, which, in turn, has
negatively impacted our financial results. The financial strength ratings of our
primary insurance subsidiaries (other than Conseco Senior Health Insurance
Company, or "Conseco Senior") were upgraded in the second quarter of 2004 by
A.M. Best, S&P and Moody's and again in the third quarter of 2004 by Moody's.
The current financial strength ratings of our primary insurance subsidiaries
(other than Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very
Good)," "BB+" and "Ba1," respectively. The ratings of Conseco Senior from A.M.
Best, S&P and Moody's are "B (Fair)," "CCC" and "Caa1," respectively. The "B++"
rating and the "B" rating from A.M. Best are the fifth and seventh highest,
respectively, of sixteen possible ratings. The "BB+" rating and the "CCC" rating
from S&P are the eleventh and eighteenth highest, respectively, of twenty-one
possible ratings. The "Ba1" rating and the "Caa1" rating from Moody's are the
eleventh and seventeenth highest of twenty-one possible ratings. While we or our
subsidiaries have recently been assigned positive ratings outlooks by these
agencies, most of our competitors have higher financial strength ratings and we
believe it is critical for us to continue to improve our ratings to be
competitive.
If we fail to achieve and maintain an "A" category rating from A.M. Best,
we may continue to experience declining sales of our insurance products,
additional defections of our independent and career sales force, and increased
policies being redeemed or allowed to lapse. These events would adversely affect
our financial results, which could then lead to further downgrades.
Our results of operations may be negatively impacted if we are unable to
achieve the goals of our initiatives to restructure our principal insurance
businesses.
Our Conseco Insurance Group segment has experienced declining sales as well
as expense levels that exceed product pricing. We have implemented several
initiatives to improve operating results, including: (i) focusing sales efforts
on higher margin products, such as our specified disease products; (ii) reducing
operating expenses by eliminating or reducing marketing costs of certain
products; (iii) streamlining administrative procedures and reducing personnel;
(iv) increasing retention rates on our more profitable blocks of inforce
business; and (v) stabilizing the profitability of the long-term care block of
business in run-off sold through independent agents through premium rate
increases, improved claim adjudication procedures and other actions. Many of our
initiatives address issues resulting from the substantial number of acquisitions
of our predecessor. Between 1982 and 1997, our predecessor completed 19
transactions involving the acquisitions of 44 separate insurance companies. Our
efforts involve improvements to our policy administration procedures and
significant systems conversions, such as the elimination of duplicate processing
systems for similar business. These initiatives may result in unforeseen
expenses, complications or delays, and may be inadequate to address all issues.
Conversions to new processing systems can result in valuation differences
between the prior system and the new system. These differences have not been
material to us in the past. Our planned conversions could result in such
valuation adjustments, and there can be no assurance that the adjustments would
not be material to future earnings. Further, some of these initiatives have only
recently begun to be executed, and may not ultimately be successfully
accomplished. We expect to spend over $10 million on capital expenditures during
the remainder of 2005 (including amounts related to these initiatives). While
our future operating performance depends greatly on the success of these
efforts, even if we successfully implement these measures, they alone may not
sufficiently improve our results of operations.
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The results of operations of our insurance business will decline if our
premium rates are not adequate or if we are unable to obtain regulatory
approval to increase rates.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, maintenance costs to
administer the policies and the interest rate earned on our investment of
premiums. In setting premium rates, we consider historical claims information,
industry statistics, the rates of our competitors and other factors, but we
cannot predict with certainty the future actual claims on our products. If our
actual claims experience proves to be less favorable than we assumed and we are
unable to raise our premium rates, our financial results may be adversely
affected.
Most of our supplemental health policies allow us to increase premium rates
when warranted by our actual claims experience. These rate increases must be
approved by the applicable state insurance departments, and we are required to
submit actuarial claims data to support the need for such rate increases. The
re-rate application and approval process on supplemental health products is a
normal recurring part of our business operations and reasonable rate increases
are typically approved by the state departments as long as they are supported by
actual claims experience and are not unusually large in either dollar amount or
percentage increase. For policy types on which rate increases are a normal
recurring event, our estimates of insurance liabilities assume we will be able
to raise rates if the blocks warrant such increases in the future.
The benefit ratio for our long-term care products, included in the other
business in run-off segment, has increased in recent periods and was 98 percent
during the six months ended June 30, 2005. We will have to raise rates or take
other actions with respect to some of these policies or our financial results
will be adversely affected. During the first six months of 2005, as well as
2004, 2003 and 2002, we received approvals for rate increases totaling $5
million, $48 million, $37 million and $44 million, respectively, relating to
this long-term care business, which had approximately $380 million of collected
premiums in 2004.
We review the adequacy of our premium rates regularly and file proposed
rate increases on our products when we believe existing premium rates are too
low. It is possible that we will not be able to obtain approval for premium rate
increases from currently pending requests or from future requests. If we are
unable to raise our premium rates because we fail to obtain approval in one or
more states, our net income may decrease. Moreover, in some instances, our
ability to exit unprofitable lines of business is limited by the guaranteed
renewal feature of the policy. Due to this feature, we cannot exit such business
without regulatory approval, and accordingly, we may be required to continue to
service those products at a loss for an extended period of time. Most of our
long-term care business is guaranteed renewable, and, if necessary rate
increases were not approved, we would be required to recognize a loss and
establish a premium deficiency reserve.
If, however, we were successful in obtaining regulatory approval to raise
premium rates, the increased premium rates may reduce the volume of our new
sales and cause existing policyholders to allow their policies to lapse. This
could result in a significantly higher ratio of claim costs to premiums if
healthier policyholders who get coverage elsewhere allow their policies to
lapse, while policies of less healthy policyholders continue inforce. This would
reduce our premium income and profitability in future periods.
On home health care policies issued in some areas of Florida and other
states, payments made for the benefit of policyholders have exceeded premiums
received by a significant margin. Substantially all of these policies were
issued through independent agents by certain of our subsidiaries prior to their
acquisitions by us in 1996 and 1997. On April 20, 2004, the Florida Office of
Insurance Regulation issued an order to our subsidiary, Conseco Senior, which
affects approximately 11,000 home health care policies issued in Florida by
Conseco Senior and its predecessor companies. Pursuant to the order, Conseco
Senior must offer the following three alternatives to holders of these policies:
o retention of their current policy with a rate increase of 50 percent
in the first year and actuarially justified increases in subsequent
years;
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15 percent
in subsequent years; and
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CONSECO, INC. AND SUBSIDIARIES
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o receipt of a paid up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy.
We completed the process of notifying our home health care policyholders of
these choices in the second quarter of 2005. We expect to know the results of
most policyholder elections by September 30, 2005.
On July 1, 2004, the Florida Office of Insurance Regulation issued a
similar order impacting approximately 4,500 home health care policies that are
the obligations of one of our other insurance subsidiaries, Washington National
Insurance Company, or Washington National. We expect to complete the process of
notifying these policyholders of their choices in the third quarter of 2005. The
orders also require Conseco Senior and Washington National to pursue a similar
course of action with respect to approximately 24,000 home health care policies
issued in other states, subject to consideration and approval by other state
insurance departments. If we are unsuccessful in obtaining rate increases or
other forms of relief in other states, or if the policy changes approved by the
Florida Office of Insurance Regulation prove inadequate, our future results of
operations could be adversely affected.
We are also aggressively seeking rate increases on other long-term care
policies in our other business in run-off segment. If we are unable to obtain
these rate increases, the profitability of these policies and the performance of
this block of business could be adversely affected.
The limited historical claims experience on our long-term care products
could negatively impact our operations if our estimates prove wrong and we
have not adequately set premium rates.
In setting premium rates, we consider historical claims information and
other factors, but we cannot predict future claims with certainty. This is
particularly applicable to our long-term care insurance products, for which we
have relatively limited historical claims experience. Long-term care products
tend to have fewer claims than other health products such as Medicare
supplement, but when claims are incurred, they tend to be much higher in dollar
amount. Also, long-term care products have a much longer tail, meaning that
claims are incurred much later in the life of the policy than most other
supplemental health products. As a result of these traits, longer historical
experience is necessary to appropriately price products.
Our Bankers Life segment has offered long-term care insurance since 1985.
Bankers Life's claims experience on its long-term care blocks has generally been
lower than its pricing expectations. However, the lapses on these policies have
been lower than our pricing expectations and this is expected to result in
higher benefit ratios in the future.
The long-term care insurance businesses included in the other business in
run-off segment were acquired through acquisitions completed in 1996 and 1997.
The majority of such business was written between 1990 and 1997. The experience
on these acquired blocks has generally been worse than the acquired companies'
original pricing expectations. We have received necessary regulatory approvals
for numerous premium rate increases in recent years pertaining to these blocks.
Even with these rate increases, these blocks experienced benefit ratios of 98
percent in the six months ended June 30, 2005, 103 percent in 2004, 103 percent
in the four months ended December 31, 2003, 170 percent in the eight months
ended August 31, 2003, and 139 percent in 2002. If future claims experience
proves to be worse than anticipated as our long-term care blocks continue to
age, our financial results could be adversely affected.
Our reserves for future insurance policy benefits and claims may prove to
be inadequate, requiring us to increase liabilities and resulting in
reduced net income and shareholders' equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders primarily based on assumptions made by our
actuaries. For our life insurance business, our limit of risk retention for each
policy is generally $0.8 million or less because amounts above $0.8 million are
ceded to reinsurers. For our health insurance business, we establish an active
life reserve, a liability for due and unpaid claims, claims in the course of
settlement, and incurred but not reported claims, and a reserve for the present
value of amounts on claims not yet due. We establish reserves based on
assumptions and estimates of factors either established at the fresh-start date
for business inforce then or considered when we set premium rates for business
written after that date.
Many factors can affect these reserves and liabilities, such as economic
and social conditions, inflation, hospital and pharmaceutical costs, regulatory
actions, changes in doctrines of legal liability and extra-contractual damage
awards. Therefore, the reserves and liabilities we establish are necessarily
based on estimates, assumptions and prior years' statistics.
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It is possible that actual claims will materially exceed our reserves and have a
material adverse effect on our results of operations and financial condition. We
have incurred significant losses beyond our estimates as a result of actual
claim costs and persistency of our long-term care business included in the other
business in run-off segment. For example, we increased claim reserves by $130
million during 2002 and $85 million during the eight months ended August 31,
2003, as a result of adverse developments and changes in our estimates of
ultimate claims for these products. Our financial performance depends
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in setting our reserves. If our
assumptions with respect to future claims are incorrect, and our reserves prove
to be insufficient to cover our actual losses and expenses, we would be required
to increase our liabilities, and our financial results could be adversely
affected.
Our ability to meet our obligations may be constrained by our subsidiaries'
ability to distribute cash to us.
Conseco, Inc. and CDOC, Inc., our wholly owned subsidiary and a guarantor
under our senior credit facility, are holding companies with no business
operations of their own. As a result, they depend on their operating
subsidiaries for cash to make principal and interest payments on debt, including
the debentures, 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 us or CDOC for any reason could limit their
ability to pay cash dividends or other disbursements to us and CDOC. In
addition, we may need to contribute additional capital to improve the risk-based
capital ratios of certain insurance subsidiaries and this could affect the
ability of our top tier insurance subsidiary to pay dividends. Accordingly, this
would limit the ability of CDOC and us to meet debt service requirements and
satisfy other financial obligations.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of, or in a few states, the lesser of:
o statutory net gain from operations or statutory net income for the
prior year; or
o 10 percent of statutory capital and surplus at the end of the
preceding year.
Any dividends in excess of these levels, as well as principal and interest
payments on surplus debentures, require the approval of the director or
commissioner of the applicable state insurance department. The following table
sets forth the aggregate amount of dividends and other distributions that our
insurance subsidiaries paid to us in each of the last two fiscal years (dollars
in millions) and for the six-month period ended June 30, 2005:
Six Months
Ended
June 30, Year Ended December 31,
---------- -----------------------
2005 2004 2003
---- ---- ----
Dividends................................................... $ - $ 45.8 $4.5
Surplus debenture interest, which for 2004 included $148.0
million related to prior years............................ 25.4 192.1 -
----- ------ ----
Total paid............................................. $25.4 $237.9 $4.5
===== ====== ====
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Our Credit Facility contains various restrictive covenants and required
financial ratios that limit our operating flexibility.
As of June 30, 2005, we had $767.1 million principal amount of debt
outstanding under our Credit Facility. The Credit Facility imposes a number of
covenants and financial ratios that we must meet or maintain, including required
earnings before interest, taxes, depreciation and amortization, as defined in
the senior credit facility, of greater than or equal to: $725.0 million for each
rolling four quarters ending through December 31, 2005; $775.0 million for each
rolling four quarters ending during the period January 1, 2006, through December
31, 2006; and $825.0 million for each rolling four quarters thereafter. Our
required earnings, as defined in the Credit Facility, exceeded $1.0 billion for
the four quarters ended June 30, 2005, and therefore we were in compliance.
Although our forecasts indicate we will meet and/or maintain all of the Credit
Facility's covenants and financial ratios, our ability to do so may be affected
by events beyond our control.
Our Credit Facility also imposes restrictions that limit our flexibility to
plan for and react to changes in the economy and industry, thereby increasing
our vulnerability to adverse economic and industry conditions. These
restrictions include limitations on our ability to: (i) incur additional
indebtedness; (ii) transfer or sell assets; (iii) enter into mergers or other
business combinations; (iv) pay cash dividends or repurchase stock; and (v) make
investments and capital expenditures.
We are in the process of amending and restating our Credit Facility. The
amended and restated senior credit facility will continue to impose a number of
covenants and financial ratios that we must meet or maintain.
S&P and Moody's have assigned ratings on our senior secured debt of "BB-
(Marginal)" and "B2 (Poor)," respectively. In S&P's view, an obligation rated
"BB-" is less vulnerable to nonpayment than other speculative issues, but the
obligor currently has the capacity to meet its obligation. S&P has a total of
twenty-two separate categories rating senior debt, ranging from "AAA (Extremely
Strong)" to "D (Payment Default)." A "BB-" rating is the thirteenth highest
rating. In Moody's view, an obligation rated "B" generally lacks characteristics
of a desirable investment, and any assurance of interest or principal payments
or of maintenance of other terms of the contract over any long period of time
may be small. Moody's has a total of twenty-one separate categories in which to
rate senior debt, ranging from "Aaa (Exceptional)" to "C (Lowest Rated)." A "B2"
rating is the fifteenth highest rating. If we were to require additional
capital, either to refinance our existing indebtedness or to help fund future
growth, our current senior debt ratings could restrict our access to such
capital.
Our net income and revenues will suffer if policyholder surrender levels
differ significantly from our assumptions.
Surrenders of our annuities and life insurance products can result in
losses and decreased revenues if surrender levels differ significantly from
assumed levels. At June 30, 2005, approximately 18 percent of our total
insurance liabilities, or approximately $4.4 billion, could be surrendered by
the policyholder without penalty. The surrender charges that are imposed on our
fixed rate annuities typically decline during a penalty period, which ranges
from five to twelve years after the date the policy is issued. Surrenders and
redemptions could require us to dispose of assets earlier than we had planned,
possibly at a loss. Moreover, surrenders and redemptions require faster
amortization of either the acquisition costs or the commissions associated with
the original sale of a product, thus reducing our net income. We believe
policyholders are generally more likely to surrender their policies if they
believe the issuer is having financial difficulties, or if they are able to
reinvest the policy's value at a higher rate of return in an alternative
insurance or investment product.
For example, policyholder redemptions of annuity and, to a lesser extent,
life products increased after the downgrade of our A.M. Best financial strength
rating to "B (Fair)" in August of 2002. When redemptions exceed our previous
assumptions, we are required to accelerate the amortization of the value of
policies inforce at the Effective Date, and the cost of policies produced (such
amortization is collectively referred to as "amortization of insurance
acquisition costs") to write off the balance associated with the redeemed
policies. We recorded additional amortization related to higher redemptions and
changes to our lapse assumptions of $203.2 million in 2002. Such additional
amortization was not significant in 2003 or 2004.
Recently enacted and future legislation could adversely affect the
financial performance of our insurance operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and pending legislative proposals concerning
healthcare reform contain features that could severely limit, or eliminate, our
ability to vary pricing terms or apply medical underwriting standards to
individuals, thereby potentially increasing our benefit ratios and adversely
impacting our financial results. In
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CONSECO, INC. AND SUBSIDIARIES
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particular, Medicare reform could affect our ability to price or sell our
products or profitably maintain our blocks inforce. For example, the Medical
Advantage program provides incentives for health plans to offer managed care
plans to seniors. The growth of managed care plans under this program could
decrease sales of the traditional Medicare supplement products we sell.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards 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 information regarding lapse and replacement rates for
policies and the percentage of claims denied. Enactment of any proposal that
would limit the amount we can charge for our products, such as guaranteed
premium rates, or that would increase the benefits we must pay, such as
limitations on waiting periods, or that would otherwise increase the costs of
our business, could adversely affect our financial results.
Tax law changes could adversely affect our insurance product sales and
profitability.
We sell deferred annuities and some forms of life insurance that are
attractive, 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, to reduce the federal estate tax gradually over a ten-year period
(with total elimination of the federal estate tax in 2010) and to increase
contributions that may be made to individual retirement accounts and 401(k)
accounts. While these tax law changes will expire at the beginning of 2011
absent future congressional action, they could in the interim diminish the
appeal of our annuity and life insurance products because the benefit of tax
deferral is lessened when tax rates are lower and because fewer people may
purchase these products when they can contribute more to individual retirement
accounts and 401(k) accounts. Additionally, Congress has considered, from time
to time, other possible changes to U.S. tax laws, including elimination of the
tax deferral on the accretion of value within certain annuities and life
insurance products. Such a change would make these products less attractive to
prospective purchasers and therefore would be likely to reduce our sales of
these products.
Our investment portfolio is subject to several risks that may diminish the
value of our invested assets and negatively impact our profitability.
The value of our investment portfolio is subject to numerous factors, which
are difficult to predict, and are, in many instances, beyond our control. These
factors include, but are not limited to, the following:
o Changes in interest rates can reduce the value of our investments.
Actively managed fixed maturity investments comprised 90 percent of
our total investments as of June 30, 2005. An increase in interest
rates of 10 percent could reduce the value of our actively managed
fixed maturity investments and short-term investments, net of
corresponding changes in insurance acquisition costs, by approximately
$625 million, in the absence of other factors.
o Our actively managed fixed maturity investments are subject to a risk
regarding the ability of the issuers to make timely repayments of the
securities. This risk is significantly greater with respect to
below-investment grade securities, which comprised 3.3 percent of our
actively managed fixed maturity investments as of June 30, 2005. We
have sustained substantial credit-related investment losses in recent
periods when a number of large, highly leveraged issuers experienced
significant financial difficulties. For example, we have recognized
other-than-temporary declines in value on several of our investments,
including K-Mart Corp., Amerco, Inc., Global Crossing, MCI
Communications, Mississippi Chemical, United Airlines and Worldcom,
Inc. We have recorded writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which
caused us to conclude a decline in the fair value of the investment
was other than temporary as follows: $1.3 million in the first six
months of 2005; $18.1 million in 2004; $9.6 million in the four months
ended December 31, 2003; $51.3 million in the eight months ended
August 31, 2003; and $556.8 million in 2002.
In order to reduce our exposure to similar credit losses, we have taken a
number of specific steps, including:
34
CONSECO, INC. AND SUBSIDIARIES
-------------------
o reducing the percentage of below-investment grade fixed maturity
investments from 5.9 percent at December 31, 2001, to 3.3 percent at
June 30, 2005;
o implementing conservative portfolio compliance guidelines which
generally limit our exposure to single issuer risks; and
o expanding our portfolio reporting procedures to proactively identify
changes in value related to credit risk in a more timely manner.
Our structured security investments, which comprised 26 percent of our
actively managed fixed maturity investments at June 30, 2005, are subject to
risks relating to variable prepayment and default on the assets underlying such
securities, such as mortgage loans. To the extent that structured security
investments prepay faster than the expected rate of repayment, refinancing or
default on the underlying assets, such investments, which have a cost basis in
excess of par, may be redeemed at par, thus resulting in a loss.
Our need for liquidity to fund substantial product surrenders or policy
claims may require that we maintain highly liquid, and therefore lower-yielding,
assets, or that we sell assets at a loss, thereby further eroding the
performance of our portfolio.
We have sustained substantial investment losses in the past and may again
in the future. Because a substantial portion of our net income is derived from
returns on our investment portfolio, significant losses in the portfolio may
have a direct and materially adverse impact on our results of operations. In
addition, losses on our investment portfolio could reduce the investment returns
that we are able to credit to our customers of certain products, thereby
impacting our sales and further eroding our financial performance.
Changing interest rates may adversely affect our results of operations.
Our profitability is directly affected by fluctuating interest rates. While
we monitor the interest rate environment and have previously employed hedging
strategies to mitigate such impact, 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 to customer deposits. Our ability to
adjust for such a compression is limited by the guaranteed minimum rates that we
must credit to policyholders on certain products, as well as the terms on most
of our other products that limit reductions in the crediting rates to
pre-established intervals. As of June 30, 2005, approximately 42 percent of our
insurance liabilities were subject to interest rates that may be reset annually;
46 percent had a fixed explicit interest rate for the duration of the contract;
8 percent had credited rates that approximate the income we earn; and the
remainder had no explicit interest rates. Second, if interest rate changes
produce an unanticipated increase in surrenders of our spread-based products, we
may be forced to sell invested assets at a loss in order to fund such
surrenders. Third, the profits from many non-spread-based insurance products,
such as long-term care policies, are also adversely affected when interest rates
decline because we may be unable to reinvest the cash from premiums received at
the interest rates anticipated when we sold the policies. Finally, changes in
interest rates can have significant effects on the performance of our structured
securities portfolio, including collateralized mortgage obligations, as a result
of changes in the prepayment rate of the loans underlying such securities. We
follow asset/liability strategies that are designed to mitigate the effects of
interest rate changes on our profitability but do not currently employ
derivative instruments for this purpose. We may not be successful in
implementing these strategies and achieving adequate investment spreads.
We use computer models to simulate our cash flows expected from existing
business under various interest rate scenarios. These simulations help us
measure the potential gain or loss in fair value of our interest-sensitive
financial instruments. With such estimates, we seek to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, exposure to
interest rate risk is minimized because a change in the value of assets should
be largely offset by a change in the value of liabilities. At June 30, 2005, the
duration of our fixed maturity securities was approximately 6.3 years, and the
duration of our insurance liabilities was approximately 7.4 years. We estimate
that our fixed maturity securities and short-term investments, net of
corresponding changes in insurance acquisition costs, would decline in fair
value by approximately $625 million if interest rates were to increase by 10
percent from rates as of June 30, 2005. This compares to a decline in fair value
of $630 million based on amounts and rates at December 31, 2004. The
calculations involved in our computer simulations incorporate numerous
35
CONSECO, INC. AND SUBSIDIARIES
-------------------
assumptions, require significant estimates and assume an immediate change in
interest rates without any management reaction to such change. Consequently,
potential changes in the values of our financial instruments indicated by the
simulations will likely be different from the actual changes experienced under
given interest rate scenarios, and the differences may be material. Because we
actively manage our investments and liabilities, our net exposure to interest
rates can vary over time.
Volatility in the securities markets, and other economic factors, may
adversely affect our business, particularly our sales of certain life
insurance products and annuities.
Fluctuations in the securities markets and other economic factors may
adversely affect sales and/or policy surrenders of our annuities and life
insurance policies. For example, volatility in the equity markets may deter
potential purchasers from investing in equity-indexed annuities and may cause
current policyholders to surrender their policies for the cash value or to
reduce their investments. For example, our sales of these products decreased
significantly in 2001 and 2002 during periods of significant declines in the
equity markets. Sales of equity-indexed annuities totaled $220.1 million in 2002
as compared to $380.9 million in 2001. In addition, significant or unusual
volatility in the general level of interest rates could negatively impact sales
and/or lapse rates on certain types of insurance products.
We are subject to further risk of loss notwithstanding our reinsurance
agreements.
We transfer exposure to certain risks to others through reinsurance
arrangements. Under these arrangements, other insurers assume a portion of our
losses and expenses associated with reported and unreported claims in exchange
for a portion of policy premiums. The availability, amount and cost of
reinsurance depend on general market conditions and may vary significantly. As
of June 30, 2005, our reinsurance receivables totaled $897.0 million. Our ceded
life insurance inforce totaled $18.8 billion. Our seven largest reinsurers
accounted for 84 percent of our ceded life insurance inforce. We face credit
risk with respect to reinsurance. When we obtain reinsurance, we are still
liable for those transferred risks if the reinsurer cannot meet its obligations.
Therefore, the inability of our reinsurers to meet their financial obligations
may require us to increase liabilities, thereby reducing our net income and
shareholders' equity.
Our business is subject to extensive regulation, which limits our operating
flexibility and could result in our insurance subsidiaries being placed
under regulatory control or otherwise negatively impact our financial
results.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate. Our insurance subsidiaries are subject
to state insurance laws that establish supervisory agencies. Such agencies have
broad administrative powers including: granting and revoking licenses to
transact business; regulating sales and other practices; approving premium rate
increases; licensing agents; approving policy forms; setting reserve and
solvency requirements; determining the form and content of required statutory
financial statements; limiting dividends; and prescribing the type and amount of
investments insurers can make. The regulations issued by state insurance
agencies can be complex and subject to differing interpretations. If a state
insurance regulatory agency determines that one of our insurance company
subsidiaries is not in compliance with applicable regulations, the subsidiary is
subject to various potential administrative remedies including, without
limitation, monetary penalties, restrictions on the subsidiary's ability to do
business in that state and a return of a portion of policyholder premiums.
During its bankruptcy period and throughout most of 2003, our predecessor
operated under heightened scrutiny from state insurance regulators and under
certain consent orders, thereby restricting the ability of its insurance
subsidiaries to pay any dividends or other amounts to any non-insurance company
parent without prior approval. The successful completions of the bankruptcy in
2003 and capital restructuring in 2004 reduced the level of scrutiny from our
state insurance regulators; however, we cannot be assured that regulators will
not seek to assert greater supervision and control over our insurance
subsidiaries' businesses and financial affairs in the future. If our financial
condition were to deteriorate, we may be required to enter into similar orders
in the future.
Our insurance subsidiaries are also subject to risk-based capital
requirements. These requirements were designed to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks
associated with asset quality, mortality and morbidity, asset and liability
matching and other business factors. The requirements are used by states as an
early warning tool to discover potentially weakly-capitalized companies for the
purpose of initiating regulatory action. Generally, if an insurer's risk-based
capital falls below specified levels, the insurer would be subject to different
degrees of regulatory action depending upon the magnitude of the deficiency. The
2004 statutory annual statements filed with the state insurance regulators of
each of our insurance subsidiaries reflected total adjusted capital in excess of
the levels subjecting the subsidiaries to any regulatory action. However, as a
result of losses on the long-term care business within the other business
36
CONSECO, INC. AND SUBSIDIARIES
-------------------
in run-off segment, the risk-based capital ratio of Conseco Senior, which issued
most of the long-term care business in our other business in run-off segment,
was near the level at which it would have been required to submit a
comprehensive plan to insurance regulators proposing corrective actions aimed at
improving its capital position.
Our insurance subsidiaries may be required to pay assessments to fund
policyholder losses or liabilities and this may negatively impact our
financial results.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments up to certain
prescribed limits to fund policyholder losses or liabilities of other insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Although past assessments have not been material, if there were a
number of large insolvencies, future assessments could be material and could
have a material adverse effect on our operating results and financial position.
Litigation and regulatory investigations are inherent in our business and
may harm our financial strength and reduce our profitability.
Insurance companies historically have been subject to substantial
litigation resulting from claims, disputes and other matters. In addition to the
traditional policy claims associated with their businesses, insurance companies
typically face policyholder suits and class action suits. The class action and
policyholder suits are often in connection with insurance sales practices,
policy and claims administration practices and other market conduct issues.
State insurance departments focus on sales practices and product issues in their
market conduct examinations. Negotiated settlements of class action and other
lawsuits have had a material adverse effect on the business, financial condition
and results of operations of insurance companies. We are, in the ordinary course
of our business, a plaintiff or defendant in actions arising out of our
insurance business, including class actions and reinsurance disputes, and, from
time to time, we are also involved in various governmental and administrative
proceedings and investigations. The ultimate outcome of these lawsuits and
investigations, however, cannot be predicted with certainty. They could,
individually or in the aggregate, have a material adverse effect on our
financial condition. Because our insurance subsidiaries were not part of the
bankruptcy proceedings underwent by our predecessor company and some of its
non-insurance subsidiaries, those proceedings did not result in the discharge of
any claims, including claims asserted in litigation, against our insurance
subsidiaries.
Competition from companies that have greater market share, higher ratings
and greater financial resources may impair our ability to retain existing
customers and sales representatives, attract new customers and sales
representatives and maintain or improve our financial results.
The supplemental health insurance, annuity and individual life insurance
markets are highly competitive. Competitors include other life and accident and
health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
Our principal competitors vary by product line. Our main competitors for
agent sold long-term care insurance products include Genworth Financial, John
Hancock Financial Services, Lincoln Benefit Life, MetLife and Unum Provident.
Our main competitors for agent sold Medicare supplement insurance products
include Mutual of Omaha, Blue Cross and Blue Shield, United Teachers Associates
Insurance Company, Central Reserve Life Insurance Company and Standard Life and
Accident.
In some of our product lines, such as life insurance and fixed annuities,
we have a relatively small market share. Even in some of the lines in which we
are one of the top five writers, our market share is relatively small. For
example, while our Bankers Life segment ranked fourth in annualized premiums of
individual long-term care insurance in 2004 with a market share of approximately
9 percent, the top three writers of individual long-term care insurance had
annualized premiums with a combined market share of approximately 51 percent
during the period. In addition, while our Bankers Life segment was ranked third
in annualized premiums of individual Medicare supplement insurance in 2004 with
a market share of approximately 14 percent, the top two writers of individual
Medicare supplement insurance had annualized premiums with a combined market
share of approximately 68 percent during the period.
Virtually all of our major competitors have higher financial strength
ratings than we do. Many of our competitors are larger companies that have
greater capital, technological and marketing resources and have access to
capital at a lower cost. Recent industry consolidation, including business
combinations among insurance and other financial services companies, has
resulted in larger competitors with even greater financial resources.
Furthermore, changes in federal law have narrowed the
37
CONSECO, INC. AND SUBSIDIARIES
-------------------
historical separation between banks and insurance companies, enabling
traditional banking institutions to enter the insurance and annuity markets and
further increase competition. This increased competition may harm our ability to
maintain or improve our profitability.
In addition, because the actual cost of products is unknown when they are
sold, we are subject to competitors who may sell a product at a price that does
not cover its actual cost. Accordingly, if we do not also lower our prices for
similar products, we may lose market share to these competitors. If we lower our
prices to maintain market share, our profitability will decline.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among insurance and financial
services companies for sales representatives. We compete for sales
representatives primarily on the basis of our financial position, financial
strength ratings, support services, 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 and profitability would suffer.
38
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
We manage our business through the following: two primary operating
segments, Bankers Life and Conseco Insurance Group, which are defined on the
basis of product distribution; a third segment comprised of other business in
run-off; and corporate operations, which consists of holding company activities
and certain noninsurance businesses. The following tables and narratives
summarize the operating results of our segments for the periods presented
(dollars in millions):
Three months ended Six months ended
June 30, June 30,
-------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Income (loss) before net realized investment gains (losses),
net of related amortization,
and income taxes (a non-GAAP measure) (a):
Bankers Life.............................................. $ 68.4 $ 53.7 $127.2 $110.1
Conseco Insurance Group................................... 66.1 68.6 130.5 129.1
Other Business in Run-off................................. 21.4 15.6 42.9 30.5
Corporate operations...................................... (22.8) (27.5) (43.4) (66.6)
------ ------ ------ ------
133.1 110.4 257.2 203.1
------ ------ ------ ------
Net realized investment gains (losses),
net of related amortization:
Bankers Life.............................................. .5 .4 2.4 11.4
Conseco Insurance Group................................... 5.2 (3.1) 4.3 5.7
Other Business in Run-off................................. 2.4 (.9) 4.5 1.8
Corporate operations...................................... (1.3) - (1.3) (2.8)
------ ------ ------ ------
6.8 (3.6) 9.9 16.1
------ ------ ------ ------
Income (loss) before taxes:
Bankers Life.............................................. 68.9 54.1 129.6 121.5
Conseco Insurance Group................................... 71.3 65.5 134.8 134.8
Other Business in Run-off................................. 23.8 14.7 47.4 32.3
Corporate operations...................................... (24.1) (27.5) (44.7) (69.4)
------ ------ ------ ------
Income before taxes.................................... $139.9 $106.8 $267.1 $219.2
====== ====== ====== ======
<FN>
- ------------
(a) We believe that an analysis of income (loss) before net realized
investment gains (losses), net of related amortization, and income taxes
(a non-GAAP measure) is important to evaluate the financial performance of
the Company, and is a measure commonly used in the life insurance
industry. Management uses this measure to evaluate performance because
realized gains or losses can be affected by events that are unrelated to a
company's underlying fundamentals. However, the non-GAAP measure does not
replace the corresponding GAAP measure. The table above reconciles the
non-GAAP measure to the corresponding GAAP measure.
</FN>
General: Conseco is the top tier holding company for a group of insurance
companies operating throughout the United States that develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. We distribute these products through our Bankers Life
segment, which utilizes a career agency force and direct response marketing, and
through our Conseco Insurance Group segment, which utilizes professional
independent producers. Our Other Business in Run-off segment consists of: (i)
long-term care products written in prior years through independent agents; (ii)
small group and individual major medical business which we stopped renewing in
2001; and (iii) other group major medical business which we no longer market.
Most of the long-term care business in run-off relates to business written by
certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997.
39
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Premium collections:
Annuities.................................................. $ 238.6 $ 230.4 $ 460.3 $ 407.7
Supplemental health........................................ 304.5 293.2 618.1 596.3
Life....................................................... 55.7 41.1 104.3 84.1
-------- -------- -------- --------
Total collections........................................ $ 598.8 $ 564.7 $1,182.7 $1,088.1
======== ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based........................................ $ 355.6 $ 358.4 $ 355.3 $ 356.8
Equity-indexed......................................... 310.0 271.4 305.5 269.1
Deposit based.......................................... 4,041.3 3,406.5 3,982.0 3,347.1
Health................................................... 3,029.0 2,773.6 2,996.2 2,742.8
Life:
Interest sensitive..................................... 350.9 331.8 348.5 331.4
Non-interest sensitive................................. 746.6 752.1 743.0 753.8
-------- -------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded................... $8,833.4 $7,893.8 $8,730.5 $7,801.0
======== ======== ======== ========
Revenues:
Insurance policy income.................................... $ 373.6 $ 346.6 $ 732.9 $ 691.7
Net investment income:
General account invested assets.......................... 120.9 103.8 237.3 201.7
Equity-indexed products based on the change
in value of options.................................... (.9) (.3) (3.8) .9
Trading account income related to policyholder
and reinsurer accounts................................. 7.7 (12.8) 2.8 (6.9)
Change in value of embedded derivatives
related to modified coinsurance agreements............. (7.7) 12.8 (2.8) 6.9
Fee revenue and other income............................... (.2) .2 .4 .5
-------- -------- -------- --------
Total revenues......................................... 493.4 450.3 966.8 894.8
-------- -------- -------- --------
Expenses:
Insurance policy benefits.................................. 300.4 270.8 591.9 539.3
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below................. 41.1 35.7 80.2 71.9
Equity-indexed products based on the change
in value of indices.................................... (.3) 1.7 (1.5) 3.5
Amortization related to operations......................... 45.0 43.6 91.8 89.3
Interest expense on investment borrowings.................. .8 .7 1.5 1.1
Other operating costs and expenses......................... 38.0 44.1 75.7 79.6
-------- -------- -------- --------
Total expenses......................................... 425.0 396.6 839.6 784.7
-------- -------- -------- --------
Income before net realized investment gains, net
of related amortization, and income taxes.................... 68.4 53.7 127.2 110.1
-------- -------- -------- --------
Net realized investment gains.............................. .5 .4 2.5 11.4
Amortization related to net realized
investment gains......................................... - - (.1) -
-------- -------- -------- --------
Net realized investment gains,
net of related amortization.......................... .5 .4 2.4 11.4
-------- -------- -------- --------
Income before income taxes...................................... $ 68.9 $ 54.1 $ 129.6 $ 121.5
======== ======== ======== ========
(continued)
40
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................... $250.1 $231.2 $496.5 $456.1
Benefit ratio (a)....................................... 81.4% 77.9% 81.1% 77.1%
Medicare supplement:
Insurance policy benefits............................... $118.7 $111.2 $236.3 $217.2
Benefit ratio (a)....................................... 72.4% 69.0% 72.1% 67.3%
Long-term care:
Insurance policy benefits............................... $129.8 $118.4 $256.6 $235.0
Benefit ratio (a)....................................... 92.6% 89.1% 92.2% 89.2%
Interest-adjusted benefit ratio (b)..................... 64.3% 62.4% 64.1% 62.6%
Other:
Insurance policy benefits............................... $1.6 $1.6 $3.6 $3.9
Benefit ratio (a)....................................... 50.8% 56.4% 57.9% 68.2%
<FN>
- ----------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for
Bankers Life's long-term care products by dividing such product's insurance
policy benefits less interest income on the accumulated assets backing the
insurance liabilities by insurance policy income. Interest income is an
important factor in measuring the performance of this product. The net cash
flows from long-term care products generally cause an 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 benefit ratio
will typically increase, but the increase in the change in reserve will be
partially offset by interest income earned on the accumulated assets. The
interest-adjusted benefit ratio reflects the effects of the interest income
offset. Since interest income is an important factor in measuring the
performance of this product, management believes a benefit ratio which
includes the effect of interest income is useful in analyzing product
performance. The investment income earned on the accumulated assets backing
Bankers Life's long-term care reserves was $39.6 million and $35.5 million
in the three months ended June 30, 2005 and 2004, respectively and $78.2
million and $70.0 million in the six months ended June 30, 2005 and 2004,
respectively.
</FN>
Total premium collections were $598.8 million in the second quarter of
2005, up 6.0 percent from 2004 and were $1,182.7 million in the first six months
of 2005, up 8.7 percent from 2004. See "Premium Collections" for further
analysis of Bankers Life's premium collections.
Average liabilities for insurance products, net of reinsurance ceded were
$8.8 billion in the second quarter of 2005, up 12 percent from 2004. Average
liabilities for insurance products, net of reinsurance ceded were $8.7 billion
in the first six months of 2005, up 12 percent from 2004. The increase in such
liabilities was primarily due to increases in annuity reserves resulting from
higher sales of these products in recent periods.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $120.9 million in the second
quarter of 2005, up 16 percent from 2004 and was $237.3 million in the first six
months of 2005, up 18 percent from 2004. The average balance of general account
invested assets was $8.5 billion and $7.5 billion in the second quarters of 2005
and 2004, respectively. The yield on these assets was 5.7 percent and 5.5
percent in the second quarters of 2005 and 2004, respectively. The average
balance of general account invested assets was $8.4 billion and $7.4 billion in
the first six months of 2005 and 2004, respectively. The yield on these assets
was 5.6 percent and 5.5 percent in the first six months of 2005 and 2004,
respectively. The increase in general account invested assets is primarily due
to
41
CONSECO, INC. AND SUBSIDIARIES
-------------------
increased sales of our annuity products in recent periods. The increase in yield
was due to changes in the composition of the portfolio.
Net investment income related to equity-indexed products based on the
change in value of the options represents the change in the estimated fair value
of 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 is more than adequate to cover the cost of the options and
other costs related to these policies. Option costs attributable to benefits
provided were $1.9 million and $1.8 million in the second quarters of 2005 and
2004, respectively, and $3.7 million and $3.6 million in the first six months of
2005 and 2004, respectively. These costs are reflected in net investment income.
Investment income (loss) related to equity-indexed products before these costs
was $1.0 million and $1.5 million in the second quarters of 2005 and 2004,
respectively; and $(.1) million and $4.5 million in the first six months of 2005
and 2004, respectively. Such amounts are generally offset by the corresponding
charge (credit) to amounts added to policyholder account balances for
equity-indexed products based on the change in value of the indices. Such income
and related charges fluctuate based on the value of options embedded in the
segment's equity-indexed annuity policyholder account balances subject to this
benefit and to the performance of the index to which the returns on such
products are linked.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading security accounts which are designed to act as
hedges for embedded derivatives related to certain modified coinsurance
agreements. The income on our trading account securities is designed to be
substantially offset by the change in value of embedded derivatives related to
modified coinsurance agreements described below.
Change in value of embedded derivatives related to modified coinsurance
agreements is 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 account, which we carry
at estimated fair value with changes in such value recognized as trading account
income. We expect the change in the value of the embedded derivatives to be
largely offset by the change in value of the trading securities.
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
The Medicare supplement business consists of both individual and group
policies. Governmental regulations generally require us to attain and maintain a
ratio of total benefits incurred to total premiums earned (as calculated based
on amounts reported for statutory accounting purposes), after three years, of
not less than 65 percent on individual products and not less than 75 percent on
group products. The benefit ratio experienced in the first half of 2005
reflected a $2.5 million claim reserve deficiency (net of a $.4 million
redundancy in the second quarter of 2005) resulting from the ultimate
development of reserves at December 31, 2004 as well as a higher level of paid
claims compared to the first half of 2004. The benefit ratio in the first six
months of 2004 was favorably impacted by positive developments of $3.5 million
from insurance liabilities established in prior periods.
The net cash flows from our long-term care products generally cause an
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 benefit ratio
typically increases, but the increase in reserve is partially offset by
investment income earned on the accumulated assets. The benefit ratio on this
business has increased over the last year, consistent with the aging of this
block. In addition, the older policies have not lapsed at the rate we assumed in
our pricing, which is an industry-wide issue. In the first quarter of 2005, we
began introducing several new long-term care products to replace our previous
products which had lower pricing assumptions. To date, these new products have
been approved by the regulatory authorities in 46 states. The interest-adjusted
benefit ratio for long-term care products is calculated by dividing the
insurance product's insurance policy benefits less interest income on the
accumulated assets backing the insurance liabilities by insurance policy income.
The interest-adjusted benefit ratio on this business was 64.3 percent and 62.4
percent in the second quarters of 2005 and 2004, respectively, and 64.1 percent
and 62.6 percent in the first six months of 2005 and 2004, respectively. During
the quarter ended June 30, 2005, we made certain adjustments to the assumptions
we use to calculate insurance liabilities for future long-term care benefits,
resulting in a net reduction to insurance liabilities of $6.4 million. The
primary change related to policies that provide for increased benefits to
reflect inflation. Our previous assumptions had reflected the increased
projected benefit costs for the inflation benefit in insurance liabilities at
the time of billing immediately prior to the policy anniversary date which was
earlier than the actual terms of the
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
policy. Our new method calculates the increased projected benefit costs on the
policy anniversary date which is in accordance with the actual terms of the
policy.
The benefit ratios on our other products are subject to fluctuations due to
the smaller size of these blocks of business.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $41.1 million in the second quarter of
2005, up 15 percent from 2004 and were $80.2 million in the first six months of
2005, up 12 percent from 2004. The increase is primarily due to increases in
annuity reserves (due to higher sales of these products in recent periods)
partially offset by decreases in average crediting rates. The weighted average
crediting rates for these products were 3.7 percent and 3.8 percent in the
second quarters of 2005 and 2004, respectively, and 3.7 percent and 3.9 percent
in the first six months of 2005 and 2004, respectively.
Amounts added to equity-indexed products based on the change in value of
the indices correspond to the related investment income accounts described
above.
Amortization related to operations includes amortization of the value of
policies inforce at the Effective Date and the cost of policies produced
(collectively referred to as "amortization of insurance acquisition costs").
Insurance acquisition costs are amortized either: (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. In
addition, for universal life-type and investment-type products, we are required
to adjust the total amortization recorded to date through the statement of
operations if actual experience or other evidence suggests that earlier
estimates of future gross profits should be revised. Accordingly, amortization
for universal life-type and investment-type products is dependent on the profits
realized during the period and on our expectation of future profits. For other
products, we amortize insurance acquisition costs in relation to actual and
expected premium revenue, and amortization is only adjusted if expected premium
revenue changes or if we determine the balance of these costs is not recoverable
from future profits. Bankers Life's amortization expense was $45.0 million and
$43.6 million in the second quarters of 2005 and 2004, respectively, and $91.8
million and $89.3 million in the first six months of 2005 and 2004,
respectively. Such amounts were generally consistent with the related premium
revenue and gross profits for such periods and the assumptions we made when we
established the value of policies inforce as of the Effective Date.
Interest expense on investment borrowings fluctuates with our investment
borrowing activities and the interest rates thereon. Average investment
borrowings in our Bankers Life segment were $127.0 million and $164.4 million
during the first six months of 2005 and 2004, respectively. The weighted average
interest rates on such borrowings were 2.3 percent and 1.4 percent during the
first six months of 2005 and 2004, respectively.
Other operating costs and expenses in our Bankers Life segment were $38.0
million in the second quarter of 2005, down 14 percent from 2004 and were $75.7
million in the first six months of 2005, down 4.9 percent from 2004. The
decreases were due primarily to lower consulting and outside services expenses.
Net realized investment gains (losses) fluctuated each period. During the
six months ended June 30, 2005, we recognized net realized investment gains in
this segment of $2.5 million from the sales of investments (primarily fixed
maturities). During the first six months of 2004, net realized investment gains
in this segment included $14.7 million of net gains from the sales of
investments (primarily fixed maturities), net of $3.3 million of writedowns of
fixed maturities, equity securities and other invested assets resulting from
declines in fair values that we concluded were other than temporary. There were
no such writedowns in the first six months of 2005.
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Premium collections:
Annuities.................................................. $ 28.1 $ 15.9 $ 53.4 $ 29.3
Supplemental health........................................ 166.0 181.8 340.6 372.7
Life....................................................... 83.0 90.2 172.7 192.0
--------- -------- -------- --------
Total collections........................................ $ 277.1 $ 287.9 $ 566.7 $ 594.0
========= ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based.......................................... $ 281.8 $ 239.2 $ 283.4 $ 240.0
Equity-indexed........................................... 1,357.0 1,505.5 1,378.0 1,522.0
Deposit based............................................ 3,500.3 3,824.1 3,541.5 3,867.7
Separate accounts and investment trust liabilities....... 30.5 34.2 31.2 35.2
Health..................................................... 2,374.3 2,321.4 2,374.5 2,318.2
Life:
Interest sensitive....................................... 3,122.2 3,278.9 3,134.4 3,298.6
Non-interest sensitive................................... 1,426.7 1,445.3 1,429.6 1,450.5
--------- --------- --------- ---------
Total average liabilities for insurance products,
net of reinsurance ceded............................. $12,092.8 $12,648.6 $12,172.6 $12,732.2
========= ========= ========= =========
Revenues:
Insurance policy income...................................... $ 265.1 $ 289.7 $ 542.0 $ 589.7
Net investment income:
General account invested assets............................ 179.0 173.5 356.7 347.0
Equity-indexed products based on the change in value
of options............................................... (3.7) (.4) (16.8) 3.9
Trading account income related to policyholder and
reinsurer accounts....................................... 5.7 (18.1) (3.3) (5.2)
Change in value of embedded derivatives related to
modified coinsurance agreements.......................... (2.7) 3.9 (1.0) 1.3
Fee revenue and other income................................. .6 1.5 1.1 3.3
--------- --------- --------- ---------
Total revenues........................................... 444.0 450.1 878.7 940.0
--------- ----------- --------- ---------
Expenses:
Insurance policy benefits.................................... 203.4 194.1 404.6 427.9
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below............................ 64.6 63.8 128.9 131.7
Equity-indexed products based on the change in
value of indices......................................... 6.5 4.5 (3.9) 14.7
Amortization related to operations........................... 37.1 36.0 80.7 76.3
Interest expense on investment borrowings.................... 2.2 1.2 4.2 2.1
Other operating costs and expenses........................... 64.1 81.9 133.7 158.2
--------- --------- --------- ---------
Total expenses........................................... 377.9 381.5 748.2 810.9
--------- --------- --------- ---------
Income before net realized investment gains (losses),
net of related amortization, and income taxes................ 66.1 68.6 130.5 129.1
--------- --------- --------- ---------
Net realized investment gains (losses)....................... 6.3 (5.1) 3.8 11.1
Amortization related to net realized investment
gains (losses)............................................. (1.1) 2.0 .5 (5.4)
--------- --------- --------- ---------
Net realized investment gains (losses),
net of related amortization............................ 5.2 (3.1) 4.3 5.7
--------- --------- --------- ---------
Income before income taxes...................................... $ 71.3 $ 65.5 $ 134.8 $ 134.8
========= ========= ========= =========
(continued)
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits................................ $116.9 $121.4 $232.0 $246.7
Benefit ratio (a)........................................ 69.9% 64.0% 67.8% 64.9%
Medicare supplement:
Insurance policy benefits................................ $46.8 $59.0 $91.9 $117.8
Benefit ratio (a)........................................ 63.2% 62.9% 59.0% 62.0%
Specified disease:
Insurance policy benefits................................ $66.5 $59.0 $134.5 $122.1
Benefit ratio (a)........................................ 74.0% 64.3% 74.7% 67.2%
Interest-adjusted benefit ratio (b)...................... 43.0% 35.3% 43.9% 38.1%
Other:
Insurance policy benefits................................ $3.6 $3.4 $5.6 $6.8
Benefit ratio(a)......................................... 109.9% 82.7% 84.8% 79.2%
<FN>
- -------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for
Conseco Insurance Group's specified disease products by dividing such
product's insurance policy benefits less interest income on the accumulated
assets backing the insurance liabilities by policy income. Interest income
is an important factor in measuring the performance of this product. The
net cash flows from specified disease products generally cause an
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
benefit ratio will typically increase, but the increase in the change in
reserve will be partially offset by interest income earned on the
accumulated assets. The interest-adjusted benefit ratio reflects the
effects of the interest income offset. Since interest income is an
important factor in measuring the performance of this product, management
believes a benefit ratio which includes the effect of interest income is
useful in analyzing product performance. The investment income earned on
the accumulated assets backing the specified disease reserves was $27.8
million and $26.7 million in the three months ended June 30, 2005 and 2004,
respectively, and $55.5 million and $53.0 million in the six months ended
June 30, 2005 and 2004, respectively.
</FN>
Collections on insurance products were $277.1 million in the second quarter
of 2005, down 3.8 percent from 2004 and were $566.7 million in the first six
months of 2005, down 4.6 percent from 2004. This decrease was primarily due to
lower premiums collected from our Medicare supplement products. During the
remainder of 2005, we expect to increase our annuity sales efforts and to
continue to emphasize the sale of specified disease and Medicare supplement
insurance products. See "Premium Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$12.1 billion in the second quarter of 2005, down 4.4 percent from 2004. Average
liabilities for insurance products, net of reinsurance ceded were $12.2 billion
in the first six months of 2005, down 4.4 percent from 2004. This decrease was
primarily due to policyholder redemptions and lapses exceeding new sales.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $179.0 million in the second
quarter of 2005, up 3.2 percent from 2004 and was $356.7 million in the first
six months of 2005, up 2.8 percent from 2004. The average balance of general
account invested assets was $12.3 billion and $12.5 billion in the second
quarters of 2005 and 2004, respectively. The yield on these assets was 5.8
percent and 5.5 percent
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
in the second quarters of 2005 and 2004, respectively. The average balance of
general account invested assets was $12.3 billion and $12.6 billion in the first
six months of 2005 and 2004, respectively. The yield on these assets was 5.8
percent and 5.5 percent in the first six months of 2005 and 2004, respectively.
The increase in yield reflects income of $9.0 million ($5.8 million in the
second quarter of 2005) for investments (which had a par value in excess of the
cost basis) which were called or prepaid by the issuer during the first six
months of 2005.
Net investment income related to equity-indexed products based on the
change in value of options represents the change in the estimated fair value of
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 is more than adequate to cover the cost of the options and
other costs related to these policies. Option costs that are attributable to
benefits provided were $8.4 million and $9.4 million in the second quarters of
2005 and 2004, respectively and $16.8 million and $19.6 million in the first six
months of 2005 and 2004, respectively. These costs are reflected in net
investment income. Net investment income (loss) related to equity-indexed
products before these costs was $4.7 million and $9.0 million in the second
quarters of 2005 and 2004, respectively, and nil million and $23.5 million in
the first six months of 2005 and 2004, respectively. Such amounts were partially
offset by the corresponding charge (credit) to amounts added to policyholder
account balances for equity-indexed products based on the change in value of the
indices. Such income and related charges fluctuate based on the value of options
embedded in the segment's equity-indexed annuity policyholder account balances
subject to this benefit and to the performance of the index to which the returns
on such products are linked.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading security accounts, which are designed to act as
hedges for embedded derivatives related to: (i) Conseco Insurance Group's
equity-indexed products; and (ii) certain modified coinsurance agreements. In
addition, such income includes the income on investments backing the market
strategies of certain annuity products which provide for different rates of cash
value growth based on the experience of a particular market strategy. The income
on our trading account securities is designed to substantially offset: (i) the
change in value of embedded derivatives related to modified coinsurance
agreements described below; and (ii) certain amounts included in insurance
policy benefits.
Change in value of embedded derivatives related to modified coinsurance
agreements is described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We have transferred the specific block of
investments related to these agreements to our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
trading account income. The change in the value of the embedded derivatives has
largely been offset by the change in value of the trading securities.
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
The benefit ratios on Conseco Insurance Group's Medicare Supplement
products in the 2005 and 2004 periods were impacted by rate increases. The
higher rates increased policyholder lapses. The release of the policy benefit
reserve related to the lapsed business contributed to the lower benefit ratios
in the 2005 and 2004 periods. Governmental regulations generally require us to
attain and maintain a ratio of total benefits incurred to total premiums earned
(as calculated based on amounts reported for statutory accounting purposes),
after three years, of not less than 65 percent on these products.
Conseco Insurance Group's specified disease products generally provide
fixed or limited benefits. For example, payments under cancer insurance policies
are generally made directly to, or at the direction of, the policyholder
following diagnosis of, or treatment for, a covered type of cancer.
Approximately three-fourths of our specified disease policies inforce (based on
policy count) are sold with return of premium or cash value riders. The return
of premium rider generally provides that after a policy has been inforce for a
specified number of years or upon the policyholder reaching a specified age, we
will pay to the policyholder, or a beneficiary under the policy, the aggregate
amount of all premiums paid under the policy, without interest, less the
aggregate amount of all claims incurred under the policy. The cash value rider
is similar to the return of premium rider, but also provides for payment of a
graded portion of the return of premium benefit if the policy terminates before
the return of premium benefit is earned. Accordingly, the net cash flows from
these products generally result in the accumulation of amounts in the early
years of a policy (accounted for as reserve increases) which will be paid out as
benefits in later policy years (accounted for as reserve decreases).
Accordingly, as the policies age, the benefit ratio will typically increase, but
the increase in the change in reserve will be partially offset by investment
income earned on the accumulated assets. In addition, the benefit ratio for the
first half of 2005 reflects unfavorable claim experience. The interest-adjusted
benefit ratio for specified disease products is calculated by dividing the
insurance product's insurance policy benefits less
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
interest income on the accumulated assets backing the insurance liabilities by
insurance policy income.
The benefit ratios on Conseco Insurance Group's other products are subject
to fluctuations due to the smaller size of these blocks of business.
From time-to-time, we experience higher (or lower) than expected death
claims in the life business of the Conseco Insurance Group segment. For example,
during the first quarter of 2004, we experienced adverse life mortality of
approximately $4.4 million. Since the first quarter of 2004, our life mortality
experience generally returned to levels comparable to previous periods.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $64.6 million in the second quarter of
2005, up 1.3 percent from 2004 and were $128.9 million in the first six months
of 2005, down 2.1 percent from 2004. During the second quarter of 2004, we
experienced high surrenders of certain life products, which resulted in a
release of amounts previously added to policyholder account balances of $3.9
million. The fluctuations are primarily due to a smaller block of annuity
business inforce and changes in the weighted average crediting rates. The
weighted average crediting rate for these products was approximately 4 percent
in both the first six months of 2005 and 2004, respectively.
Amounts added to equity-indexed products based on the change in value of
the indices correspond to the related investment income accounts described
above.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs are amortized either: (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. In addition, for universal life-type and
investment-type products, we are required to adjust the total amortization
recorded to date through the statement of operations if actual experience or
other evidence suggests that earlier estimates of future gross profits should be
revised. Accordingly, amortization for universal life-type and investment-type
products is dependent on the profits realized during the period and on our
expectation of future profits. For other products, we amortize insurance
acquisition costs in relation to actual and expected premium revenue, and
amortization is only adjusted if expected premium revenue changes or if we
determine the balance of these costs is not recoverable from future profits. The
rate increases implemented in early 2005 and 2004 on our Medicare supplement
products resulted in higher lapses than we anticipated. These lapses reduced our
estimates of future expected premium income and, accordingly, we recognized
additional amortization expense in the 2005 periods. The assumptions we use to
estimate our future gross profits and premiums involve significant judgment. A
revision to our current assumptions could result in increases or decreases to
amortization expense in future periods.
During the second quarter of 2004, we evaluated certain amortization
assumptions used to estimate gross profits for universal life-type products and
investment-type products by comparing them to our actual experience. We made
refinements to the previous assumptions related to investment income to match
the actual experience and our estimates for future assumptions. The changes we
made did not affect our expectations for the total estimated profits to be
earned on this business, but did affect how we expect the profits to emerge over
time. These new assumptions resulted in a retroactive reduction to the
amortization of insurance intangibles of $7.7 million in the second quarter of
2004.
Interest expense on investment borrowings fluctuates with Conseco Insurance
Group's investment borrowing activities and the interest rates thereon. Average
investment borrowings were $300.8 million and $327.0 million during the first
six months of 2005 and 2004, respectively. The weighted average interest rates
on such borrowings were 2.8 percent and 1.3 percent during the first six months
of 2005 and 2004, respectively.
Other operating costs and expenses were $64.1 million in the second quarter
of 2005, down 22 percent from 2004 and were $133.7 million in the first six
months of 2005, down 15 percent from 2004. These decreases are primarily due to
lower commission expenses resulting from lower premium collections and lower
compensation costs reflecting our cost reduction initiatives. Operating expenses
in the first six months of 2005 and 2004 reflected reductions related to expense
recoveries associated with the Predecessor's bankruptcy of $7.6 million and $8.0
million, respectively.
Net realized investment gains (losses) fluctuate each period. During the
six months ended June 30, 2005, we recognized net realized investment gains of
$3.8 million from the sales of investments (primarily fixed maturities). During
the first six months of 2004, net realized investment gains included $18.4
million of net gains from the sales of investments (primarily fixed maturities),
net of $7.3 million of writedowns of fixed maturities, equity securities and
other invested assets
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
resulting from declines in fair values that we concluded were other than
temporary. There were no such writedowns in the first six months of 2005.
Amortization related to net realized investment gains (losses) represents
the increases or decreases in amortization which result from realized investment
gains or losses. When we sell securities at a gain (loss) and reinvest the
proceeds at a different yield, we increase (reduce) the amortization of
insurance acquisition costs in order to reflect the change in future expected
yields. Sales of fixed maturity investments resulted in an increase (decrease)
in the amortization of insurance acquisition costs of $1.1 million and $(2.0)
million in the second quarters of 2005 and 2004, respectively, and $(.5) million
and $5.4 million in the first six months of 2005 and 2004, respectively.
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-Off (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Premium collections:
Long-term care.......................................... $ 87.7 $ 92.1 $ 180.0 $ 190.7
Major medical........................................... .6 5.3 1.3 11.4
-------- -------- -------- --------
Total collections.................................. $ 88.3 $ 97.4 $ 181.3 $ 202.1
======== ======== ======== ========
Average liabilities for insurance products:
Long-term care.......................................... $3,311.9 $3,282.3 $3,303.6 $3,288.0
Major medical........................................... 46.3 75.6 48.4 80.4
-------- -------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded....................... $3,358.2 $3,357.9 $3,352.0 $3,368.4
======== ======== ======== ========
Revenues:
Insurance policy income................................. $ 89.8 $ 100.7 $ 181.3 $ 204.0
Net investment income on general account invested
assets................................................ 44.8 40.9 88.0 81.2
Fee revenue and other income............................ .2 .2 .3 .5
-------- -------- -------- --------
Total revenues...................................... 134.8 141.8 269.6 285.7
-------- -------- -------- --------
Expenses:
Insurance policy benefits............................... 87.7 95.9 174.2 197.2
Amortization related to operations...................... 4.8 4.7 10.6 9.5
Interest expense on investment borrowings............... - .1 - .1
Other operating costs and expenses...................... 20.9 25.5 41.9 48.4
-------- -------- -------- --------
Total expenses...................................... 113.4 126.2 226.7 255.2
-------- -------- -------- --------
Income before net realized investment gains
(losses) and income taxes......................... 21.4 15.6 42.9 30.5
Net realized investment gains (losses).................. 2.4 (.9) 4.5 1.8
-------- -------- -------- --------
Income before income taxes.......................... $ 23.8 $ 14.7 $ 47.4 $ 32.3
======== ======== ======== ========
Health benefit ratios:
Insurance policy benefits............................. $87.7 $95.9 $174.2 $197.2
Benefit ratio (a)..................................... 97.6% 95.2% 96.0% 96.6%
Interest-adjusted benefit ratio (b)................... 48.6% 55.7% 48.4% 57.9%
<FN>
- -----------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for
long-term care products by dividing such product's insurance policy
benefits less interest income on the accumulated assets backing such
insurance liabilities by policy income. Interest income is an important
factor in measuring the performance of this product. The net cash flows
from long-term care products generally cause an 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 benefit ratio will
typically increase, but the increase in the change in reserve will be
partially offset by investment income earned on the accumulated assets. The
interest-adjusted benefit ratio reflects the
</FN>
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
effects of the interest income offset. Since interest income is an
important factor in measuring the performance of this product, management
believes a benefit ratio which includes the effect of interest income is
useful in analyzing product performance. The investment income earned on
the accumulated assets backing long-term care reserves in our Other
Business in Run-off segment was $44.0 million and $39.7 million in the
three months ended June 30, 2005 and 2004, respectively, and $86.4 million
and $79.0 million in the six months ended June 30, 2005 and 2004,
respectively.
Total premium collections were $88.3 million in the second quarter of 2005,
down 9.3 percent from 2004 and were $181.3 million in the first six months of
2005, down 10 percent from 2004, because we have ceased marketing the long-term
care business and major medical business of this segment. Accordingly, collected
premiums will decrease over time as policies lapse partially offset by premium
rate increases. See "Premium Collections" for further analysis.
Average liabilities of insurance products, net of reinsurance ceded were
$3.4 billion in the second quarter of 2005, up slightly from 2004. Average
liabilities for insurance products, net of reinsurance ceded were $3.4 billion
in the first six months of 2005, down .5 percent from 2004.
Insurance policy income is comprised of premiums earned on the segment's
long-term care and major medical policies. See "Premium Collections" for further
analysis.
Net investment income on general account invested assets was $44.8 million
in the second quarter of 2005, up 9.5 percent from 2004 and was $88.0 million in
the first six months of 2005, up 8.4 percent from 2004. The average balance of
general account invested assets was $3.0 billion in both the second quarters of
2005 and 2004. The yield on these assets was 6.0 percent and 5.5 percent in the
second quarters of 2005 and 2004, respectively. The average balance of general
account invested assets was $3.0 billion in both the first six months of 2005
and 2004. The yield on these assets was 5.9 percent and 5.5 percent in the first
six months of 2005 and 2004, respectively. The increase in yield was primarily
due to lengthening the duration of this portfolio to better match the duration
of the related insurance liabilities.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below related to benefit ratios in the blocks of long-term care
business included in this segment. Benefit ratios are calculated by dividing the
product's insurance policy benefits by insurance policy income.
This segment includes long-term care insurance inforce, substantially all
of which was issued through independent agents by certain subsidiaries prior to
their acquisitions by Conseco in 1996 and 1997. The loss experience on these
products has been worse than we originally expected. Although we anticipated a
higher level of benefits to be paid on these products as the policies aged, the
paid claims have exceeded our expectations. We have experienced adverse
developments on home health care policies issued in certain areas of Florida and
other states. This adverse experience is reflected in our high benefit ratios.
We have been aggressively seeking rate increases and pursuing other actions on
such long-term care policies. Since mid-2004, we have been actively managing our
long-term care cases and claim adjudication processes. On April 20, 2004, the
Florida Office of Insurance Regulation issued an order to our subsidiary,
Conseco Senior, that affected approximately 11,000 home health care policies
issued in Florida by Conseco Senior and its predecessor companies. Pursuant to
the order, Conseco Senior must offer the following three alternatives to holders
of these policies:
o retention of their current policy with a rate increase of 50 percent
in the first year and actuarially justified increases in subsequent
years;
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15 percent
in subsequent years; or
o receipt of a paid up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy.
We completed the process of notifying our home health care policyholders of
these choices in the second quarter of 2005. We expect to know the results of
most policyholder elections by September 30, 2005.
On July 1, 2004, the Florida Office of Insurance Regulation issued a
similar order impacting approximately 4,500 home health care policies which are
obligations of our subsidiary, Washington National Insurance Company
("Washington National"). We expect to complete the process of notifying these
policyholders of their choices in the third quarter of 2005. The orders also
require Conseco Senior and Washington National to pursue a similar course of
action with respect to
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
approximately 24,000 home health care policies in other states, subject to
consideration and approval by the other state insurance departments. If we are
unsuccessful in obtaining rate increases or other forms of relief in those
states, or if the policy changes approved by the Florida Office of Insurance
Regulation prove inadequate, our future results of operations could be adversely
affected.
We believe our actions to seek rate increases and to improve our claims
adjudication processes are resulting in improved benefit ratios on this
business. In addition, our benefit ratio for the 2004 periods reflect: (i)
unfavorable claims experience on our long-term care products; partially offset
by (ii) the elimination of $3.0 million in the second quarter of 2004 ($10.0
million in the first six months of 2004) of reserve redundancies related to our
discontinued major medical business.
The net cash flows from long-term care products generally cause an
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 benefit 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 benefit ratio for long-term care products is
calculated by dividing the insurance product's insurance policy benefits less
interest income on the accumulated assets backing the insurance liabilities by
insurance policy income.
Amortization related to operations includes amortization of insurance
acquisition costs.
Other operating costs and expenses were $20.9 million in the second quarter
of 2005, down 18 percent from 2004 and were $41.9 million in the first six
months of 2005, down 13 percent from 2004. The decrease is consistent with our
goal to reduce operating expenses and improve the efficiency of our operations.
Net realized investment gains fluctuated each period. During the six months
ended June 30, 2005, we recognized net realized investment gains in this segment
of $4.5 million from the sales of investments (primarily fixed maturities).
During the first six months of 2004, net realized investment gains included $2.2
million of net gains from the sales of investments (primarily fixed maturities),
net of a writedown of $.4 million related to an investment with a fair value
decline that we concluded was other than temporary. There were no such
writedowns in the first six months of 2005.
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
Corporate (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Corporate operations:
Interest expense on corporate debt........................ $(13.1) $(21.1) $(25.1) $(48.9)
Net investment income .................................... 3.3 .3 3.8 .5
Fee revenue and other income.............................. 3.3 2.6 6.3 7.6
Gain on extinguishment of debt............................ - 2.8 - 2.8
Other operating costs and expenses........................ (16.3) (12.1) (28.4) (28.6)
------ ------ ------ ------
Loss before net realized investment losses
and income taxes...................................... (22.8) (27.5) (43.4) (66.6)
Net realized investment losses............................ (1.3) - (1.3) (2.8)
------ ------ ------ ------
Loss before income taxes................................ $(24.1) $(27.5) $(44.7) $(69.4)
====== ====== ====== ======
Interest expense on corporate debt decreased in the 2005 periods primarily
due to the refinancing of our Previous Credit Facility in the second quarter of
2004 which decreased our corporate debt and provided better interest rate terms.
Our average corporate debt outstanding was $767.5 million and $1.2 billion
during the first six months of 2005 and 2004, respectively. The average interest
rate on our debt was 6.4 percent and 7.8 percent during the first six months of
2005 and 2004, respectively.
Investment income primarily included income earned on short-term
investments held by the Corporate segment.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. Fee revenue and other income decreased primarily as
a result of a decrease in the market value of investments managed for others,
upon which these fees are based.
Gain on extinguishment of debt of $2.8 million in the three and six months
ended June 30, 2004, resulted from the repayment of our Previous Credit Facility
as further described in the note to the consolidated financial statements
entitled "Changes in Direct Corporate Obligations". The gain resulted from the
release of a $6.3 million accrual for a fee that would have been required to be
paid under the Previous Credit Facility, partially offset by the write-off of
unamortized amendment fees.
Other operating costs and expenses include general corporate expenses, net
of amounts charged to subsidiaries for services provided by the corporate
operations. These amounts fluctuate from quarter to quarter as a result of
expenses such as consulting, legal and severance costs which often do not occur
ratably throughout the year. General corporate expenses in the three and six
months ended June 30, 2004 included severance expense of $1.8 million and $6.8
million, respectively.
Net realized investment losses in the first six months of 2005 and 2004
included a writedown of $1.3 million and $2.9 million, respectively, due to an
other-than-temporary decline in value of an investment.
PREMIUM COLLECTIONS
In accordance with GAAP, insurance policy income 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 financial strength ratings of
our insurance subsidiaries as an important factor in determining whether to
market or purchase. Ratings have the most impact on our annuity and
interest-sensitive life insurance products. Our insurance companies' financial
strength ratings were downgraded by all of the major rating agencies beginning
in July 2002, in connection with the financial distress that ultimately led to
our Predecessor's bankruptcy. In the second quarter of 2004,
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
such ratings of our primary insurance subsidiaries (except Conseco Senior) were
upgraded by A.M. Best Company ("A.M. Best"), S&P and Moody's Investors Services,
Inc. ("Moody's"). In the third quarter of 2004, Moody's again upgraded the
ratings of our primary insurance subsidiaries (except Conseco Senior). The
current financial strength ratings of our primary insurance subsidiaries (except
Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very Good), "BB+" and
"Ba1", respectively. The current financial strength ratings of Conseco Senior
from A.M. Best, S&P and Moody's are "B (Fair)", "CCC" and "Caa1", respectively.
For a description of these ratings and additional information on our ratings,
see "Liquidity for Insurance Operations." Many of our competitors have higher
financial strength ratings and we believe it is critical for us to continue to
improve our ratings to be competitive.
We set 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 is less favorable than we anticipated
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 blocks of our health insurance business become
unprofitable. We generally cannot raise our health insurance premiums in any
state until we obtain the approval of the state insurance regulator. We review
the adequacy of our premium rates regularly and file rate increases on our
products when we believe such 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 such requests are denied in one or
more states, our net income may decrease. If such requests are approved,
increased premium rates may reduce the volume of our new sales and may cause
existing policyholders to lapse their policies. If the healthier policyholders
allow their policies to lapse, this would reduce our premium income and
profitability in future periods. Additionally, we may be required to expense all
or a portion of the insurance acquisition costs relating to such lapsed
policies, adversely affecting our financial results in that period.
Our insurance segments sell products through three primary distribution
channels -- career agents and direct marketing (our Bankers Life segment) and
independent producers (our Conseco Insurance Group segment). Our career agency
force in the Bankers Life segment sells primarily Medicare supplement and
long-term care insurance policies, senior life insurance and annuities. These
agents visit the customer's home, which permits one-on-one contact with
potential policyholders and promotes strong personal relationships with existing
policyholders. Bankers Life's direct marketing distribution channel is engaged
primarily in the sale of "graded benefit life" and simplified issue life
insurance policies which are sold directly to the policyholder. Our independent
producer distribution channel in the Conseco Insurance Group segment consists of
a general agency and insurance brokerage distribution system comprised of
independent licensed agents doing business in all fifty states, the District of
Columbia, and certain protectorates of the United States. Independent producers
are a diverse network of independent agents, insurance brokers and marketing
organizations. Our independent producer distribution channel sells primarily
specified disease and Medicare supplement insurance policies, universal life
insurance and annuities.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2005 2004 2005 2004
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................... $ 24.0 $ 7.4 $ 40.1 $ 13.9
------ ------ -------- --------
Other fixed (first-year).................................. 213.7 223.0 417.9 392.8
Other fixed (renewal)..................................... .9 - 2.3 1.0
------ ------ -------- --------
Subtotal - other fixed annuities........................ 214.6 223.0 420.2 393.8
------ ------ -------- --------
Total annuities......................................... 238.6 230.4 460.3 407.7
------ ------ -------- --------
Supplemental health:
Medicare supplement (first-year).......................... 17.6 17.3 35.3 34.1
Medicare supplement (renewal)............................. 142.3 138.4 294.3 289.0
------ ------ -------- --------
Subtotal - Medicare supplement.......................... 159.9 155.7 329.6 323.1
------ ------ -------- --------
Long-term care (first-year)............................... 17.1 17.9 34.2 34.7
Long-term care (renewal).................................. 124.4 116.4 248.1 232.1
------ ------ -------- --------
Subtotal - long-term care............................... 141.5 134.3 282.3 266.8
------ ------ -------- --------
Other health (first-year)................................. .3 .2 .5 .5
Other health (renewal).................................... 2.8 3.0 5.7 5.9
------ ------ -------- --------
Subtotal - other health................................. 3.1 3.2 6.2 6.4
------ ------ -------- --------
Total supplemental health............................... 304.5 293.2 618.1 596.3
------ ------ -------- --------
Life insurance:
First-year................................................ 23.8 12.9 39.1 23.8
Renewal................................................... 31.9 28.2 65.2 60.3
------ ------ -------- --------
Total life insurance.................................... 55.7 41.1 104.3 84.1
------ ------ -------- --------
Collections on insurance products:
Total first-year premium collections on
insurance products...................................... 296.5 278.7 567.1 499.8
Total renewal premium collections on
insurance products...................................... 302.3 286.0 615.6 588.3
------ ------ -------- --------
Total collections on insurance products................. $598.8 $564.7 $1,182.7 $1,088.1
====== ====== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections from
career agents increased 3.6 percent, to $238.6 million, in the second quarter of
2005, and 13 percent, to $460.3 million, in the first six months of 2005, as
compared to the same periods in 2004. The sales of these products in 2005 and
2004 have benefited from the low rates credited on competing products in the
marketplace. Annuity collections were favorably impacted in the 2005 periods by
higher sales of our equity-indexed products due in part to the general stock
market performance which has made the products more attractive.
Supplemental health products include Medicare supplement, long-term care
and other insurance products distributed through our career agents. 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.
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
Collected premiums on Medicare supplement policies increased 2.7 percent,
to $159.9 million, in the second quarter of 2005, and 2.0 percent, to $329.6
million, in the first six months of 2005, compared to the same periods in 2004.
First-year premium collections on these products were comparable to the same
periods in 2004.
Premiums collected on Bankers Life's long-term care policies increased 5.4
percent, to $141.5 million, in the second quarter of 2005, and 5.8 percent, to
$282.3 million, in the first six months of 2005, compared to the same periods in
2004 primarily due to persistency of our existing business and new sales in
recent periods.
Other health products include various products which we no longer actively
market. Premiums collected in the 2005 periods were comparable to the same
periods in 2004.
Life products in our Bankers Life segment are sold primarily to the senior
market through our career agents and our direct response distribution channel.
Life premiums collected in this segment increased 36 percent, to $55.7 million,
in the second quarter of 2005, and 24 percent, to $104.3 million, in the first
six months of 2005, compared to the same periods in 2004 as a result of an
increased focus on life products, including the introduction in the first
quarter of 2005 of a new single premium whole life product.
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year).............................. $ 20.5 $ 6.4 $ 39.8 $ 12.2
Equity-indexed (renewal)................................. 3.1 5.1 5.6 7.2
------ ------ ------ ------
Subtotal - equity-indexed annuities.................... 23.6 11.5 45.4 19.4
------ ------ ------ ------
Other fixed (first-year)................................. 1.2 2.6 2.1 3.2
Other fixed (renewal).................................... 3.3 1.8 5.9 6.7
------ ------ ------ ------
Subtotal - other fixed annuities....................... 4.5 4.4 8.0 9.9
------ ------ ------ ------
Total annuities........................................ 28.1 15.9 53.4 29.3
------ ------ ------ ------
Supplemental health:
Medicare supplement (first-year)......................... 3.3 5.9 6.4 13.5
Medicare supplement (renewal)............................ 69.3 81.3 145.5 167.8
------ ------ ------ ------
Subtotal - Medicare supplement......................... 72.6 87.2 151.9 181.3
------ ------ ------ ------
Specified disease (first-year)........................... 7.9 8.5 16.0 16.7
Specified disease (renewal).............................. 82.4 82.4 166.5 166.0
------ ------ ------ ------
Subtotal - specified disease........................... 90.3 90.9 182.5 182.7
------ ------ ------ ------
Other health (first-year)................................ - .1 - .1
Other health (renewal)................................... 3.1 3.6 6.2 8.6
------ ------ ------ ------
Subtotal - other health................................ 3.1 3.7 6.2 8.7
------ ------ ------ ------
Total supplemental health.............................. 166.0 181.8 340.6 372.7
------ ------ ------ ------
Life insurance:
First-year............................................... 2.1 4.9 4.9 10.6
Renewal.................................................. 80.9 85.3 167.8 181.4
------ ------ ------ ------
Total life insurance................................... 83.0 90.2 172.7 192.0
------ ------ ------ ------
Collections on insurance products:
Total first-year premium collections on
insurance products..................................... 35.0 28.4 69.2 56.3
Total renewal premium collections on
insurance products..................................... 242.1 259.5 497.5 537.7
------ ------ ------ ------
Total collections on insurance products................ $277.1 $287.9 $566.7 $594.0
====== ====== ====== ======
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers, many of whom discontinued
marketing our products after A.M. Best lowered our financial strength ratings in
2002. Total annuity premiums collected in this segment increased 77 percent, to
$28.1 million, in the second quarter of 2005, and 82 percent, to $53.4 million,
in the first six months of 2005, compared to the same periods in 2004 due to
increased sales efforts in this segment, particularly related to equity-indexed
products.
The accumulation value of equity-indexed 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 one of several equity market
indices during each year of their term. We purchase options in an effort to
hedge increases to policyholder benefits resulting from increases in the
indices. Total collected premiums for these products increased 105 percent, to
$23.6 million,
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
in the second quarter of 2005, and 134 percent, to $45.4 million, in the first
six months of 2005, over the same periods in 2004 due to the recent introduction
of two new products and certain sales incentives provided to professional
independent producers. In addition, these products have become more attractive
due to the general stock market performance in recent periods.
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. SPDA and FPDA policies typically have an interest
rate that is guaranteed for the first policy year, after which we have the
discretionary ability to change the crediting rate to any rate not below a
guaranteed minimum rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products increased 2.3 percent, to $4.5
million, in the second quarter of 2005, and decreased by 19 percent, to $8.0
million, in the first six months of 2005, compared to the same periods in 2004
due to our emphasis on the sales of other products that are less ratings
sensitive.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers. Our profits on supplemental health
policies depend on the overall level of sales, the length of time the business
remains inforce, investment yields, claim experience and expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment decreased 17 percent, to $72.6 million, in the second quarter of
2005, and 16 percent, to $151.9 million, in the first six months of 2005,
compared to the same periods in 2004. We implemented increases in premium rates
in both the first half of 2005 and 2004. These rate increases have resulted in
higher than expected lapses which impacted the premiums collected for these
products in this segment. In January 2005, we began selling a Medicare
supplement policy in another subsidiary which is more competitively priced.
Premiums collected on specified disease products in the three and six
months ended June 30, 2005 were comparable to the same periods in 2004.
Premiums collected from other health products decreased 16 percent, to $3.1
million, in the second quarter of 2005, and 29 percent, to $6.2 million, in the
first six months of 2005, compared to the same periods in 2004 because we no
longer actively market many of these products.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected decreased 8.0
percent, to $83.0 million, in the second quarter of 2005, and 10 percent, to
$172.7 million, in the first six months of 2005, compared to the same periods in
2004. Our A.M. Best rating has negatively affected our sales of life products.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-Off (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2005 2004 2005 2004
---- ---- ---- ----
Premiums collected by product:
Long-term care:
First-year.............................................. $ - $ - $ - $ .2
Renewal................................................. 87.7 92.1 180.0 190.5
----- ----- ------ ------
Subtotal - long-term care............................. 87.7 92.1 180.0 190.7
----- ----- ------ ------
Major medical:
Group (renewal)......................................... - 4.5 - 9.6
Individual (renewal).................................... .6 .8 1.3 1.8
----- ------ ------ ------
Total major medical................................... .6 5.3 1.3 11.4
----- ------ ------ ------
Collections on insurance products:
Total first-year premium collections on
insurance products.................................... - - - .2
Total renewal premium collections on
insurance products.................................... 88.3 97.4 181.3 201.9
----- ----- ------ ------
Total collections on insurance products............... $88.3 $97.4 $181.3 $202.1
===== ===== ====== ======
The Other Business in Run-off segment includes: (i) long-term care products
written in prior years through independent agents; and (ii) group and individual
major medical business in run-off.
Long-term care premiums collected in this segment decreased 4.8 percent, to
$87.7 million, in the second quarter of 2005, and 5.6 percent, to $180.0
million, in the first six months of 2005, compared to the same periods in 2004.
Most of the long-term care premiums in this segment relate to business written
by certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997.
We ceased selling new long-term care policies through professional independent
producers in the second quarter of 2003. We expect this segment's long-term care
premiums to reflect additional policy lapses in the future, partially offset by
premium rate increases. See "Results of Operations - Other Business in Run-Off"
for additional discussion related to orders issued by the Florida Office of
Insurance Regulation regarding certain blocks of our long-term care business.
Major medical premium collections continue to decrease as we manage the
run-off of this block of business.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between June 30, 2005 and
December 31, 2004, primarily reflect: (i) our net income for the six months
ended June 30, 2005; and (ii) changes in the fair value of actively managed
fixed maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At June 30, 2005, we increased the
carrying value of such investments by $848.1 million as a result of this fair
value adjustment.
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our capital structure as of June 30, 2005, and December 31, 2004, was as
follows (dollars in millions):
June 30, December 31,
2005 2004
---- ----
Total capital:
Corporate notes payable................................................ $ 758.8 $ 758.9
Shareholders' equity:
Preferred stock..................................................... 667.8 667.8
Common stock........................................................ 1.5 1.5
Additional paid-in-capital.......................................... 2,603.0 2,597.8
Accumulated other comprehensive income.............................. 473.5 337.3
Retained earnings................................................... 448.7 297.8
-------- --------
Total shareholders' equity....................................... 4,194.5 3,902.2
-------- --------
Total capital.................................................... $4,953.3 $4,661.1
======== ========
The following table summarizes certain financial ratios as of and for the
six months ended June 30, 2005, and as of and for the year ended December 31,
2004:
June 30, December 31,
2005 2004
---- ----
Book value per common share................................................................... $23.35 $21.41
Book value per common share, excluding accumulated other comprehensive income (a)............. 20.21 19.18
Ratio of earnings to fixed charges............................................................ 2.08x 1.90x
Ratio of earnings to fixed charges and preferred dividends.................................... 1.86x 1.58x
Debt to total capital ratios:
Corporate debt to total capital............................................................ 15% 16%
Corporate debt to total capital, excluding accumulated other comprehensive income (a)...... 17% 18%
Corporate debt and preferred stock to total capital........................................ 29% 31%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (a)................................................................. 32% 33%
<FN>
- --------------------
(a) This non-GAAP measure differs from the corresponding GAAP measure presented
immediately above because accumulated other comprehensive income has been
excluded from the value of capital used to determine this measure.
Management believes this non-GAAP measure is useful because it removes the
volatility that arises from changes in accumulated other comprehensive
income. Such volatility is often caused by changes in the estimated fair
value of our investment portfolio resulting from changes in general market
interest rates rather than the business decisions made by management.
However, this measure does not replace the corresponding GAAP measure.
</FN>
Liquidity for insurance operations
Our insurance operating companies generally receive adequate cash flow from
premium collections and investment income to meet their obligations. Life
insurance and annuity liabilities are generally long-term in nature.
Policyholders may, however, withdraw funds or surrender their policies, subject
to any applicable 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 3, 2005, A.M. Best revised its outlook on our primary insurance
subsidiaries to positive from stable, except Conseco Senior (the issuer of most
of our long-term care business in our Other Business in Run-off segment), for
which the outlook remains stable. On June 25, 2004, A.M. Best upgraded the
financial strength ratings of our primary insurance
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
subsidiaries from "B (Fair)" to "B++ (Very Good)", except Conseco Senior whose
"B (Fair)" rating was affirmed by A.M. Best. According to A.M. Best, these
rating actions reflected the substantial recapitalization of our balance sheet,
improved absolute and risk-adjusted capital on a statutory basis and improving
operating fundamentals. The "B++" rating is assigned to companies that have a
good ability, in A.M. Best's opinion, to meet their ongoing obligations to
policyholders. The "B" rating is assigned to companies which have a fair ability
in A.M. Best's opinion to meet their current obligations to policyholders, but
are financially vulnerable to adverse changes in underwriting and economic
conditions. 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 a superior ability to meet ongoing obligations to
policyholders. The "B++" rating and the "B" rating from A.M. Best are the fifth
and seventh highest, respectively, of sixteen possible ratings.
On August 2, 2005, S&P revised its outlook on our primary insurance
subsidiaries to positive from stable, except Conseco Senior, for which the
outlook remains stable. On May 27, 2004, S&P upgraded the financial strength
ratings of our primary insurance subsidiaries from "BB-" to "BB+", except
Conseco Senior, which was assigned a "CCC" rating. S&P financial strength
ratings range from "AAA" to "R" and some companies are not rated. Rating
categories from "BB" to "CCC" are classified as "vulnerable", and pluses and
minuses show the relative standing within a category. In S&P's view, an insurer
rated "BB" has marginal financial security characteristics and although positive
attributes exist, adverse business conditions could lead to an insufficient
ability to meet financial commitments. In S&P's view, an insurer rated "CCC" has
very weak financial security characteristics and is dependent on favorable
business conditions to meet financial commitments. The "BB+" rating and the
"CCC" rating from S&P are the eleventh and eighteenth highest, respectively, of
twenty-one possible ratings.
On July 29, 2005, the ratings for our primary insurance subsidiaries were
placed on review for upgrade by Moody's, except Conseco Senior, for which the
rating was affirmed with a developing outlook. On May 27, 2004, Moody's upgraded
the financial strength ratings of our primary insurance companies from "Ba3" to
"Ba2", except Conseco Senior, which was assigned a "Caa1" rating. On August 9,
2004, Moody's again upgraded the financial strength ratings of our primary
insurance companies from "Ba2" to "Ba1" and reaffirmed the "Caa1" rating of
Conseco Senior. Moody's financial strength ratings range from "Aaa" to "C".
Rating categories from "Ba" to "C" are considered "vulnerable" by Moody's, and
may be supplemented with numbers "1", "2", or "3" to show relative standing
within a category. In Moody's view, an insurer rated "Ba" offers questionable
financial security and the ability of the insurer to meet policyholder
obligations may be very moderate and thereby not well safeguarded in the future.
In Moody's view, an insurer rated "Caa" offers very poor financial security and
may default on its policyholder obligations or there may be elements of danger
with respect to punctual payment of policyholder obligations and claims. The
"Ba1" rating and "Caal" rating from Moody's are the eleventh and seventeenth
highest, respectively, of twenty-one possible ratings.
We have adopted several initiatives designed to reduce the expense levels
in our Conseco Insurance Group segment. These initiatives include system
conversions that will eliminate duplicate processing systems. We expect to spend
over $10 million on capital expenditures during the remainder of 2005 (including
amounts related to these initiatives). We believe we have adequate cash flows
from operations to fund these initiatives.
Liquidity of the Holding Companies
On June 22, 2004, we entered into the Credit Facility. The Credit Facility
is a six-year term loan, the proceeds of which were used: (i) to refinance in
full all indebtedness, including accrued interest, under the Previous Credit
Facility; (ii) to repurchase $106.6 million of certain affiliated preferred
stock; and (iii) for other general corporate purposes. We are required to make:
(i) a principal payment of $1.1 million on December 31, 2005; and (ii) quarterly
principal payments of $2.0 million commencing March 31, 2006, and continuing
until March 31, 2010. The remaining principal balance is due on June 22, 2010.
The Company made an optional prepayment of $28.0 million in December 2004. The
Company made a mandatory prepayment of $.9 million (after consideration of the
$28.0 million prepayment) on March 31, 2005, based on the Company's excess cash
flows at December 31, 2004, as defined in the Credit Facility. See the note to
the consolidated financial statements entitled "Notes Payable - Direct Corporate
Obligations" for further discussion related to the Credit Facility.
In July 2005, we announced that we are seeking to raise, subject to market
and other conditions, $300 million through a private offering of convertible
debentures ($330 million if the initial purchasers' option is exercised in
full). The offering will be made only to qualified institutional buyers in
compliance with Rule 144A under the Securities Act of 1933. The Company intends
to use the proceeds of the debentures to repay debt under its Credit Facility.
The debentures to be offered will not be registered under the Securities Act of
1933 or any state securities laws, and may not be offered or sold in the United
States absent registration or an applicable exemption from registration
requirements.
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CONSECO, INC. AND SUBSIDIARIES
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In July 2005, we announced that we have engaged Banc of America Securities
LLC and J.P. Morgan Securities Inc. to act as lead arrangers and joint
bookrunners in connection with the amendment of our existing Credit Facility.
The amendment is expected to provide for, among other things, a reduction in the
principal amount of the Credit Facility to $475 million through the application
of proceeds of the convertible debentures, a reduction in the interest spread on
the term loan, relaxed financial covenants and increased flexibility to enter
into capital markets transactions.
At June 30, 2005, Conseco Inc. and CDOC held unrestricted cash of $60.8
million. In addition, our other non-life insurance subsidiaries held
unrestricted cash of approximately $41.8 million which could be upstreamed to
the parent companies if needed.
Conseco and CDOC are holding companies with no business operations of their
own; they depend on their operating subsidiaries for cash to make principal and
interest payments on debt, and to pay administrative expenses and income taxes.
Conseco and CDOC receive cash from insurance subsidiaries, consisting of
dividends and distributions, principal and interest payments on surplus
debentures, fees for services and tax-sharing payments, as well as cash from
non-insurance subsidiaries consisting of loans and advances. A deterioration in
the financial condition, earnings or cash flow of the material subsidiaries of
Conseco or CDOC for any reason could hinder such subsidiaries' ability to pay
cash dividends or other disbursements to Conseco and/or CDOC, which, in turn,
would limit Conseco's and/or CDOC's ability to meet debt service requirements
and satisfy other financial obligations. In addition, we may need to contribute
additional capital to certain insurance subsidiaries to improve their Risk-Based
Capital ("RBC") ratios and this could affect the ability of our top tier
insurance subsidiary to pay dividends.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of (or in a few states, the lesser of): (i) statutory net gain
from operations or net income for the prior year; or (ii) 10 percent of
statutory capital and surplus as of the end of the preceding year. Any dividends
in excess of these levels require the approval of the director or commissioner
of the applicable state insurance department.
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
provide assurance that we will possess sufficient income and liquidity to meet
all of our liquidity requirements and other obligations.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted following the insurance laws of its state of domicile with
such state's insurance regulator as the receiver for 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 would have no right to
proceed against the assets of our insurance subsidiaries or to cause their
liquidation under federal and state bankruptcy laws.
Under our Credit Facility, we have agreed to a number of covenants and
other provisions that restrict our ability to engage in various financing
transactions and pursue certain operating activities without the prior consent
of the lenders. We have also agreed to meet or maintain various financial
ratios. These requirements represent significant restrictions on the manner in
which we may operate our business and our ability to meet these financial
covenants may be affected by events beyond our control. If we default under any
of these requirements (subject to certain remedies), the lenders could declare
all outstanding borrowings, accrued interest and fees to be immediately due and
payable. If that were to occur, we cannot provide assurance that we would have
sufficient liquidity to repay or refinance this indebtedness.
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CONSECO, INC. AND SUBSIDIARIES
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INVESTMENTS
At June 30, 2005, the amortized cost and estimated fair value of actively
managed fixed maturities and equity securities were as follows (dollars in
millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities................................................ $12,232.9 $635.2 $30.3 $12,837.8
United States Treasury securities and obligations of
United States government corporations and agencies................ 1,788.6 28.9 2.8 1,814.7
States and political subdivisions................................... 916.3 38.0 1.8 952.5
Debt securities issued by foreign governments....................... 142.8 9.5 .1 152.2
Structured securities .............................................. 5,803.8 141.0 3.7 5,941.1
Below-investment grade (primarily corporate securities)................ 715.4 34.7 6.7 743.4
--------- ------ ----- ---------
Total actively managed fixed maturities............................. $21,599.8 $887.3 $45.4 $22,441.7
========= ====== ===== =========
Equity securities...................................................... $32.4 $1.6 $.2 $33.8
===== ==== === =====
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our actively managed
fixed maturity securities by industry category as of June 30, 2005 (dollars in
millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 5,942.5 26.5%
Manufacturing........................................................................ 2,340.6 10.4
Bank and finance..................................................................... 2,301.8 10.3
U.S. Government...................................................................... 1,814.7 8.1
Services............................................................................. 1,556.8 6.9
Utilities............................................................................ 1,410.0 6.3
Communications....................................................................... 1,126.9 5.0
States and political subdivisions.................................................... 957.7 4.3
Agriculture, forestry and mining..................................................... 870.2 3.9
Asset-backed securities.............................................................. 778.4 3.5
Transportation....................................................................... 592.4 2.6
Retail and wholesale................................................................. 583.1 2.6
Other................................................................................ 2,166.6 9.6
--------- ----
Total fixed maturity securities................................................... $22,441.7 100.0%
========= =====
Below-Investment Grade Securities
At June 30, 2005, the amortized cost of the Company's below-investment
grade fixed maturity securities was $715.4 million, or 3.3 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $743.4 million, or 104 percent of the
amortized cost. The value of these securities varies based on the economic terms
of the securities, structural considerations and the creditworthiness of the
issuer of the securities.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of loss upon default by the
borrower is significantly greater for below-investment grade securities as such
securities are generally unsecured and often subordinated to other creditors of
the issuer. Also, issuers of below-investment grade securities
62
CONSECO, INC. AND SUBSIDIARIES
-------------------
usually have higher levels of debt and are more sensitive to adverse economic
conditions, such as recession or increasing interest rates, than are investment
grade issuers. The Company attempts to reduce the overall risk related to its
investment in below-investment grade securities, 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
During the six months ended June 30, 2005, we recognized net realized
investment gains of $9.5 million, which were comprised of $10.8 million of net
gains from the sales of investments (primarily fixed maturities) with proceeds
of $7.4 billion, net of $1.3 million of writedowns of other invested assets
resulting from a decline in the fair value of an investment that we concluded
was other than temporary. During the first six months of 2004, we recognized net
realized investment gains of $21.5 million, which were comprised of $35.4
million of net gains from the sales of investments (primarily fixed maturities)
with proceeds of $5.7 billion, net of $13.9 million of writedowns of fixed
maturity investments, equity securities and other invested assets resulting from
declines in fair values that we concluded were other than temporary. At June 30,
2005, fixed maturity securities in default as to the payment of principal or
interest had an aggregate amortized cost of nil and a carrying value of $1.4
million.
During the six months ended June 30, 2005, we sold $1.9 billion of fixed
maturity investments which resulted in gross investment losses (before income
taxes) of $39.9 million. We sell securities at a loss for a number of reasons
including, but not limited to: (i) changes in the investment environment; (ii)
expectation that the market value could deteriorate further; (iii) desire to
reduce our exposure to an issuer or an industry; (iv) changes in credit quality;
(v) identification of a superior investment alternative; or (vi) our analysis
indicates there is a high probability that the security is
other-than-temporarily impaired.
Investments with Other-Than-Temporary Losses
During the six months ended June 30, 2005, we recorded a writedown of $1.3
million related to our holdings in an investment in a company facing litigation
from the Canadian government. Our analysis of the value of the underlying net
assets of the company indicated that the decline in fair value of the investment
is other than temporary.
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 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) our
view of the investment's rating and whether the investment is investment-grade
and/or 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.
When 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 of that particular investment in relation to other investments in
our portfolio. If such circumstances exist with respect to other investments,
those investments are also written down to fair value. Future events may occur,
or additional or updated information may become available, which may necessitate
future realized losses of securities in our portfolio. Significant losses in the
carrying value of our investments could have a material adverse effect on our
earnings in future periods.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at June 30,
2005, by contractual maturity. Actual maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties. Most of the structured securities
shown below provide for periodic payments throughout their lives (dollars in
millions).
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CONSECO, INC. AND SUBSIDIARIES
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Estimated
Amortized fair
cost value
--------- ---------
Due in one year or less................................................................... $ 55.4 $ 55.2
Due after one year through five years..................................................... 611.5 604.4
Due after five years through ten years.................................................... 658.9 643.8
Due after ten years....................................................................... 1,002.4 983.1
-------- --------
Subtotal............................................................................... 2,328.2 2,286.5
Structured securities..................................................................... 442.8 439.1
-------- --------
Total.................................................................................. $2,771.0 $2,725.6
======== ========
At June 30, 2005, we held one investment in our fixed maturity portfolio
which was rated below-investment grade or classified as an equity-type security
and had an unrealized loss position exceeding 20 percent of the cost basis. At
June 30, 2005, such investment had an amortized cost and estimated fair value of
$1.4 million and $.9 million, respectively.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we have both the ability and intent to hold securities with
unrealized losses until they mature or recover in value, we may sell securities
at a loss in the future because of actual or expected changes in our view of the
particular investment, its industry, its type or the general investment
environment. As described in the note to our consolidated financial statements
entitled "Recently Issued Accounting Standards", certain guidance related to
determining when an impairment of an investment is other than temporary is being
considered by the Emerging Issues Task Force. Depending on the ultimate guidance
issued, including guidance regarding management's assertion about intent and
ability to hold actively managed fixed maturities for a period of time
sufficient to allow for any anticipated recovery, the Company's practice of
selling securities at a loss could result in a requirement to report unrealized
losses in a different manner, including reflecting unrealized losses in the
income statement as other-than-temporary impairments.
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CONSECO, INC. AND SUBSIDIARIES
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The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position, at
June 30, 2005 (dollars in millions):
Less than 12 months 12 months or greater Total
----------------------- ---------------------- ----------------------
Estimated Estimated Estimated
fair Unrealized fair Unrealized fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 135.6 $ (1.6) $ 40.6 $(1.2) $ 176.2 $ (2.8)
States and political subdivisions. 51.2 (.5) 64.0 (1.9) 115.2 (2.4)
Debt securities issued by
foreign governments............ 6.1 (.1) .7 - 6.8 (.1)
Corporate securities.............. 1,741.4 (31.9) 246.9 (4.5) 1,988.3 (36.4)
Structured securities............. 399.3 (3.2) 39.8 (.5) 439.1 (3.7)
-------- ------ ------ ----- -------- ------
Total actively managed
fixed maturities............... $2,333.6 $(37.3) $392.0 $(8.1) $2,725.6 $(45.4)
======== ====== ====== ===== ======== ======
Equity securities................. $3.5 $ - $2.6 $(.2) $6.1 $(.2)
==== ====== ==== ==== ==== ====
Based on management's current assessment of investments with unrealized
losses at June 30, 2005, 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. If
the Company concludes in future periods that the unrealized loss is other than
temporary, a charge to earnings would be recognized.
Structured Securities
At June 30, 2005, fixed maturity investments included $5.9 billion of
structured securities (or 26 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations and commercial mortgage-backed securities. The yield
characteristics of structured securities differ in some respects from those of
traditional fixed-income securities. For example, interest and principal
payments on mortgage-backed securities occur more frequently, often monthly. In
addition, mortgage-backed securities are subject to a higher degree of risk
associated with variable payments of principal. For example, 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 various security-specific structural considerations (for example
the repayment priority of a given security in a securitization structure).
In general, the rate of prepayments on the underlying mortgage loans and
the securities backed by these loans increase when prevailing interest rates
decline significantly in absolute terms and also relative to the interest rates
on such loans. The yields on mortgage-backed securities purchased at a discount
to par will increase when the underlying mortgages prepay faster than expected.
The yields on mortgage-backed securities purchased at a premium will decrease
when the underlying mortgages prepay faster than expected. When interest rates
decline, the proceeds from the prepayment of mortgage-backed securities may be
reinvested at lower rates than we were earning on the prepaid securities. When
interest rates increase, prepayments on mortgage-backed securities decrease as
fewer underlying mortgages are refinanced. When this occurs, the average
maturity 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, because of a decrease in the annual
amortization of the premium.
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CONSECO, INC. AND SUBSIDIARIES
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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 June 30, 2005 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 202.3 $ 202.8 $ 206.7
4 percent - 5 percent............................................................... 1,405.7 1,353.7 1,388.5
5 percent - 6 percent............................................................... 3,464.1 3,430.8 3,506.3
6 percent - 7 percent............................................................... 620.4 637.2 655.4
7 percent - 8 percent............................................................... 146.4 152.6 156.2
8 percent and above................................................................. 26.1 27.7 29.4
-------- -------- --------
Total structured securities (a).............................................. $5,865.0 $5,804.8 $5,942.5
======== ======== ========
<FN>
- ------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $1.0 million and $1.4 million,
respectively.
</FN>
The amortized cost and estimated fair value of structured securities at
June 30, 2005, 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............ $3,515.9 $3,587.1 16%
Planned amortization classes and accretion-directed bonds................. 1,166.3 1,197.3 5
Commercial mortgage-backed securities..................................... 1,117.4 1,152.8 5
Subordinated classes and mezzanine tranches............................... 4.8 4.9 -
Other..................................................................... .4 .4 -
-------- -------- --
Total structured securities (a).................................... $5,804.8 $5,942.5 26%
======== ======== ==
<FN>
- -----------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $1.0 million and $1.4 million,
respectively.
</FN>
Pass-through securities and sequential and targeted amortization class
securities have different prepayment variability characteristics and can be used
as collateral for collateralized mortgage obligations. Sequential classes are a
series of tranches that return principal to tranche holders in a detailed
hierarchy.
Targeted amortization classes, planned amortization classes and
accretion-directed bonds adhere to fixed schedules of principal payments as long
as the underlying mortgages experience prepayments within certain estimated
ranges. Changes in prepayment rates are first absorbed by support or companion
classes. This insulates the timing of receipt of cash flows 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, generally income producing properties that are
managed for profit. Property types include multi-family dwellings including
apartments, retail centers, hotels, restaurants, hospitals, nursing homes,
warehouses, and office buildings. The CMBS market generally offers higher yields
than similar-rated corporate bonds. Most CMBS have call protection features
whereby underlying borrowers may not prepay their mortgages for stated periods
of time without incurring prepayment penalties.
Mortgage Loans
At June 30, 2005, the mortgage loan balance was primarily comprised of
commercial loans. Substantially less than one percent of the mortgage loan
balance was noncurrent at June 30, 2005.
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CONSECO, INC. AND SUBSIDIARIES
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Investment Borrowings
Our investment borrowings averaged approximately $433.5 million during the
first six months of 2005, compared with $501.6 million during the same period of
2004 and were collateralized by investment securities with fair values
approximately equal to the loan value. The weighted average interest rates on
such borrowings were 2.6 percent and 1.3 percent during the first six months of
2005 and 2004, respectively.
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 Conseco's Annual Report on Form 10-K for the year ended
December 31, 2004. There have been no material changes in the first six months
of 2005 to such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. Conseco's management,
under the supervision and with the participation of the Chief Executive Officer
and the Chief Financial Officer, evaluated the effectiveness of Conseco's
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended). Based on this
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that, as of June 30, 2005, Conseco's disclosure controls and procedures were
effective to ensure that information required to be disclosed by Conseco in
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commission's rules and forms.
Changes to Internal Controls and Procedures for Financial Reporting. We
have implemented several initiatives to streamline our administrative procedures
and improve our actuarial valuation systems at our insurance subsidiaries. Our
efforts include improvements to our policy administrative procedures and
significant system conversions, such as the elimination of multiple systems for
similar lines of business. During the first six months of 2005, we implemented
new administrative systems for certain life and long-term care products and a
new actuarial valuation system for our equity-indexed annuities. We expect to
implement additional system conversions in the future. We believe that the new
systems will provide better information and will enhance our operational
efficiencies. As part of the new system implementations, we expect to make
further adjustments to our operating procedures in an effort to gain additional
efficiencies and effectiveness. We believe the changes will also result in
improvements to our internal controls over financial reporting.
Other than the changes related to new system conversions, no significant
changes in Conseco's internal controls over financial reporting have occurred
during the quarter ended June 30, 2005, that have materially affected, or are
reasonably likely to materially affect, Conseco's internal controls over
financial reporting.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
PART II - OTHER INFORMATION
ITEM 1. LITIGATION AND OTHER LEGAL PROCEEDINGS.
Information required for Part II, Item 1 is incorporated by reference to
the discussion under the heading "Litigation and Other Legal Proceedings" in the
footnotes to our consolidated financial statements included in Part I, Item 1 of
this Form 10-Q.
ITEM 6. EXHIBITS.
a) Exhibits.
10.20 Conseco, Inc. 2005 Pay for Performance Incentive Plan.
12.1 Computation of Ratio of Earnings to Fixed Charges and
Preferred Dividends.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: August 8, 2005 By: /s/ Eugene M. Bullis
--------------------
Eugene M. Bullis
Executive Vice President and
Chief Financial Officer
(authorized officer and principal
financial officer)
69