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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 quarterly period ended March 31, 2006
[ ] 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 a large accelerated filer,
an accelerated filer or a non-accelerated filer (see definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act).
Large accelerated filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act): Yes [ ] No [ X ]
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 April 28, 2006: 151,513,754
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of March 31, 2006 and December 31, 2005.................................. 3
Consolidated Statement of Operations for the three months ended March 31, 2006 and 2005................ 5
Consolidated Statement of Shareholders' Equity for the three months ended March 31, 2006 and 2005...... 6
Consolidated Statement of Cash Flows for the three months ended March 31, 2006 and 2005................ 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............................................. 31
Overview ............................................................................................. 32
Critical Accounting Policies ......................................................................... 32
Results of Operations................................................................................. 34
Premium Collections................................................................................... 46
Liquidity and Capital Resources....................................................................... 51
Investments........................................................................................... 55
Investment in Variable Interest Entity................................................................ 61
New Accounting Standards ............................................................................. 62
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................................... 62
Item 4. Controls and Procedures............................................................................... 62
PART II - OTHER INFORMATION
Item 1. Legal Proceedings .................................................................................... 62
Item 1A. Risk Factors.......................................................................................... 62
Item 6. Exhibits ............................................................................................. 63
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
March 31, December 31,
2006 2005
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
March 31, 2006 - $22,567.9; December 31, 2005 - $22,380.2)........................... $22,116.8 $22,494.2
Equity securities at fair value (cost: March 31, 2006 - $31.2;
December 31, 2005 - $25.6)........................................................... 33.0 27.1
Mortgage loans......................................................................... 1,328.2 1,264.2
Policy loans........................................................................... 424.0 429.8
Trading securities..................................................................... 697.8 716.3
Other invested assets ................................................................. 126.4 109.6
--------- ---------
Total investments.................................................................. 24,726.2 25,041.2
Cash and cash equivalents:
Unrestricted........................................................................... 102.9 237.8
Restricted............................................................................. 21.8 35.2
Accrued investment income................................................................. 327.3 315.4
Value of policies inforce at the Effective Date........................................... 2,410.3 2,414.0
Cost of policies produced................................................................. 862.2 758.8
Reinsurance receivables................................................................... 878.8 887.5
Income tax assets, net.................................................................... 1,624.4 1,496.6
Assets held in separate accounts.......................................................... 30.1 29.8
Other assets.............................................................................. 387.3 341.0
--------- ---------
Total assets....................................................................... $31,371.3 $31,557.3
========= =========
(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
March 31, December 31,
2006 2005
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $12,689.0 $12,686.8
Traditional products................................................................... 11,898.5 11,872.2
Claims payable and other policyholder funds............................................ 846.8 842.1
Liabilities related to separate accounts............................................... 30.1 29.8
Other liabilities........................................................................ 503.6 440.0
Investment borrowings.................................................................... 314.7 315.1
Notes payable - direct corporate obligations............................................. 805.3 851.5
--------- ---------
Total liabilities.................................................................. 27,088.0 27,037.5
--------- ---------
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: March 31, 2006 - 151,513,212; December 31, 2005 - 151,513,434)........ 1.5 1.5
Additional paid-in capital............................................................... 3,198.4 3,194.1
Accumulated other comprehensive income (loss)............................................ (224.2) 71.7
Retained earnings........................................................................ 639.8 584.7
--------- ---------
Total shareholders' equity......................................................... 4,283.3 4,519.8
--------- ---------
Total liabilities and shareholders' equity......................................... $31,371.3 $31,557.3
========= =========
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
March 31,
-----------------------
2006 2005
---- ----
Revenues:
Insurance policy income............................................................. $ 754.7 $ 727.7
Net investment income (loss):
General account assets............................................................ 351.3 337.8
Policyholder and reinsurer accounts............................................... 14.1 (23.3)
Net realized investment gain (loss)................................................. (3.1) 1.6
Fee revenue and other income........................................................ 4.7 4.2
-------- --------
Total revenues.................................................................. 1,121.7 1,048.0
-------- --------
Benefits and expenses:
Insurance policy benefits........................................................... 726.8 671.0
Interest expense.................................................................... 16.4 14.7
Amortization........................................................................ 118.6 94.7
Other operating costs and expenses.................................................. 158.8 140.4
-------- --------
Total benefits and expenses..................................................... 1,020.6 920.8
-------- --------
Income before income taxes...................................................... 101.1 127.2
Income tax expense on period income.................................................... 36.5 45.4
-------- --------
Net income...................................................................... 64.6 81.8
Preferred stock dividends.............................................................. 9.5 9.5
-------- --------
Net income applicable to common stock........................................... $ 55.1 $ 72.3
======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding............................................... 151,521,000 151,058,000
=========== ===========
Net income........................................................................ $.36 $.48
==== ====
Diluted:
Weighted average shares outstanding............................................... 183,541,000 186,764,000
=========== ===========
Net income........................................................................ $.35 $.44
==== ====
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, 2006............................. $4,519.8 $667.8 $3,195.6 $ 71.7 $584.7
Comprehensive loss, net of tax:
Net income...................................... 64.6 - - - 64.6
Change in unrealized appreciation
of investments (net of applicable income tax
benefit of $165.6)............................ (295.9) - - (295.9) -
--------
Total comprehensive loss.................... (231.3)
Stock option and restricted stock plans......... 4.3 - 4.3 - -
Dividends on preferred stock.................... (9.5) - - - (9.5)
-------- ------ -------- -------- ------
Balance, March 31, 2006.............................. $4,283.3 $667.8 $3,199.9 $(224.2) $639.8
======== ====== ======== ======= ======
Balance, January 1, 2005............................. $3,902.2 $667.8 $2,599.3 $ 337.3 $297.8
Comprehensive loss, net of tax:
Net income...................................... 81.8 - - - 81.8
Change in unrealized appreciation of
investments (net of applicable income tax
benefit of $101.8)............................ (181.9) - - (181.9) -
--------
Total comprehensive loss.................... (100.1)
Stock option and restricted stock plans......... 2.3 - 2.3 - -
Dividends on preferred stock.................... (9.5) - - - (9.5)
-------- ------ -------- ------- ------
Balance, March 31, 2005.............................. $3,794.9 $667.8 $2,601.6 $ 155.4 $370.1
======== ====== ======== ======= ======
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)
Three months ended
March 31,
----------------------
2006 2005
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 665.1 $ 635.3
Net investment income................................................................. 361.6 348.6
Fee revenue and other income.......................................................... 4.7 4.2
Net sales of trading securities....................................................... 4.8 26.1
Insurance policy benefits............................................................. (541.2) (450.6)
Interest expense...................................................................... (19.0) (11.6)
Policy acquisition costs.............................................................. (114.8) (107.2)
Other operating costs................................................................. (155.2) (153.0)
Taxes................................................................................. 1.0 5.9
--------- ----------
Net cash provided by operating activities........................................... 207.0 297.7
--------- ----------
Cash flows from investing activities:
Sales of investments.................................................................. 1,880.6 3,148.0
Maturities and redemptions of investments............................................. 167.3 320.6
Purchases of investments.............................................................. (2,292.4) (4,183.8)
Change in restricted cash............................................................. 13.4 .2
Other................................................................................. (7.6) (4.8)
--------- ----------
Net cash used by investing activities .............................................. (238.7) (719.8)
--------- ----------
Cash flows from financing activities:
Issuance of common stock.............................................................. .8 -
Payments on notes payable............................................................. (46.3) (.9)
Amounts received for deposit products................................................. 435.1 402.1
Withdrawals from deposit products..................................................... (482.9) (452.6)
Investment borrowings................................................................. (.4) (6.2)
Dividends paid on preferred stock..................................................... (9.5) (9.5)
--------- ----------
Net cash used by financing activities............................................. (103.2) (67.1)
--------- ----------
Net decrease in cash and cash equivalents......................................... (134.9) (489.2)
Cash and cash equivalents, beginning of period........................................... 237.8 776.6
--------- ----------
Cash and cash equivalents, end of period................................................. $ 102.9 $ 287.4
========= ==========
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 2005 Form 10-K of Conseco,
Inc.
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"),
in connection with our 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 2006 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, 2005, 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 inforce at the Effective Date, certain investments, assets and
liabilities related to income taxes, liabilities for insurance 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 one of 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 securities 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 $697.8 million and $716.3 million at March 31, 2006 and
December 31, 2005, respectively.
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Accumulated other comprehensive income (loss) is comprised of the net
effect of unrealized appreciation (depreciation) on our investments. These
amounts, included in shareholders' equity as of March 31, 2006 and December 31,
2005, were as follows (dollars in millions):
March 31, December 31,
2006 2005
---- ----
Net unrealized appreciation (depreciation) on investments............................. $(444.0) $120.9
Adjustment to value of policies inforce at the Effective Date......................... 68.0 (9.2)
Adjustment to cost of policies produced............................................... 25.9 (.3)
Deferred income tax asset (liability)................................................. 125.9 (39.7)
------- ------
Accumulated other comprehensive income (loss).................................... $(224.2) $ 71.7
======= ======
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 September 10, 2003 is referred to as the value of policies inforce
at 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.
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 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.
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 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 included the impact of this adjustment in accumulated other comprehensive
income within shareholders' equity.
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
March 31,
---------------------
2006 2005
---- ----
Net income................................................................................... $64.6 $81.8
Preferred stock dividends.................................................................... (9.5) (9.5)
----- -----
Net income applicable to common stock
for basic earnings per share.......................................................... 55.1 72.3
Effect of dilutive securities:
Preferred stock dividends................................................................. 9.5 9.5
----- -----
Net income applicable to common stock and assumed conversions for diluted earnings
per share............................................................................. $64.6 $81.8
===== =====
Shares:
Weighted average shares outstanding
for basic earnings per share............................................................ 151,521 151,058
------- -------
Effect of dilutive securities on weighted average shares:
Class B mandatorily convertible preferred stock......................................... 30,989 35,027
Stock option and restricted stock plans................................................. 1,031 679
------- -------
Dilutive potential common shares........................................................ 32,020 35,706
------- -------
Weighted average shares outstanding for diluted earnings per share........................ 183,541 186,764
======= =======
In August 2005, we completed the private offering of $330.0 million of
3.50% Convertible Debentures due September 30, 2035 (the "Debentures"). In
future periods, our diluted shares outstanding may include incremental shares
issuable upon conversion of all or part of such Debentures. Since the $330.0
million principal amount can only be redeemed for cash, it has no impact on the
diluted earnings per share calculation. In accordance with the conversion
feature of these Debentures, we may be required to pay a stock premium along
with redeeming the accreted principal amount for cash, if our common stock
reaches a certain market price. In accordance with the consensus from EITF No.
04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings
per Share", we will include the dilutive effect of our Debentures in the
calculation of diluted earnings per share when the impact is dilutive. As of
March 31, 2006, the conversion feature of these Debentures did not have a
dilutive effect because the weighted average market price of our common stock
did not exceed the initial conversion price of $26.66. Therefore, the Debentures
had no effect on our diluted shares outstanding or our diluted earnings per
share for the three months ended March 31, 2006.
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
-------------------
STOCK-BASED COMPENSATION
The Company has a long-term incentive plan which permits the grant of CNO
incentive or non-qualified stock options, restricted stock awards, stock
appreciation rights, performance shares or units and certain other equity-based
awards to certain directors, officers and employees of the Company and certain
other individuals who perform services for the Company. A maximum of 10 million
shares may be issued under the plan. Our stock option awards are generally
granted with an exercise price equal to the market price of the Company's stock
on the date of grant. Our stock option awards generally vest on a graded basis
over a four year service term and expire ten years from the date of grant. Our
restricted stock awards generally vest on a graded basis over a three year
service term.
Prior to January 1, 2006, we measured 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 was recorded
when the quoted market price at the grant date exceeded the amount an employee
had to pay to acquire the stock. When the Company issued employee stock options
with an exercise price equal to or greater than the market price of our stock on
the grant date, no compensation cost was 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" required 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 revised SFAS 123 and superseded APB 25. SFAS 123R
provided additional guidance on accounting for share-based payments and required
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.
Conseco implemented SFAS 123R using the modified prospective method on January
1, 2006. Under this method, the Company began recognizing compensation cost for
all awards granted on or after January 1, 2006. In addition, we are required to
recognize compensation cost over the remaining requisite service period for the
portion of outstanding awards that were not vested as of January 1, 2006 and
were not previously expensed on a pro forma basis pursuant to SFAS 123. In
accordance with the modified prospective transition method, our consolidated
financial statements for prior periods have not been restated to reflect
compensation cost determined under the fair value method. 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 previously required. During the first three months of 2006, we did not
capitalize any stock-based compensation expense.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
A summary of the Company's stock option activity and related information
for the three months ended March 31, 2006, is presented below (shares in
thousands, dollars in millions):
Weighted Weighted
average average Aggregate
exercise remaining intrinsic
Shares price life value
------ ----- ---- -----
Outstanding at the beginning of the period........................ 3,536 $19.89
Options granted................................................... 25 24.82
Exercised......................................................... (39) 20.89 $.2
Forfeited or terminated........................................... (15) 19.90
-----
Outstanding at the end of the period.............................. 3,507 19.92 8.3 years $21.8
===== === =====
Options exercisable at the end of
the period..................................................... 1,377 20.01 8.1 years $9.0
===== === ====
Available for future grant........................................ 4,238
=====
We recognized compensation expense related to stock options totaling $1.4
million ($.9 million after income taxes) in the first three months of 2006.
Compensation expense related to stock options reduced both basic and diluted
earnings per share by less than one cent in the first three months of 2006. At
March 31, 2006, the unrecognized compensation expense for non-vested stock
options totaled $9.9 million which is expected to be recognized over a weighted
average period of 2.2 years.
If compensation cost had been determined based on the fair value at the
grant dates for all awards issued after January 1, 1995, 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
March 31,
2005
----
Net income, as reported ............................................................................... $81.8
Less stock-based employee compensation expense determined
under the fair value method for all awards, net of
income taxes...................................................................................... .7
-----
Pro forma net income................................................................................... $81.1
=====
Earnings per share:
Basic, as reported................................................................................ $.48
Basic, pro forma.................................................................................. .47
Diluted, as reported.............................................................................. $.44
Diluted, pro forma................................................................................ .43
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following table summarizes information about stock options outstanding
at March 31, 2006 (shares in thousands):
Options outstanding Options exercisable
-------------------------------------------- ----------------------------
Number Remaining Average exercise Number Average exercise
Range of exercise prices outstanding life (in years) price exercisable price
- ------------------------ ----------- --------------- ----- ----------- -----
$16.20 - $20.37................... 1,594 8.3 $18.42 607 $18.72
$21.00 - $25.45................... 1,913 8.4 21.16 770 21.02
----- -----
3,507 1,377
===== =====
A summary of the Company's non-vested restricted stock activity for the
three months ended March 31, 2006, is presented below (shares in thousands):
Weighted
average
grant date
Shares fair value
------ ----------
Non-vested shares, beginning of period.............................. 1,392 $18.57
Vested.......................................................... (3) 20.29
-----
Non-vested shares, end of period.................................... 1,389 18.57
=====
At March 31, 2006, the unrecognized compensation expense for non-vested
restricted stock totaled $15.2 million which is expected to be recognized over a
weighted average period of 1.7 years. We recognized compensation expense related
to restricted stock awards totaling $3.1 million and $2.3 million in the first
three months of 2006 and 2005, respectively.
The fair value of each stock option grant is estimated on the date of grant
using the Black-Scholes option valuation model with the following weighted
average assumptions:
Three months
ended
March 31,
---------------------------
2006 Grants 2005 Grants(a)
----------- --------------
Weighted average risk-free interest rates.................................. 4.6%
Weighted average dividend yields........................................... 0.0%
Volatility factors......................................................... 22%
Weighted average expected life............................................. 6.2 years
Weighted average fair value per share...................................... $8.35
<FN>
- --------------
(a) There were no stock option grants in the first three months of 2005.
</FN>
The risk-free interest rate is based on the U.S. Treasury yield curve in
effect at the time of grant. The dividend yield is based on the Company's
history and expectation of dividend payouts. Volatility factors are based on the
weekly historical volatility of the Company's common stock since our emergence
from bankruptcy in September 2003. The expected life is based on the average of
the graded vesting period and the contractual terms of the option.
SFAS 123R also requires us to estimate the amount of unvested stock-based
awards that will be forfeited in future periods and reduce the amount of
compensation expense recognized over the applicable service period to reflect
this estimate. In accordance with SFAS 123R, we periodically evaluate our
forfeiture assumptions to more accurately reflect our actual forfeiture
experience.
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Cash received from the exercise of stock options was $.8 million during the
three months ended March 31, 2006. There were no stock options exercised in the
first three months of 2005.
The Company does not currently recognize tax benefits resulting from tax
deductions in excess of the compensation expense recognized because of net
operating loss carryforwards ("NOLs") which are available to offset future
taxable income.
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
March 31,
-----------------------
2006 2005
---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.................................................................... $ 12.5 $ 12.3
Supplemental health.......................................................... 310.5 301.7
Life......................................................................... 59.3 42.2
Other........................................................................ 27.1 3.1
Net investment income (a)......................................................... 133.2 113.5
Fee revenue and other income (a).................................................. 1.5 .6
Net realized investment gains (losses) (a)........................................ (1.0) 2.0
-------- --------
Total Bankers Life revenues.............................................. 543.1 475.4
-------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities.................................................................... 3.5 5.6
Supplemental health.......................................................... 158.0 171.7
Life......................................................................... 92.1 96.2
Other........................................................................ 2.8 3.4
Net investment income (a)......................................................... 182.0 157.3
Fee revenue and other income (a).................................................. .4 .5
Net realized investment losses (a)................................................ (5.1) (2.5)
-------- --------
Total Conseco Insurance Group revenues................................... 433.7 432.2
-------- --------
Other Business in Run-off:
Insurance policy income - supplemental health..................................... 88.9 91.5
Net investment income (a)......................................................... 44.7 43.2
Fee revenue and other income (a).................................................. .1 .1
Net realized investment gains (a)................................................. 3.0 2.1
-------- --------
Total Other Business in Run-off revenues................................. 136.7 136.9
-------- --------
Corporate:
Net investment income............................................................. 5.5 .5
Fee and other income.............................................................. 2.7 3.0
-------- --------
Total corporate revenues................................................. 8.2 3.5
-------- --------
Total revenues........................................................... $1,121.7 $1,048.0
-------- --------
(continued on next page)
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended
March 31,
-----------------------
2006 2005
---- ----
Expenses:
Bankers Life:
Insurance policy benefits........................................................ $ 380.1 $329.4
Amortization..................................................................... 61.1 46.9
Interest expense on investment borrowings........................................ - .7
Other operating costs and expenses............................................... 40.1 37.7
-------- ------
Total Bankers Life expenses................................................. 481.3 414.7
-------- ------
Conseco Insurance Group:
Insurance policy benefits........................................................ 262.4 255.1
Amortization..................................................................... 54.0 42.0
Interest expense on investment borrowings........................................ .2 2.0
Other operating costs and expenses............................................... 78.8 69.6
-------- ------
Total Conseco Insurance Group expenses...................................... 395.4 368.7
-------- ------
Other Business in Run-off:
Insurance policy benefits........................................................ 84.3 86.5
Amortization..................................................................... 3.5 5.8
Other operating costs and expenses............................................... 21.9 21.0
-------- ------
Total Other Business in Run-off expenses.................................... 109.7 113.3
-------- ------
Corporate:
Interest expense on corporate debt............................................... 12.4 12.0
Interest expense on variable interest entity..................................... 3.8 -
Other operating costs and expenses............................................... 18.0 12.1
-------- ------
Total corporate expenses.................................................... 34.2 24.1
-------- ------
Total expenses.............................................................. 1,020.6 920.8
-------- ------
Income (loss) before income taxes:
Bankers Life................................................................ 61.8 60.7
Conseco Insurance Group..................................................... 38.3 63.5
Other Business in Run-off................................................... 27.0 23.6
Corporate operations........................................................ (26.0) (20.6)
-------- ------
Income before income taxes.............................................. $ 101.1 $127.2
======== ======
<FN>
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return 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. 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 and reinsurer
accounts). Net investment income (loss) related to equity-indexed products was
$11.6 million and $(16.0) million in the three months ended March 31, 2006 and
2005, respectively. These amounts were substantially offset by the corresponding
charge to insurance policy benefits. The estimated fair value of these options
was $60.9 million and $44.5 million at March 31, 2006 and December 31, 2005,
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 $211.4 million and $210.7
million at March 31, 2006 and December 31, 2005, respectively. We maintain a
specific block of investments which are equal to the balance of these
liabilities in 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 and reinsurer 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 March 31, 2006, 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 $6.2 million and $17.4 million at March 31, 2006 and
December 31, 2005, 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 maintain a specific block of
investments related to these agreements in 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 policyholder and
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. 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 March 31, 2006, we have estimated that approximately
$35.5 million of the D&O loan balance (which is included in other assets) is
collectible (net of the costs of collection). An allowance has been established
to reduce the total D&O loan balance to the amount we estimated was recoverable.
16
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
$22.2 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 March 31,
2006 and December 31, 2005 was $22.2 million and $23.2 million, respectively,
and is included in the caption "Other liabilities" in the consolidated balance
sheet.
REINSURANCE
The cost of reinsurance ceded totaled $58.0 million and $60.6 million in
the three months ended March 31, 2006 and 2005, respectively. We deduct this
cost from insurance policy income. In each case, the ceding Conseco subsidiary
is directly liable for claims reinsured even if the assuming company is unable
to pay. Reinsurance recoveries netted against insurance policy benefits totaled
$59.7 million and $71.9 million in the three months ended March 31, 2006 and
2005, 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 $38.9 million and $14.3 million in the three months ended March
31, 2006 and 2005, 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
March 31,
-----------------------
2006 2005
---- ----
Current tax provision.................................................................... $ - $ -
Deferred tax provision................................................................... 36.5 45.4
----- -----
Income tax expense on period income............................................. $36.5 $45.4
===== =====
17
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:
Three months ended
March 31,
-----------------------
2006 2005
---- ----
U.S. statutory corporate rate........................................................ 35.0% 35.0%
Other nondeductible expenses......................................................... 1.4 .6
State taxes.......................................................................... .7 .5
Provision for tax issues, tax credits and other...................................... (1.0) (.4)
---- ----
Effective tax rate.......................................................... 36.1% 35.7%
==== ====
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
March 31, December 31,
2006 2005
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries.................................................... $ 811.4 $ 812.8
Non-life companies............................................................. 791.7 796.5
Capital loss carryforwards........................................................ 392.5 397.3
Deductible temporary differences:
Insurance liabilities.......................................................... 1,386.9 1,433.2
Unrealized depreciation of investments......................................... 125.9 -
Reserve for loss on loan guarantees............................................ 154.1 155.5
--------- ---------
Gross deferred tax assets.................................................... 3,662.5 3,595.3
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (56.9) (67.8)
Value of policies inforce at the Effective Date and cost of policies produced.. (750.3) (752.7)
Unrealized appreciation of investments......................................... - (39.7)
Other.......................................................................... (177.5) (186.9)
--------- ---------
Gross deferred tax liabilities............................................... (984.7) (1,047.1)
--------- ---------
Net deferred tax assets before valuation allowance........................... 2,677.8 2,548.2
Valuation allowance................................................................... (1,043.8) (1,043.8)
--------- ---------
Net deferred tax assets...................................................... 1,634.0 1,504.4
Current income taxes accrued.......................................................... (9.6) (7.8)
--------- ---------
Net income tax assets, net................................................... $ 1,624.4 $ 1,496.6
========= =========
Conseco and its affiliates are currently under examination by the Internal
Revenue Service ("IRS") for the tax year ending 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.
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 NOLs. We evaluate the
realizability of our deferred income tax assets and assess the need for a
valuation allowance on an ongoing basis. In evaluating our deferred
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
income tax assets, we consider whether it is more likely than not that the
deferred income tax assets will be realized. The ultimate realization of our
deferred income tax assets depends upon generating sufficient future taxable
income during the periods in which our temporary differences become deductible
and before our capital loss carryforwards and NOLs expire. In addition, the use
of the Company's NOLs is dependent, in part, on whether: (i) the IRS affirms the
tentative settlement agreement related to the allocation of the tax loss on our
Predecessor's investment in Conseco Finance Corp. ("CFC") (the "CFC loss"); and
(ii) the IRS does not take an adverse position in the future regarding the tax
position we plan to take in our tax returns with respect to the allocation of
cancellation of indebtedness income. These matters are described below.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets as we believed that the realization of such net
deferred income tax assets in future periods was uncertain. During 2004 and
2005, we concluded that it was no longer necessary to maintain certain portions
of the previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $947.0 million in 2004 and $585.8 million in 2005.
However, we are required to continue to record a valuation allowance of $1,043.8
million at March 31, 2006, because we have determined that it is more likely
than not that a portion of our deferred tax assets will not be realized. This
determination was made by evaluating each component of the deferred tax asset
and assessing the effects of limitations or interpretations on the value of such
component to be fully recognized in the future. There was no change in our
valuation allowance during the first quarter of 2006.
The Internal Revenue Code (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 (including NOLs of the non-life entities). There is no
limitation on the ability to utilize NOLs generated by a life insurance company.
In addition, the timing and manner in which the Company will be able to
utilize some of its NOLs is limited by Section 382 of the Code. Section 382
imposes limitations on a corporation's ability to use its NOLs when the company
undergoes an ownership change. Because the Company underwent an ownership change
pursuant to its reorganization, this limitation applies to the Company. 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.
We have also evaluated the likelihood that we will have sufficient taxable
income to offset the available deferred tax assets. This assessment required
significant judgment. Based upon our current projections of future income that
we completed at December 31, 2005, we believe that we will more likely than not
recover $1,634.0 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.
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
As of March 31, 2006, we had $4.6 billion of NOLs and $1.1 billion of
capital loss carryforwards, which expire as follows (dollars in millions):
Net operating
loss carryforwards(a) Total loss carryforwards
--------------------- Capital loss Total loss ---------------------------------------
Year of expiration Life Non-life carryforwards carryforwards Subject to ss.382 Not subject to ss.382
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
2006....... $ - $ .1 $ 2.5 $ 2.6 $ 2.6 $ -
2007....... - .1 449.2 449.3 449.3 -
2008....... - .1 583.7 583.8 583.8 -
2009....... - 10.5 86.2 96.7 10.5 86.2
2010....... - 2.6 - 2.6 2.6 -
2011....... - .4 - .4 .4 -
2012....... - 11.4 - 11.4 11.4 -
2016....... 49.3 - - 49.3 49.3 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6(a) 12.0 - 2,182.6 56.1 2,126.5
2019....... - .7 - .7 .7 -
2020....... 63.5 - - 63.5 - 63.5
2021....... 1.7 - - 1.7 - 1.7
2023....... - 2,110.7(a) - 2,110.7 61.0 2,049.7
2024....... - 1.3 - 1.3 - 1.3
2025....... - 112.2 - 112.2 - 112.2
-------- -------- -------- -------- -------- --------
Total...... $2,318.3 $2,262.1 $1,121.6 $5,702.0 $1,260.9 $4,441.1
======== ======== ======== ======== ======== ========
<FN>
- -------------
(a) The allocation of the NOLs summarized above assumes: (i) the IRS
affirms the tentative settlement agreement related to the allocation
of the CFC loss; and (ii) the IRS does not take an adverse position in
the future regarding the tax position we plan to take in our tax
returns with respect to the allocation of cancellation of indebtedness
income. These matters are described below. If the IRS does not approve
the tentative settlement agreement, a question would exist as to
whether $2.1 billion of NOLs expiring in 2018 relate to the life
companies (as presented above) or to the non-life companies. If the
IRS approves the tentative settlement agreement but disagrees with the
tax position we plan to take with respect to the allocation of
cancellation of indebtedness income, and their position prevails, $631
million of the NOLs expiring in 2018 would be characterized as
non-life NOLs.
</FN>
The following paragraphs describe some of the open matters related to the
classification of our NOLs.
Conseco and its affiliates are currently under examination by the IRS for
the tax year ending December 31, 2003. During the 2003 audit, the IRS questioned
the Company's tax position on the CFC loss, and requested Technical Advice from
the National Office of the IRS. The Technical Advise Memorandum ("TAM") issued
by the National Office confirmed the Company's position that the CFC loss would
be treated as a post-emergence loss and therefore would not be subject to the
Section 382 limitation. However, the TAM was adverse to the Company's position
that the CFC loss was incurred by a life insurance company. The Company then
requested, pursuant to its appeal rights, that the issue be resolved through the
IRS's Fast-Track resolution process, and a settlement was reached. The
settlement was incorporated as an adjustment in the audit. The tentative
settlement characterized $2.1 billion of the CFC loss as life insurance company
losses and the remaining amount as non-life losses prior to application of the
cancellation of indebtedness attribute reductions described below. Due to the
carryback of capital losses during the audit period resulting in a refund in
excess of $2 million, the audit is not final until the Joint Committee on
Taxation (the "Joint Committee"), which is a committee composed of 10 members
(five of whom are members of the Committee on Finance of the United States
Senate and five of whom are members of the Committee on Ways and Means of the
United States House of Representatives), has approved it. Generally, the IRS
must audit and the Joint Committee must approve any tax years in which there is
a refund in excess of $2 million, as required by Internal Revenue Code Section
6405. The IRS has proposed to the Joint Committee, in a special report as
mandated by IRC ss.6405(b), that the audited tax year for 2003 be accepted as
adjusted. This special report was sent to the Joint Committee in February of
2006. If the Joint Committee does not approve the audit, the Committee will
explain its objections to the IRS and the IRS must then
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
address those objections in the audit and resubmit the audit for approval.
Review by the Joint Committee can take as long as nine months to complete.
The Code provides that any income realized as a result of the cancellation
of indebtedness in bankruptcy (cancellation of debt income or "CODI") must
reduce NOLs. We realized an estimated $2.5 billion of CODI when we emerged from
bankruptcy. Pursuant to the Company's interpretation of the tax law, the CODI
reductions were all used to reduce non-life NOLs. However, if the IRS were to
disagree with our interpretation and ultimately prevail, we believe $631 million
of NOLs classified as life company NOLs would be re-characterized as non-life
NOLs and subject to the 35% limitation discussed above. Such a
re-characterization would also extend the year of expiration as life company
NOLs expire after 15 years whereas non-life NOLs expire after 20 years. The
Company does not expect the IRS to consider this issue for a number of years.
The Company has adopted SFAS 123R in calendar year 2006. Pursuant to this
accounting rule, the Company is precluded from recognizing the tax benefits of
any tax windfall upon the exercise of a stock option or the vesting of
restricted stock unless such deduction resulted in actual cash savings to the
Company. Because of the Company's NOLs, no cash savings have occurred. NOL
carryforwards of $.1 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital when realized.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of March 31, 2006 and December 31, 2005 (dollars in millions):
March 31, December 31,
2006 2005
---- ----
3.50% convertible debentures............................................................ $330.0 $330.0
$447.0 million secured credit agreement................................................. 478.3 524.6(a)
Unamortized discount on convertible debentures.......................................... (3.0) (3.1)
------ ------
Direct corporate obligations....................................................... $805.3 $851.5
====== ======
<FN>
- --------------
(a) Includes a one-time increase in the facility as further discussed
below.
</FN>
In August 2005, we completed the private offering of $330 million of 3.50%
Convertible Debentures due September 30, 2035 (the "Debentures"). Related
issuance costs of $7.9 million were recorded as deferred charges and will be
amortized as an increase to interest expense through September 30, 2010, which
is the earliest date the Debenture holders may require the Company to repurchase
them. The net proceeds from the offering of approximately $320 million were used
to repay term loans outstanding under the Company's $800.0 million secured
credit facility (the "Credit Facility"). The terms of the Debentures are
governed by an indenture dated as of August 15, 2005 between the Company and The
Bank of New York Trust Company, N.A., as trustee (the "Indenture"). At March 31,
2006, unamortized issuance costs (classified as other assets) related to the
Debentures were $7.0 million.
Upon the occurrence of certain specified events, the Debentures will be
convertible, at the option of the holders, into cash or, under certain
circumstances, cash and shares of the Company's common stock at an initial
conversion price of approximately $26.66 per share. The number of shares to be
received by a converting holder is subject to adjustment for certain dilutive
events. The amount of cash to be received upon conversion is equal to the lesser
of: (i) the accreted principal amount of the converting Debenture; or (ii) the
conversion value of such Debentures (as calculated in accordance with the
Indenture).
In connection with the sale of the Debentures, the Company also entered
into a Registration Rights Agreement (the "Registration Rights Agreement") with
the initial purchasers. Pursuant to that agreement, the Company filed with the
SEC a shelf registration statement with respect to the resale of the Debentures
and the sale of our shares of common stock issuable upon conversion of the
Debentures. If the Company failed to comply with certain of its obligations
under the Registration
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Rights Agreement, additional interest would be payable on the Debentures. The
Company filed the shelf registration statement on November 8, 2005, and it
became effective on March 16, 2006.
In August 2005, we entered into a $447.0 million secured credit agreement
(the "Amended Credit Facility"). The proceeds of the Amended Credit Facility
were used to repay the remaining principal amount of the Credit Facility. The
Amended Credit Facility provided for a one-time increase in the facility or the
addition of a new facility of up to $325.0 million. In December 2005, we
borrowed an additional $80.0 million pursuant to this provision. The proceeds
from the additional borrowing were used to increase the capital and surplus of
our insurance subsidiaries. During the first three months of 2006, we made
scheduled principal payments totaling $1.3 million on our Amended Credit
Facility as well as a mandatory prepayment of $45.0 million based on the
Company's excess cash flows at December 31, 2005, as defined in the Amended
Credit Facility. There were $5.3 million and $5.6 million of unamortized
issuance costs (classified as other assets) related to our Amended Credit
Facility at March 31, 2006 and December 31, 2005, respectively.
Under the terms of the Amended Credit Facility, we are required to make
quarterly principal payments of .25 percent (approximately $1.2 million) of the
remaining principal amount through March 31, 2010. However, as a result of the
mandatory prepayment discussed above, our next scheduled principal payment is
due June 30, 2007. The remaining principal balance is due on June 22, 2010. The
amount outstanding under the Amended Credit Facility bears interest, payable at
least quarterly, based on either a Eurodollar rate or a base rate. The
Eurodollar rate on the Amended Credit Facility is equal to LIBOR plus 2 percent,
compared to LIBOR plus 3.5 percent under the Credit Facility. The base rate on
the Amended Credit Facility is equal to 1 percent (2.5 percent under the Credit
Facility) plus the greater of: (i) the Federal funds rate plus .50 percent; or
(ii) Bank of America's prime rate. If the Company's senior secured long-term
debt is rated at least Ba3 by Moody's Investors Service, Inc. ("Moody's") and
BB- by S&P, in each case with a stable outlook, the margins on the Eurodollar
rate or the base rate would each be reduced by .25 percent. In March 2006,
Moody's upgraded our senior secured debt rating to "Ba3" from "B2". At March 31,
2006, the interest rate on our Amended Credit Facility was 6.5 percent.
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
2006............................................ $ -
2007............................................ 3.6
2008............................................ 4.8
2009............................................ 4.8
2010............................................ 795.1
------
$808.3
======
Pursuant to the Amended Credit Facility, as long as the debt to total
capitalization ratio (as defined in the Amended Credit Facility) is greater than
20 percent and certain insurance subsidiaries (as defined in the Amended Credit
Facility) have financial strength ratings of less than A- from A.M. Best, 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 Amended Credit
Facility. The Company may make optional prepayments at any time in minimum
amounts of $3.0 million or any multiple of $1.0 million in excess thereof.
The Amended 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 15 percent at March 31, 2006); (ii) an interest coverage ratio
greater than or equal to 2.00 to 1 for each rolling four quarters ending June
30, 2007, and 2.50 to 1 for each rolling four quarters thereafter (such ratio
exceeded the minimum requirement for the four quarters ending March 31, 2006);
(iii) an aggregate risk-based capital ratio, as defined in the Amended Credit
Facility, greater than or equal to 245 percent at March 31, 2006, and 250
percent for each quarter ending thereafter (such ratio exceeded the minimum
risk-based capital requirements at March 31, 2006); (iv) a combined statutory
capital and surplus level of greater than $1,270.0 million (combined statutory
capital and surplus at March 31, 2006 exceeded such requirement); and (v)
specified investment portfolio requirements (such investment portfolio
requirements were met at March 31, 2006).
The Amended Credit Facility includes an $80.0 million revolving credit
facility that can be used for general corporate purposes and that would mature
on June 22, 2009. There were no amounts outstanding under the revolving credit
facility at
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
March 31, 2006. The Company pays a commitment fee equal to .50 percent of the
unused portion of the revolving credit facility on an annualized basis. The
revolving credit facility bears interest based on either a Eurodollar rate or a
base rate in the same manner as described above for the Amended Credit Facility.
SALES INDUCEMENTS
Certain of our annuity products offer sales inducements to contract holders
in the form of enhanced crediting rates or bonus payments in the initial period
of the contract. Certain of our life insurance products offer persistency
bonuses credited to the contract holders balance after the policy has been
outstanding for a specified period of time. These enhanced rates and persistency
bonuses 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 $10.6 million and $4.7 million during the three
months ended March 31, 2006 and 2005, respectively. Amounts amortized totaled
$4.3 million and $1.0 million during the three months ended March 31, 2006 and
2005, respectively. The unamortized balance of deferred sales inducements at
March 31, 2006 and December 31, 2005 was $76.4 million and $70.1 million,
respectively. The balance of insurance liabilities for persistency bonus
benefits was $314.6 million and $320.7 million at March 31, 2006 and December
31, 2005, respectively.
RECENTLY ISSUED ACCOUNTING STANDARDS
Pending Accounting Standards
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140"
("SFAS 155"). SFAS 155 amends SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), and SFAS 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities"
and resolves issues addressed in SFAS 133 Implementation Issue No. D1,
"Application of Statement 133 to Beneficial Interest in Securitized Financial
Assets". SFAS 155: (a) permits fair value remeasurement for any hybrid financial
instrument that contains an embedded derivative that otherwise would require
bifurcation; (b) clarifies which interest-only strips and principal-only strips
are not subject to the requirements of SFAS 133; (c) establishes a requirement
to evaluate beneficial interests in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain an embedded derivative requiring bifurcation; (d)
clarifies that concentrations of credit risk in the form of subordination are
not embedded derivatives; and, (e) eliminates restrictions on a qualifying
special-purpose entity's ability to hold passive derivative financial
instruments that pertain to beneficial interests that are or contain a
derivative financial instrument. The standard also requires presentation within
the financial statements that identifies those hybrid financial instruments for
which the fair value election has been applied and information on the income
statement impact of the changes in fair value of those instruments. SFAS 155 is
effective for all financial instruments acquired or issued in a fiscal year that
begins after September 15, 2006. Given its recent issuance, management is still
assessing the impact SFAS 155 will have on our results of operations or
financial position.
In September 2005, the Accounting Standards Executive Committee issued
Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred
Acquisition Costs in Connection With Modifications or Exchanges of Insurance
Contracts" ("SOP 05-1"). This statement provides guidance on accounting for
deferred acquisition costs on an internal replacement which is defined broadly
as a modification in product benefits, features, rights, or coverages that
occurs by the exchange of an existing contract for a new contract, or by
amendment, endorsement, or rider to an existing contract, or by the election of
a benefit, feature, right, or coverage within an existing contract. An internal
replacement that is determined to result in a replacement contract that is
substantially unchanged from the replaced contract should be accounted for as a
continuation of the replaced contract. Contract modifications resulting in a
replacement contract that is substantially changed from the replaced contract
should be accounted for as an extinguishment of the replaced contract and any
unamortized deferred acquisition costs, unearned revenue liabilities, and
deferred sales inducement assets from the replaced contract should not be
deferred in connection with the replacement contract. The provisions of SOP 05-1
are effective for internal replacements occurring in fiscal years beginning
after December 15, 2006. We are currently assessing the impact of SOP 05-1,
however we do not expect the pronouncement to have a material impact on our
results of operations or financial position.
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Adopted Accounting Standards
The FASB issued SFAS 123R in December 2004. SFAS 123R revises SFAS 123 and
supersedes APB 25. SFAS 123R provides additional guidance on accounting for
share-based payments and requires 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. SFAS 123R is effective for all awards granted,
modified, repurchased or cancelled and requires the recognition of compensation
cost over the remaining requisite service period for the portion of outstanding
awards that were not vested as of January 1, 2006 and were not previously
expensed on a pro forma basis in the disclosure included under the caption
entitled "Accounting for Stock Options". 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 previously
required. We previously measured compensation expense for our stock option plans
using the intrinsic value method. Effective January 1, 2006, we were required to
recognize expense related to our stock option plans consistent with the
requirements of SFAS 123R described above. We implemented this requirement using
the modified prospective method. In March 2005, the SEC issued Staff Accounting
Bulletin No. 107, "Share-Based Payment" ("SAB 107") related to SFAS 123R. We
have followed the guidance in SAB 107 in our adoption of SFAS 123R. See the note
entitled "Accounting for Stock Options" for further information on our adoption
of SFAS 123R.
LITIGATION AND OTHER LEGAL PROCEEDINGS
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. The
amounts sought in certain of these actions are often large or indeterminate and
the ultimate outcome of certain actions is difficult to predict. In the event of
an adverse outcome in one or more of these matters, the ultimate liability may
be in excess of the liabilities we have established and could have a material
adverse effect on our business, financial condition, results of operations and
cash flows. In addition, the resolution of pending or future litigation may
involve modifications to the terms of outstanding insurance policies, which
could adversely affect the future profitability of the policies at issue.
In the cases described below, we have disclosed any specific dollar amounts
sought in the complaints. In our experience, monetary demands in complaints bear
little relation to the ultimate loss, if any, to the Company. However, for the
reasons 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 an amended consolidated class action complaint with
respect to the individual defendants on December 8, 2003. 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
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 a second time. Plaintiffs filed a second amended complaint on August
24, 2005. We filed a motion to dismiss the second amended complaint on November
7, 2005. 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.
Cost of Insurance Litigation
The Company and certain subsidiaries, including principally Conseco Life
Insurance Company, 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. In June 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). In September
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 issued an order certifying 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 October 24, 2006. In an attempt to avoid the risks and costs associated
with protracted litigation, we have been involved in settlement discussions
regarding this matter. During the first quarter of 2006, we increased our
litigation accrual related to this litigation.
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 Arlene 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.,
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, Mr. 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 December 22, 2005 a lawsuit was filed in Pennsylvania
captioned Lisa M. Jordan v. Allen R. Shank and Conseco Life Insurance Company,
Case No. 05-10204 (Court of Common Pleas, Chester County, Pennsylvania).
We believe these cost of insurance lawsuits are without merit and intend to
defend them vigorously. However, the ultimate outcome of these lawsuits cannot
be predicted with certainty and an adverse outcome could exceed the amount we
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
have accrued and could have a material impact on the Company's consolidated
financial condition, cash flows or results of operations.
Other Litigation
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 Insurance Company in June 2002. Shortly
after Manhattan National Life Insurance Company filed a motion to dismiss this
case, Plaintiffs voluntarily dismissed this action on April 4, 2006.
In October 1997, an action was filed against Conseco Variable Insurance
Company ("CVIC"), a former subsidiary of the Company, 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 July 31, 2006. 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.
On February 13, 2004, a declaratory judgment action, RLI Insurance Company
v. Conseco, Inc., et al 1:04-cv-00310-LJM-WTL, was filed in the United States
District Court for the Southern District of Indiana by RLI Insurance Company
("RLI"), Conseco's fiduciary insurance carrier. RLI is asking the court to find
that is has no liability under its policy for the claims made against Conseco in
Roderick Russell, et al. v. Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM. In
this 2004 Declaratory Judgment action, RLI claims that releases provided to them
pursuant to RLI's agreement to settle a prior case involving the Predecessor,
RLI Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No.
1:04-CV-0310DFH-TAB (Southern District, Indiana), absolved it of any further
liability for claims by Conseco. The Company is pursuing recovery from RLI of
the $10 million paid to settle the Russell matter, and has filed counterclaims
for declaratory judgment and breach of contract. The court stayed this case
until the Russell matter was resolved; however, the stay was lifted as of
November 15, 2005. We believe that 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 from RLI a substantial
portion of the amount we paid in settlement of the Russell matter.
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. 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 connection with the sale
of CVIC. We believe that we have established adequate
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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, a complaint was filed in the United States District
Court for the Northern District of Oklahoma, Robin C. Willig, as Executrix of
the Estate of Rhodes K. Scherer vs. Conseco Senior Health Insurance Company and
Conseco, Inc., Case No. 04 CV 923E (M). The plaintiff alleges that the failure
to pay long term care insurance policy proceeds has been a breach of contract
and in violation of the duty to act in good faith, and seeks actual damages in a
sum in excess of $75,000, punitive damages in a sum in excess of $75,000, her
costs, attorneys' fees, and such other and further relief as the Court and jury
determine to be just, equitable, and fair. On or about September 27, 2005, the
plaintiff dismissed Conseco, Inc. as a defendant. Discovery is ongoing. Jury
trial is currently set for September 18, 2006. We believe the action is without
merit, and intend to defend it vigorously. The ultimate outcome of the action
cannot be predicted with certainty.
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 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 court has enlarged the time for discovery
to July 2006. In addition, CMIC filed a motion requesting that the case be moved
to the U.S. District Court in Indianapolis. We anticipate a ruling on this
motion by the third quarter of 2006. The case is expected to be set for trial in
2007. We believe the action is without merit, and intend to defend it
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On November 17, 2005, a complaint was filed in the United States District
Court for the Northern District of California, Robert H. Hansen, an individual,
and on behalf of all others similarly situated v. Conseco Insurance Company, an
Illinois corporation f/k/a Conseco Annuity Assurance Company, Cause No.
C0504726. Plaintiff in this putative class action purchased an annuity in 2000
and is claiming relief on behalf of the proposed national class for alleged
violations of the Racketeer Influenced and Corrupt Organizations Act (RICO);
elder abuse; unlawful, deceptive and unfair business practices; unlawful,
deceptive and misleading advertising; breach of fiduciary duty; aiding and
abetting of breach of fiduciary duty; and unjust enrichment and imposition of
constructive trust. On January 27, 2006, a similar complaint was filed in the
same court entitled Friou P. Jones, on Behalf of Himself and All Others
Similarly Situated v. Conseco Insurance Company, an Illinois company f/k/a
Conseco Annuity Assurance Company, Cause No. C06-00537. Mr. Jones had purchased
an annuity in 2003. Each case alleged that the annuity sold was inappropriate
and that the annuity products in question are inherently unsuitable for seniors
age 65 and older. On March 3, 2006 a first amended complaint was filed in the
Hansen case adding Friou P. Jones as a named Plaintiff and adding causes of
action for fraudulent concealment and breach of the duty of good faith and fair
dealing. This in effect has consolidated the two cases, and the original Jones
case will be dismissed. The court has not yet made a determination whether the
case should go forward as a class action, and we intend to oppose any form of
class action treatment of these claims. We believe the action is without merit,
and intend to defend it vigorously. The ultimate outcome of the action cannot be
predicted with certainty.
On November 6, 2003, a Complaint was filed in State Court in Fulton County,
Georgia, Reginald Martin Agency, Inc.; Comprehensive Insurance Marketing, Inc.;
Design Benefits Inc.; Jim Jasnoski d/b/a Design Benefits, Inc.; Kenny Froug
d/b/a Atlanta Brokerage Office; Brokerage One Agency, Inc.; Tri-State Brokerage,
Inc.; Don Sepulveda d/b/a Sepulveda Insurance Group; Dean Vandersnick d/b/a
Professional Insurance Brokerage and Whitewater Brokerage, Inc. v. Conseco
Medical Insurance Company, Conseco Marketing LLC, Timothy F. O'Keefe and Edward
M. Berube, Cause No. 03VC0587 B4Y. Plaintiffs are former CMIC Field Marketing
Organizations that 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 breach of contract, fraud, negligent misrepresentation, breach of
partnership agreements and fiduciary duty, breach of implied covenant of good
faith and fair dealing, tortuous interference with business and contractual
relationships, damage to goodwill and business reputation and bad faith. At
CMIC's request, the case was removed to federal court and transferred to the
United States District Court for the Southern District of Indiana, Indianapolis
Division (Cause No. 1:04-CV-1587-TAB/RLY). CMIC filed a motion to dismiss, and
all of the causes of action have been dismissed except the fraud count and the
action for breach of fiduciary duty. The case is set to go to trial on March 5,
2007. We believe the action is without merit, and intend to defend it
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
On March 22, 2006, the Company's subsidiary, CDOC, Inc. ("CDOC"), as the
successor in interest to Statesman Insurance Company ("Statesman"), brought a
complaint for declaratory judgment against Himco Waste-Away Services, Inc.
("Himco"). CDOC, Inc. v. Himco Waste-Away Services, Inc., Case No.
29C01-0603-PL-296 (Hamilton Circuit Court, Indiana). CDOC seeks a court
declaration to determine the rights and obligations of CDOC and Himco under
certain general liability contracts Himco allegedly procured from Statesman
during the period 1969 through 1975. The coverage dispute arises out of a U.S.
Environmental Protection Agency ("EPA") claim against Himco, for which Himco
sought reimbursement of investigation and defense costs and indemnification of
its settlement with the EPA pursuant to the Statesman policies in the sum of
$1.6 million. CDOC's complaint alleges that Himco failed to comply with
conditions precedent to coverage under the Statesman policies because, among
other things, Himco's late notice to CDOC of the EPA's claim was not immediate,
as required by the policies, but rather was unreasonably late, and Himco failed
and refused to cooperate in good faith with CDOC. The complaint also alleges
that Himco's failure to provide immediate notice and cooperate precludes Himco
from seeking and receiving any insurance coverage under the Statesman policies.
The ultimate outcome of this action cannot be predicted with certainty.
Conseco Annuity Assurance Company f/k/a Beneficial Standard Life has filed
suit against J.C. Penney a/k/a Stonebridge in a case captioned, Beneficial
Standard Life Insurance Company v. J.C. Penney Life Insurance Company, and J.C.
Penney Company, Inc., United States District Court for the Central District of
California, Case No. CV-98-02792-SVW. This litigation arises from the 1967 sale
of Beneficial Fire & Casualty ("BF&C") by Beneficial Standard Life Insurance
Company ("Beneficial") to J.C. Penney Company, Inc. ("Penney"). The subject of
the case is whether Beneficial must indemnify Penney for losses and expenses
incurred as a result of claims arising under pre-sale BF&C insurance policies.
Beneficial filed suit in April 1998 seeking a judicial declaration that: (1) it
was not generally obligated to indemnify Penney under the terms of the agreement
governing the 1967 sale; and (2) that with respect to certain environmental
claims asserted by the Port of Oakland, any indemnification obligation was
excused by Penney's conduct in handling the claims. Penney counterclaimed for
breach of contract and declaratory relief. The counterclaim does not specify the
damages sought by Penney on the breach of contract claim. After a bench trial in
2002, certain rulings of the trial court were appealed to the United States
Court of Appeals for the Ninth Circuit. In June 2005, the Ninth Circuit issued
an opinion holding that the terms of the 1967 sale generally require Beneficial
to indemnify Penney for net liabilities arising from pre-sale policies, but only
after Penney pursues and exhausts available reinsurance. The Ninth Circuit
remanded the case to the trial court for further proceedings to determine if
this obligation has been excused with respect to specific claims at issue in the
case. We are now preparing an amended complaint to be filed against Stonebridge.
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 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. 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 Services v. Decatur, Case No. 29D02-0404-CC-000379 (Superior Court,
Hamilton County, Indiana); Conseco, Inc. v. Murray, Case No.
1:05-cv-01580-JDT-TAB (Southern District, Indiana); Conseco, Inc. v. Massey,
Case No. 2005-L-011316 (Circuit court, Cook County, 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, in Conseco Services v. Hilbert, Conseco Services was
granted partial final summary judgment in the amount of $62.7 million plus
interest. Mr. Hilbert has appealed that ruling. The Court of Appeals ruled in
our favor on November 8, 2005. Mr. Hilbert subsequently filed a petition to
transfer with the Indiana Supreme Court, which was denied on March 16, 2006.
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 March 31, 2006, we estimated that approximately $35.5 million, net
of collection costs, of the remaining amounts due under the loan program will be
collected and that $22.2 million will be paid to the former holders of our
Predecessor's trust preferred securities.
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.
Regulatory Examinations and Fines
Insurance companies face significant risks related to regulatory
investigations and actions. Regulatory investigations generally result from
matters related to sales or underwriting practices, payment of contingent or
other sales commissions, claim payments and procedures, product design, product
disclosure, additional premium charges for premiums paid on a periodic basis,
denial or delay of benefits, charging excessive or impermissible fees on
products, changing the way cost of insurance charges are calculated for certain
life insurance products or recommending unsuitable products to customers. We
are, in the ordinary course of our business, involved in various examinations
and inquiries subjecting us to information requests from state and other
authorities. The ultimate outcome of these examinations cannot be predicted with
certainty. In the event of an unfavorable outcome in one or more of these
matters, the ultimate liability may be in excess of liabilities we have
established and we could suffer significant reputational harm as a result of
these matters, which could also have a material adverse effect on our business,
financial condition, results of operations or cash flows.
During the first quarter of 2006, certain insurance subsidiaries (Conseco
Insurance Company, Conseco Life Insurance Company, Washington National Insurance
Company, Conseco Health Insurance Company and Conseco Senior Health Insurance
Company) agreed to settle matters resulting from a market conduct examination by
the Minnesota Commerce Department. A fine of $2.5 million was agreed to and has
been accrued in our consolidated financial statements as of March 31, 2006. Such
fine was paid in April 2006.
The terms of the settlement could result in additional benefits or options
being offered to certain policyholders.
Minnesota owners of equity-indexed annuities issued by Conseco Insurance
Company purchased on or after January 1, 1998, will receive the opportunity to
initiate a Conseco internal review and arbitration process to determine whether
they adequately understood the renewal participation rate feature of their
policy at the time the policy was originally sold. Policyholders who can prove
they did not understand renewal participation rates at the time the policy was
originally sold based on representations or omissions made by the Company or its
agents may be provided relief in the form of adjusted participation rates.
Within 60 days, we will send a separate notice to affected policyholders to
advise them of their options. There are approximately 2,000 policyholders in
this group.
To date, policyholders have not asserted claims with significant exposure
to the Company related to the potential issues addressed in the settlement.
However, management considers it probable that additional claims will be
asserted and there is a reasonable possibility that the outcome will be
unfavorable. Although the outcome of the procedures required by the settlement
cannot be predicted with certainty, management currently believes the cost of
resolving these matters will not result in a loss which exceeds the amount
accrued by more than $5 million.
29
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Three months ended
March 31,
----------------------
2006 2005
---- ----
Cash flows from operating activities:
Net income........................................................................... $ 64.6 $ 81.8
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization and depreciation.................................................... 128.8 98.1
Income taxes..................................................................... 37.5 51.3
Insurance liabilities............................................................ 96.0 128.0
Accrual and amortization of investment income.................................... (3.8) 34.1
Deferral of policy acquisition costs............................................. (114.8) (107.2)
Net realized investment (gains) losses........................................... 3.1 (1.6)
Net sales of trading securities.................................................. 4.8 26.1
Other............................................................................ (9.2) (12.9)
------- -------
Net cash provided by operating activities...................................... $ 207.0 $ 297.7
======= =======
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............................................ $3.5 $2.3
==== ====
At March 31, 2006 and December 31, 2005, restricted cash and cash
equivalents consisted of: (i) $19.8 million and $33.3 million, respectively,
held by a variable interest entity; and (ii) $2.0 million and $1.9 million,
respectively, of segregated cash held for the benefit of the former holders of
TOPrS.
30
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at March 31, 2006, and the consolidated results of operations for the three
months ended March 31, 2006 and 2005, 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 SEC, press
releases, presentations by Conseco or its management or oral statements)
relative to markets for Conseco's products and trends in Conseco's operations or
financial results, as well as other statements, contain forward-looking
statements within the meaning of the federal securities laws and the Private
Securities Litigation Reform Act of 1995. Forward-looking statements typically
are identified by the use of terms such as "anticipate," "believe," "plan,"
"estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" section of our 2005 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 our ability to continue to recruit and retain productive agents and
distribution partners and 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 SEC;
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;
31
CONSECO, INC. AND SUBSIDIARIES
-------------------
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
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 operating segments, which
are defined on the basis 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, Medicare Part D prescription drug program
and certain annuity products 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 in prior years through independent agents and major medical
insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments.
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2005 Annual Report on
Form 10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements.
32
CONSECO, INC. AND SUBSIDIARIES
-------------------
Accounting for marketing and quota-share agreements with Coventry Health
Care
The Medicare Modernization Act provided for the introduction of a
prescription drug benefit (Part D). In order to offer this product to our
current and potential future policyholders without investment in management and
infrastructure, we entered into a national distribution agreement with Coventry
Health Care ("Coventry") to use our career and independent agents to distribute
Coventry's prescription drug plan, Advantra Rx. We receive a fee based on the
premiums collected on plans sold through our distribution channels. In addition,
Conseco has a quota-share reinsurance agreement with Coventry for Conseco
enrollees that provides Conseco in 2006 with 50 percent of net premiums and
related profits subject to a risk corridor. Our career and independent channels
have enrolled approximately 130,000 members through March 31, 2006. The Part D
program was effective January 1, 2006.
The following describes how we account for and report these activities:
Our accounting for the national distribution agreement
o We recognize distribution and licensing fee income from Coventry over
the life of the policy based upon negotiated percentages of collected
premiums on the underlying Medicare Part D contracts.
o We also incur commissions paid to our agents. They are deferred and
amortized over the remaining term of the initial enrollment period
(the life of the policy) and the amortization is recorded in operating
expenses.
Our accounting for the quota-share agreement
o We recognize premium revenues assumed evenly over the period of the
underlying Medicare Part D contracts.
o We recognize policyholder benefits and ceding commission expense as
incurred.
o We recognize risk-share premium adjustments consistent with Coventry's
risk-share agreement with the Centers for Medicare and Medicaid
Services, as if the quarter represented an entire contract period.
The following summarizes the loss before income taxes recognized on this
business (primarily in the Bankers Life segment) during the first quarter of
2006 (dollars in millions):
Insurance policy income............................ $24.2(a)
Fee revenue and other.............................. 1.2
-----
Total revenues................................... 25.4
-----
Insurance policy benefits.......................... 24.2
Amortization expense............................... 1.9
Other operating expense (primarily ceding
commissions)..................................... 1.3
-----
Total expense.................................... 27.4
-----
Loss before income tax........................... $(2.0)
=====
<FN>
- -----------
(a) Such amount includes $7.9 million of risk-share premium adjustments.
Pursuant to the Coventry Medicare Part D Plan, the insurance plan covers 75
percent of the policyholder's prescription drug costs up to $2,250; zero percent
from $2,251 to $5,100; and 95 percent over $5,100. Given this benefit structure,
we expect the loss recognized in the first quarter of 2006 will be offset by
income in the later periods based on our estimates of the full-year policyholder
benefits expected to be incurred.
</FN>
33
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
The following tables and narratives summarize the operating results of our
segments for the periods presented (dollars in millions):
Three months ended
March 31,
-----------------------
2006 2005
---- ----
Income (loss) before net realized investment gains (losses), net of related
amortization, and income taxes (a non-GAAP measure) (a):
Bankers Life........................................................................ $ 62.3 $ 58.8
Conseco Insurance Group............................................................. 41.9 64.4
Other Business in Run-off........................................................... 24.0 21.5
Corporate operations................................................................ (26.0) (20.6)
------ ------
102.2 124.1
------ ------
Net realized investment gains (losses), net of related amortization:
Bankers Life........................................................................ (.5) 1.9
Conseco Insurance Group............................................................. (3.6) (.9)
Other Business in Run-off........................................................... 3.0 2.1
Corporate operations................................................................ - -
------ ------
(1.1) 3.1
------ ------
Income (loss) before income taxes:
Bankers Life........................................................................ 61.8 60.7
Conseco Insurance Group............................................................. 38.3 63.5
Other Business in Run-off........................................................... 27.0 23.6
Corporate operations................................................................ (26.0) (20.6)
------ ------
Income before income taxes....................................................... $101.1 $127.2
====== ======
<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 our business, 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 sold 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.
34
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended
March 31,
----------------------
2006 2005
---- ----
Premium collections:
Annuities............................................................................ $ 233.4 $ 221.7
Supplemental health.................................................................. 325.9 313.6
Life................................................................................. 66.6 48.6
-------- --------
Total collections.................................................................. $ 625.9 $ 583.9
======== ========
Average liabilities for insurance products:
Annuities:
Mortality based.................................................................. $ 362.4 $ 354.9
Equity-indexed................................................................... 413.2 301.1
Deposit based.................................................................... 4,348.3 3,922.7
Health............................................................................. 3,236.6 2,963.3
Life:
Interest sensitive............................................................... 366.7 346.1
Non-interest sensitive........................................................... 782.4 739.4
-------- --------
Total average liabilities for insurance
products, net of reinsurance ceded............................................. $9,509.6 $8,627.5
======== ========
Revenues:
Insurance policy income.............................................................. $ 409.4 $ 359.3
Net investment income:
General account invested assets.................................................... 130.8 116.4
Equity-indexed products based on the change in value of options.................... 2.4 (2.9)
Trading account income related to policyholder and reinsurer
accounts......................................................................... (7.8) (4.9)
Change in value of embedded derivatives related to modified
coinsurance agreements........................................................... 7.8 4.9
Fee revenue and other income......................................................... 1.5 .6
-------- --------
Total revenues................................................................... 544.1 473.4
-------- --------
Expenses:
Insurance policy benefits............................................................ 335.5 291.5
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.................................................... 42.1 39.1
Equity-indexed products based on change in value of indices........................ 2.5 (1.2)
Amortization related to operations................................................... 61.6 46.8
Interest expense on investment borrowings............................................ - .7
Other operating costs and expenses................................................... 40.1 37.7
-------- --------
Total expenses................................................................... 481.8 414.6
-------- --------
Income before net realized investment gains (losses), net of related amortization
and income taxes....................................................................... 62.3 58.8
-------- --------
Net realized investment gains (losses)............................................... (1.0) 2.0
Amortization related to net realized investment gains (losses)....................... .5 (.1)
-------- --------
Net realized investment gains (losses), net of related amortization ............. (.5) 1.9
-------- --------
Income before income taxes................................................................ $ 61.8 $ 60.7
======== ========
(continued)
35
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended
March 31,
----------------------
2006 2005
---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits........................................................ $277.2 $246.4
Benefit ratio (a)................................................................ 82.1% 80.8%
Medicare supplement:
Insurance policy benefits........................................................ $113.6 $117.6
Benefit ratio (a)................................................................ 67.8% 71.9%
Long-term care:
Insurance policy benefits........................................................ $138.0 $126.8
Benefit ratio (a)................................................................ 96.5% 91.8%
Interest-adjusted benefit ratio (b).............................................. 66.9% 63.9%
Other:
Insurance policy benefits........................................................ $25.6 $2.0
Benefit ratio (a)................................................................ 94.4% 65.0%
<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 $42.4 million and $38.6 million
in the three months ended March 31, 2006 and 2005, respectively.
</FN>
Total premium collections were $625.9 million in the first quarter of 2006,
up 7.2 percent from 2005. Premium collections in the first quarter of 2006
include $6.0 million of premiums collected pursuant to the quota-share agreement
with Coventry described above under "Accounting for the marketing and
quota-share agreement with Coventry Health Care". See "Premium Collections" for
further analysis of Bankers Life's premium collections.
Average liabilities for insurance products, net of reinsurance ceded were
$9.5 billion in the first quarter of 2006, up 10 percent from 2005. The increase
in such liabilities was primarily due to increases in annuity reserves resulting
from 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. Insurance policy income includes $24.2 million of premium income
from the quota-share agreement with Coventry described above under "Accounting
for the marketing and quota-share agreement with Coventry Health Care". Such
amount includes $7.9 million of risk-share premiums due from Coventry consistent
with the obligations under our quota-share agreement, as if the quarter
represented an entire contract period. See "Premium Collections" for further
analysis.
36
CONSECO, INC. AND SUBSIDIARIES
-------------------
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $130.8 million in the first
quarter of 2006, up 12 percent from 2005. The average balance of general account
invested assets was $9.2 billion and $8.3 billion in the first quarters of 2006
and 2005, respectively. The average yield on these assets was 5.7 percent and
5.6 percent in the first quarters of 2006 and 2005, respectively. The increase
in general account invested assets is primarily due to sales of our annuity
products in recent periods.
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 hedge certain potential 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. Investment income (loss) related to
equity-indexed products was $2.4 million and $(2.9) million in the first
quarters of 2006 and 2005, 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 securities, 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.
Fee and other income increased to $1.5 million in the first three months of
2006, compared to $.6 million in the same period of 2005. During the first three
months of 2006, we recognized fee income of $1.2 million pursuant to the
agreements described above under "Accounting for the marketing and quota-share
agreement with Coventry Health Care".
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 (excluding changes in
policy benefit reserves), after three years from the original issuance of the
policy and over the lifetime of the policy, 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 three months of 2006 reflected a $2.2 million
claim reserve redundancy while the 2005 period reflected a $2.9 million claim
reserve deficiency resulting from the ultimate development of reserves at
December 31, 2005 and 2004, respectively.
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 reserves 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. In the first quarter of 2005, we began introducing several new
long-term care products to replace our previous products offered for sale which
had lower pricing. To date, these new products have been approved by the
regulatory authorities in 48 states and the District of Columbia. 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 increased from 63.9
percent in the first quarter of 2005 to 66.9 percent in the first quarter of
2006.
We are seeking rate increases on approximately 65 percent of the total
long-term care inforce block in the Bankers Life segment. As a result of higher
persistency in this block and lower interest rates than assumed in the original
pricing, the
37
CONSECO, INC. AND SUBSIDIARIES
-------------------
current premium rates are too low. This rate increase process is proceeding
according to plan and, to date, we have received approval for approximately 73
percent of the total dollar amount of our requested rate increases. These rate
increases are generally consistent with the assumptions used to determine the
value of policies inforce at the Effective Date and the value of our insurance
liabilities.
The loss ratio for other health products was affected by the experience on
the Medicare Part D quota-share agreement described above under "Accounting for
marketing and quota-share agreement with Coventry Health Care". During the first
three months of 2006, we recognized insurance policy income of $24.2 million
related to the Part D program and the benefit ratio on this business was 100.1
percent, which is expected to decline throughout the year.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $42.1 million in the first quarter of
2006, up 7.7 percent from 2005. The increase is primarily due to increases in
annuity reserves (resulting from higher sales of these products) partially
offset by lower average crediting rates. The weighted average crediting rates
for these products were 3.6 percent and 3.7 percent in the first quarters of
2006 and 2005, respectively.
Amounts added to equity-indexed products based on change in value of the
indices fluctuated with the corresponding 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 and investment-type products; or (ii)
in relation to actual and expected premium revenue for other products. In
addition, for universal life 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 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 $61.6 million in
the first quarter of 2006 compared to $46.8 million in the first quarter of
2005. 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. In addition,
during the first quarter of 2006, we experienced higher lapses than we
anticipated on our Medicare supplement products. These lapses reduced our
estimates of future expected premium income and, accordingly, we recognized
additional amortization expense of $3.4 million in the first three months of
2006. 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.
Other operating costs and expenses in our Bankers Life segment were $40.1
million in the first quarter of 2006, up 6.4 percent from 2005. In the first
quarter of 2006, other operating costs and expenses include $3.2 million of
expenses related to the distribution and quota-share reinsurance agreements with
Coventry.
Net realized investment gains (losses) fluctuate each period. During the
first three months of 2006, net realized investment losses in this segment
included $.9 million of net losses from the sales of investments (primarily
fixed maturities), and $.1 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. During the
three months ended March 31, 2005, net realized investment gains in this segment
included $2.0 million of net gains from the sales of investments (primarily
fixed maturities). There were no writedowns in the first quarter of 2005.
Amortization related to net realized investment gains (losses) is the
increase or decrease in the amortization of insurance acquisition costs which
results 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 $(.5)
million and $.1 million in the first three months of 2006 and 2005,
respectively.
38
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended
March 31,
----------------------
2006 2005
---- ----
Premium collections:
Annuities.......................................................................... $ 36.2 $ 25.3
Supplemental health................................................................ 159.6 174.6
Life............................................................................... 84.1 89.7
--------- ---------
Total collections................................................................ $ 279.9 $ 289.6
========= =========
Average liabilities for insurance products:
Annuities:
Mortality based.................................................................. $ 245.1 $ 284.9
Equity-indexed................................................................... 1,309.7 1,399.1
Deposit based.................................................................... 3,292.0 3,582.7
Separate accounts and investment trust liabilities............................... 29.9 31.9
Health............................................................................. 2,380.9 2,374.6
Life:
Interest sensitive............................................................... 3,071.9 3,146.6
Non-interest sensitive........................................................... 1,452.0 1,432.5
--------- ---------
Total average liabilities for insurance products, net of reinsurance ceded..... $11,781.5 $12,252.3
========= =========
Revenues:
Insurance policy income.............................................................. $ 256.4 $ 276.9
Net investment income:
General account invested assets.................................................... 174.8 177.7
Equity-indexed products............................................................ 5.4 (16.7)
Trading account income related to policyholder and
reinsurer accounts............................................................... (.5) (5.4)
Change in value of embedded derivatives related to modified
coinsurance agreements........................................................... 2.3 1.7
Fee revenue and other income......................................................... .4 .5
--------- ---------
Total revenues................................................................... 438.8 434.7
--------- ---------
Expenses:
Insurance policy benefits............................................................ 195.9 204.7
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than those listed below.................................................... 61.2 64.3
Equity-indexed products............................................................ 5.3 (13.9)
Amortization related to operations................................................... 55.5 43.6
Interest expense on investment borrowings............................................ .2 2.0
Other operating costs and expenses................................................... 78.8 69.6
--------- ---------
Total expenses................................................................... 396.9 370.3
--------- ---------
Income before net realized investment losses, net of related amortization,
and income taxes..................................................................... 41.9 64.4
--------- ---------
Net realized investment losses....................................................... (5.1) (2.5)
Amortization related to net realized investment losses............................... 1.5 1.6
--------- ---------
Net realized investment losses, net of related amortization...................... (3.6) (.9)
--------- ---------
Income before income taxes.............................................................. $ 38.3 $ 63.5
========= =========
(continued)
39
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended
March 31,
----------------------
2006 2005
---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits....................................................... $113.7 $115.1
Benefit ratio (a)............................................................... 70.7% 65.7%
Medicare supplement:
Insurance policy benefits....................................................... $41.3 $45.0
Benefit ratio (a)............................................................... 60.3% 55.2%
Specified disease:
Insurance policy benefits....................................................... $69.4 $68.0
Benefit ratio (a)............................................................... 77.5% 75.5%
Interest-adjusted benefit ratio (b)............................................. 45.9% 44.8%
Other:
Insurance policy benefits....................................................... $3.0 $2.1
Benefit ratio(a)................................................................ 104.9% 60.8%
<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 insurance 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 $28.3
million and $27.7 million in the three months ended March 31, 2006 and
2005, respectively.
</FN>
Total premium collections were $279.9 million in the first quarter of 2006,
down 3.3 percent from the first quarter of 2005. This decrease was primarily due
to lower premiums collected from Medicare supplement products, due to lapses
following rate increases in 2005 and 2006. See "Premium Collections" for further
analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$11.8 billion in the first quarter of 2006, down 3.8 percent from 2005. The
decrease in such liabilities was due primarily to policyholder redemptions and
lapses exceeding sales in this segment.
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. The decrease is primarily due to lower premium income from
Medicare supplement products, due to lapses following rate increases in 2005 and
2006. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $174.8 million in the first
quarter of 2006, down 1.6 percent from 2005. The average balance of general
account invested assets was $11.8 billion and $12.3 billion in the first
quarters of 2006 and 2005, respectively. The average yield on these assets was
5.9 percent and 5.8 percent in the first quarters of 2006 and 2005,
respectively. This segment's investment income in the first three months of 2005
included the recognition in income of $2.4 million related to investments
40
CONSECO, INC. AND SUBSIDIARIES
-------------------
(which had a par value in excess of the cost basis) which were called by the
issuer. Such income was not significant in the first three months of 2006.
Net investment income related to equity-indexed products represents the
change in the estimated fair value of options which are purchased in an effort
to hedge certain potential 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. Net investment income (loss) related to equity-indexed products was
$9.2 million and $(13.1) million in the first quarters of 2006 and 2005,
respectively. Such amounts also include income on trading securities which are
designed to act as hedges for embedded derivatives related to equity-indexed
products. Such trading account losses were $3.8 million and $3.6 million in the
first quarters of 2006 and 2005, respectively. Such amounts were partially
offset by the corresponding charge (credit) to amounts added to policyholder
account balances for equity-indexed products. 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 indices to which the returns on such products are linked.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading securities which are designed to act as hedges
for embedded derivatives related to 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. In addition, insurance benefits in the first quarter
of 2006 were reduced for the following items. We reduced insurance benefits by
$11.5 million to reflect a change in the assumptions for the cost of options
underlying our equity-indexed products and other assumptions described below
under amortization related to operations. Such decreases were more than offset
by increased amortization of insurance acquisition costs related to the
assumption changes. We also reduced insurance benefits by $4.7 million for
deceased policyholders to reflect the release of insurance liabilities for
annuity policies which pay benefits only during the policyholders' lifetime. We
have improved our procedures to confirm the reporting of the death of these
policyholders to us in a more timely manner, resulting in this additional
release that would have otherwise been recognized in future periods.
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 first quarters of
2006 and 2005 were impacted by an increase in policyholder lapses. The release
of the policy benefit reserve related to the lapsed business contributed to the
lower benefit ratios in the 2006 and 2005 periods. Governmental regulations
generally require us to attain and maintain a ratio of total benefits incurred
to total premiums earned (excluding changes in policy benefit reserves), after
three years from the original issuance of the policy and over the lifetime of
the policy, 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
41
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 benefit ratio for the first quarter of 2006 was
unfavorably affected by higher persistency of older policies which have higher
benefit ratios than newer policies. The benefit ratio for the first quarter of
2005 reflected unfavorable claim experience. The interest-adjusted benefit ratio
for specified disease 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 benefit ratios on Conseco Insurance Group's 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 $61.2 million in the first quarter of
2006, down 4.8 percent from 2005. The decrease was primarily due to a smaller
block of annuity business inforce. The weighted average crediting rate for these
products was 3.9 percent in both the first quarters of 2006 and 2005.
Amounts added to equity-indexed products fluctuated with the corresponding
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 and investment-type
products; or (ii) in relation to actual and expected premium revenue for other
products. In addition, for universal life 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 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. Higher lapses on our Medicare supplement products have
reduced our estimates of future expected premium income and, accordingly, we
recognized additional amortization expense of $2.3 million and $3.4 million in
the first quarters of 2006 and 2005, respectively.
In accordance with SFAS 97, we are required to adjust the amortization of
insurance acquisition costs for universal life and annuity products if actual
experience or other evidence suggests that earlier estimates of expected or
actual profits used as a basis for amortization have changed. During the first
three months of 2006, we made certain adjustments to our assumptions of expected
future profits for the annuity and universal life blocks of business in this
segment related to investment returns, lapse rates, the cost of options
underlying our equity-indexed products and other refinements. We recognized
additional amortization expense of $12.4 million in the first quarter of 2006
due to these changes. This increase to amortization expense was offset by a
reduction to insurance policy benefit expense of $11.5 million, to reflect the
effect of the changes in these assumptions on the calculation of certain
insurance liabilities, such as the liability to purchase future options
underlying our equity-indexed products.
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.
Other operating costs and expenses were $78.8 million in the first quarter
of 2006, up 13 percent from 2005. The increase is primarily due to: (i) expenses
totaling $7.5 million related to certain litigation reserves; and (ii) higher
marketing expenses; partially offset by (iii) lower commission expenses
resulting from lower premium collections.
Net realized investment losses fluctuate each period. During the first
three months of 2006, net realized investment losses included $1.8 million of
net losses from the sales of investments (primarily fixed maturities), and $3.3
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary. During the three months ended March 31,
2005, we recognized net realized investment losses of $2.5 million from the
sales of investments (primarily fixed maturities). There were no writedowns in
the first quarter of 2005.
Amortization related to net realized investment losses is the increase or
decrease in the amortization of insurance acquisition costs which results from
realized investment gains or losses. When we sell securities at a gain (loss)
and reinvest
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 a decrease in the
amortization of insurance acquisition costs of $1.5 million and $1.6 million in
the first quarters of 2006 and 2005, respectively.
Other Business in Run-off (dollars in millions):
Three months ended
March 31,
----------------------
2006 2005
---- ----
Premium collections:
Long-term care..................................................................... $ 87.3 $ 92.3
Major medical..................................................................... 1.1 .7
-------- --------
Total collections............................................................. $ 88.4 $ 93.0
======== ========
Average liabilities for insurance products:
Long-term care..................................................................... $3,243.2 $3,295.2
Major medical...................................................................... 29.8 50.6
-------- --------
Total average liabilities for insurance products,
net of reinsurance ceded.................................................. $3,273.0 $3,345.8
======== ========
Revenues:
Insurance policy income............................................................ $ 88.9 $ 91.5
Net investment income on general account invested assets........................... 44.7 43.2
Fee revenue and other income....................................................... .1 .1
-------- --------
Total revenues................................................................. 133.7 134.8
-------- --------
Expenses:
Insurance policy benefits.......................................................... 84.3 86.5
Amortization related to operations................................................. 3.5 5.8
Other operating costs and expenses................................................. 21.9 21.0
-------- --------
Total expenses................................................................. 109.7 113.3
-------- --------
Income before net realized investment gains and income taxes................... 24.0 21.5
Net realized investment gains...................................................... 3.0 2.1
-------- --------
Income before income taxes..................................................... $ 27.0 $ 23.6
======== ========
Health benefit ratios:
Insurance policy benefits........................................................ $84.3 $86.5
Benefit ratio (a)................................................................ 94.8% 94.5%
Interest-adjusted benefit ratio (b).............................................. 45.1% 48.2%
<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
long-term care products by dividing such product's insurance policy
benefits less interest income on the accumulated assets backing such
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 investment income earned on the accumulated assets. The
interest-adjusted benefit
</FN>
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 long-term care reserves in our
Other Business in Run-off segment was $44.2 million and $42.4 million in
the three months ended March 31, 2006 and 2005, respectively.
Total premium collections were $88.4 million in the first quarter of 2006,
down 4.9 percent from 2005. 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
$3.3 billion in the first quarter of 2006, down 2.2 percent from 2005.
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 $44.7 million
in the first quarter of 2006, up 3.5 percent from 2005. The average balance of
general account invested assets was $3.1 billion and $3.0 billion in the first
quarters of 2006 and 2005, respectively. The average yield on these assets was
5.9 percent and 5.8 percent in the first quarters of 2006 and 2005,
respectively.
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, which was primarily
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. In particular, 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 under improved claim adjudication
processes. On April 20, 2004, the Florida Office of Insurance Regulation issued
an Order to our subsidiary, Conseco Senior Health Insurance Company ("Conseco
Senior"), that affected approximately 12,600 home health care policies issued in
Florida by Conseco Senior and its predecessor companies. On July 1, 2004, the
Florida Office of Insurance Regulation issued a similar Order impacting
approximately 4,800 home health care policies issued in Florida by our
subsidiary, Washington National Insurance Company ("Washington National") and
its predecessor companies. Pursuant to the Orders, Conseco Senior and Washington
National offered 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 (which is also the default election for policyholders who fail
to make an election by the deadline) ("option one");
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 ("option two"); 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 ("option three").
Policyholders selecting option one or option two are entitled to receive a
contingent non-forfeiture benefit if their policy subsequently lapses. In
addition, policyholders may change their initial election any time up to 30 days
prior to the anniversary date of their policies. We began to implement premium
adjustments with respect to policyholder elections in the fourth quarter of
2005. In 2005, we did not make any adjustments to the insurance liabilities when
these elections were made, although the future profitability of this block is
expected to improve. The changes in reserves due to the structural changes
arising from such elections are being recognized prospectively over the expected
remaining life of the policies pursuant to the
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
lock-in concept of Statement of Financial Accounting Standards No. 60,
"Accounting and Reporting by Insurance Enterprises" and related interpretive
accounting and actuarial guidance.
The orders also require Conseco Senior and Washington National to pursue a
similar course of action with respect to approximately 24,000 home health care
policies in other states, subject to consideration and approval by 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.
During the first quarter of 2006, we upgraded the prior version of the
valuation system used to determine reserves for the long-term care block of
business in run-off. The new version includes enhancements to more precisely
estimate insurance liabilities for policies with return of premium benefits. The
effect of this refinement and certain other reserve adjustments resulted in
decreases to our insurance liabilities of approximately $14 million in the first
quarter of 2006.
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 $21.9 million in the first quarter
of 2006, up 4.3 percent from the same period in 2005. The increase primarily
related to higher compensation expense in this segment in the first quarter of
2006.
Net realized investment gains fluctuate each period. During the first three
months of 2006, net realized investment gains included $3.1 million of net gains
from the sales of investments (primarily fixed maturities), net of $.1 million
of writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During the three months ended March 31,
2005, we recognized net realized investment gains in this segment of $2.1
million from the sales of investments (primarily fixed maturities). There were
no such writedowns in the first quarter of 2005.
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
Corporate Operations (dollars in millions):
Three months ended
March 31,
----------------------
2006 2005
---- ----
Corporate operations:
Interest expense on corporate debt.................................................. $(12.4) $(12.0)
Net investment income .............................................................. 1.0 .5
Fee revenue and other income........................................................ 2.7 3.0
Net operating results of variable interest entity................................... .7 -
Other operating costs and expenses.................................................. (18.0) (12.1)
------ ------
Loss before income taxes.......................................................... $(26.0) $(20.6)
====== ======
Interest expense on corporate debt was impacted by the issuance of the
Debentures and our Amended Credit Facility in August 2005. Our average corporate
debt outstanding was $854.1 million and $768.0 million during the first quarters
of 2006 and 2005, respectively. The average interest rate on our debt was 5.3
percent and 6.1 percent during the first quarters of 2006 and 2005,
respectively.
Net investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income and
fluctuated along with the change in the amount of invested assets in this
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.
Net operating results of variable interest entity represents the Company's
investment in a variable interest entity ("VIE"). The VIE is consolidated in
accordance with Financial Accounting Standards Board Interpretation No. 46
"Consolidation of Variable Interest Entities", revised December 2003 ("FIN
46R"). Although we do not control this entity, we consolidate it because we are
the primary beneficiary. This entity was established to issue securities and use
the proceeds to invest in loans and other permitted assets. Such consolidation
requirements did not have a material impact on our financial condition or
results of operations.
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 as a result of expenses such as consulting,
legal and severance costs which often vary from period to period. In the first
three months of 2006, other operating costs and expenses included $7.5 million
related to certain litigation reserves.
In December 2004, the FASB issued SFAS 123R, which revised SFAS 123 and
superseded APB 25. SFAS 123R provided additional guidance on accounting for
share-based payments and required 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. Conseco implemented SFAS 123R using the
modified prospective method on January 1, 2006. Under this method, the Company
began recognizing compensation cost for all awards granted on or after January
1, 2006. In addition, we are required to recognize compensation cost over the
remaining requisite service period for the portion of outstanding awards that
were not vested as of January 1, 2006 and were not previously expensed on a pro
forma basis pursuant to SFAS 123. In the first three months of 2006, we
recognized compensation expense related to stock options totaling $1.4 million.
Refer to the note to our consolidated financial statements entitled "Stock-Based
Compensation" for further discussion of our share-based payments.
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.
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
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, 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.
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,
interest-sensitive life insurance and long-term care products. Our insurance
companies' financial strength ratings were downgraded by all of the major rating
agencies beginning in July 2002, in connection with the financial distress that
ultimately led to our Predecessor's bankruptcy. In the second quarter of 2004,
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. Moody's again
upgraded the ratings of our primary insurance subsidiaries (except Conseco
Senior) in the third quarter of 2004 and the first quarter of 2006. 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 "Baa3",
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."
We set premium rates on our health insurance policies based on facts and
circumstances known at the time we issue the policies using 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. We also 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. 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 all requested premium rate increases. 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 the future.
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended
March 31,
--------------------
2006 2005
---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................................................. $ 62.9 $ 16.1
------ ------
Other fixed (first-year)................................................................ 169.6 204.2
Other fixed (renewal)................................................................... .9 1.4
------ -------
Subtotal - other fixed annuities...................................................... 170.5 205.6
------ ------
Total annuities....................................................................... 233.4 221.7
------ ------
Supplemental health:
Medicare supplement (first-year)........................................................ 24.8 17.7
Medicare supplement (renewal)........................................................... 146.4 152.0
------ ------
Subtotal - Medicare supplement........................................................ 171.2 169.7
------ ------
Long-term care (first-year)............................................................. 14.2 17.1
Long-term care (renewal)................................................................ 131.5 123.7
------ ------
Subtotal - long-term care............................................................. 145.7 140.8
------ ------
Other health (first-year)............................................................... 6.3 .2
Other health (renewal).................................................................. 2.7 2.9
------ ------
Subtotal - other health............................................................... 9.0 3.1
------ ------
Total supplemental health............................................................. 325.9 313.6
------ ------
Life insurance:
First-year.............................................................................. 26.2 15.3
Renewal................................................................................. 40.4 33.3
------ ------
Total life insurance.................................................................. 66.6 48.6
------ ------
Collections on insurance products:
Total first-year premium collections on insurance products............................. 304.0 270.6
Total renewal premium collections on insurance products................................. 321.9 313.3
------ ------
Total collections on insurance products............................................... $625.9 $583.9
====== ======
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections
increased 5.3 percent, to $233.4 million, in the first quarter of 2006 as
compared to the same period in 2005. The increase in short-term interest rates
since the first quarter of 2005 has resulted in lower first-year fixed annuity
sales as certain other competing products, such as certificates of deposits,
have become attractive. Our equity-indexed products were favorably impacted in
2006 due in part to general stock market conditions which made these products
relatively attractive and the introduction of new equity-indexed products in
2005.
Supplemental health products include Medicare supplement, long-term care
and other insurance products distributed through our career agents.
Collected premiums on Medicare supplement policies in the Bankers Life
segment increased .9 percent, to $171.2
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
million, in the first quarter of 2006 as compared to the same period in 2005.
Premiums collected on Bankers Life's long-term care policies increased 3.5
percent, to $145.7 million, in the first quarter of 2006 compared to the same
period in 2005 primarily due to sales of new products with higher premiums and
continued higher persistency of our existing business.
Other health products in 2006 include $6.0 million of first-year premiums
collected pursuant to the quota-share reinsurance agreement with Coventry
described above under "Accounting for the marketing and quota-share agreement
with Coventry Health Care." The remaining collected premiums relate to other
health products which we no longer actively market.
Life products in this 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 37 percent, to $66.6 million, in
the first quarter of 2006, compared to the same period in 2005, due to an
increased focus on life products, including the introduction in the first
quarter of 2005 of a new single premium whole life product and increased
advertising in our direct response marketing. The new single premium whole life
products accounted for $10.1 million and $1.5 million of our collected premiums
in the first quarters of 2006 and 2005, respectively. Graded benefit life
products sold through our direct response marketing channel accounted for $22.1
million of our total collected premiums in the first quarter of 2006, compared
to $19.4 million in the first quarter of 2005.
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended
March 31,
--------------------
2006 2005
---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)........................................................ $ 20.7 $ 19.3
Equity-indexed (renewal)........................................................... 2.4 2.5
------ ------
Subtotal - equity-indexed annuities.............................................. 23.1 21.8
------ ------
Other fixed (first-year)........................................................... 10.9 .9
Other fixed (renewal).............................................................. 2.2 2.6
------ ------
Subtotal - other fixed annuities................................................. 13.1 3.5
------ ------
Total annuities.................................................................. 36.2 25.3
------ ------
Supplemental health:
Medicare supplement (first-year)................................................... 8.3 3.1
Medicare supplement (renewal)...................................................... 57.6 76.2
------ ------
Subtotal - Medicare supplement................................................... 65.9 79.3
------ ------
Specified disease (first-year)..................................................... 7.2 8.1
Specified disease (renewal)........................................................ 84.2 84.1
------ ------
Subtotal - specified disease..................................................... 91.4 92.2
------ ------
Other health (renewal)............................................................. 2.3 3.1
------ ------
Total supplemental health........................................................ 159.6 174.6
------ ------
Life insurance:
First-year......................................................................... 1.7 2.8
Renewal............................................................................ 82.4 86.9
------ ------
Total life insurance............................................................. 84.1 89.7
------ ------
Collections on insurance products:
Total first-year premium collections on insurance products........................ 48.8 34.2
Total renewal premium collections on insurance products............................ 231.1 255.4
------ ------
Total collections on insurance products.......................................... $279.9 $289.6
====== ======
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity premiums
collected in this segment increased 43 percent, to $36.2 million, in the first
quarter of 2006, compared to the same period in 2005, due to increased sales
efforts in this segment, expanded product offerings and attractive crediting
rates on certain 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 this product increased 6.0 percent, to
$23.1 million, in the first quarter of 2006 over the same period in 2005 due to
the recent introduction of several new products.
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
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 274 percent, to $13.1 million, in the first quarter of 2006, compared
to the same period in 2005, due to increased sales efforts as well as attractive
crediting rates on certain products.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment decreased 17 percent, to $65.9 million, in the first quarter of
2006 compared to the same period in 2005. We have experienced lower persistency
for these products, partially offset by an increase in sales.
Premiums collected on specified disease products in the first quarter of
2006 were comparable to the same period in 2005.
Premiums collected from other health products decreased 26 percent, to $2.3
million, in the first quarter of 2006 compared to the same period in 2005
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 6.2
percent, to $84.1 million, in the first quarter of 2006 compared to the same
period in 2005. Our A.M. Best rating has negatively affected our sales of life
products.
Other Business in Run-off (dollars in millions):
Three months ended
March 31,
--------------------
2006 2005
---- ----
Premiums collected by product:
Long-term care (renewal).............................................................. $87.3 $92.3
Major medical (renewal)............................................................... 1.1 .7
----- -----
Total renewal premium collections on insurance products............................. $88.4 $93.0
===== =====
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 5.4 percent, to
$87.3 million, in the first quarter of 2006 compared to the same period in 2005.
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.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between March 31, 2006 and
December 31, 2005, primarily reflect: (i) our net income for the three months
ended March 31, 2006; 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 March 31, 2006, we decreased the
carrying value of such investments by $444.0 million as a result of this fair
value adjustment.
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our capital structure as of March 31, 2006, and December 31, 2005, was as
follows (dollars in millions):
March 31, December 31,
2006 2005
---- ----
Total capital:
Corporate notes payable................................................ $ 805.3 $ 851.5
Shareholders' equity:
Preferred stock..................................................... 667.8 667.8
Common stock........................................................ 1.5 1.5
Additional paid-in capital.......................................... 3,198.4 3,194.1
Accumulated other comprehensive income.............................. (224.2) 71.7
Retained earnings................................................... 639.8 584.7
-------- --------
Total shareholders' equity....................................... 4,283.3 4,519.8
-------- --------
Total capital.................................................... $5,088.6 $5,371.3
======== ========
The following table summarizes certain financial ratios as of and for the
three months ended March 31, 2006, and as of and for the year ended December 31,
2005:
March 31, December 31,
2006 2005
---- ----
Book value per common share................................................................... $23.86 $25.42
Book value per common share, excluding accumulated other comprehensive
income (loss) (a).......................................................................... 25.34 24.95
Ratio of earnings to fixed charges............................................................ 1.82x 2.03x
Ratio of earnings to fixed charges and preferred dividends.................................... 1.62x 1.81x
Debt to total capital ratios:
Corporate debt to total capital............................................................ 16% 16%
Corporate debt to total capital, excluding accumulated other comprehensive
income (loss) (a)........................................................................ 15% 16%
Corporate debt and preferred stock to total capital........................................ 29% 28%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (loss) (a).......................................................... 28% 29%
<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>
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
Liquidity for insurance operations
Our insurance operating companies generally receive adequate cash flows
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 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 companies 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 March 8, 2006, Moody's upgraded the financial strength rating of our
primary insurance companies from "Ba1" to "Baa3" except Conseco Senior, which
was affirmed at "Caa1". In addition, all of Moody's ratings on our insurance
subsidiaries now have a positive outlook. 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 "Aaa" to "Baa"
are classified as "Secure" by Moody's and rating categories from "Ba" to "C" are
considered "vulnerable" and these ratings may be supplemented with numbers "1",
"2", or "3" to show relative standing within a category. In Moody's view, an
insurer rated "Baa3" offers adequate financial security, however, certain
protective elements may be lacking or may be characteristically unreliable over
any great length of time. 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 "Baa3" rating and the "Caa1" rating from Moody's are
the tenth and seventeenth highest, respectively, of twenty-one possible ratings.
A positive outlook by Moody's is an opinion regarding the likely direction of a
rating over the medium term.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
We have adopted several initiatives designed to reduce the expense levels
that exceed product pricing in our Conseco Insurance Group segment. These
initiatives include system conversions which will eliminate duplicate processing
systems. We expect to spend over $23 million on capital expenditures in 2006
(including amounts related to these initiatives). We believe we have adequate
cash flows from operations to fund these initiatives.
State laws generally give state insurance regulatory agencies broad
authority to protect policyholders in their jurisdictions. Regulators have used
this authority in the past to restrict the ability of our insurance subsidiaries
to pay any dividends or other amounts to any non-insurance company parent
without prior approval. We cannot be assured that the regulators will not seek
to assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs.
Liquidity of the Holding Companies
At March 31, 2006, Conseco Inc. and CDOC held unrestricted cash of $53.5
million. Conseco Inc. 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 and tax-sharing payments, as well as cash from non-insurance
subsidiaries consisting of dividends, distributions, loans and advances. The
principal non-insurance subsidiaries that provide cash to Conseco and CDOC are
40|86 Advisors, which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives fees from the
insurance subsidiaries for providing administrative services. 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 strengthen their surplus
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 law 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.
During the first three months of 2006, we made scheduled principal payments
totaling $1.3 million on our Amended Credit Facility as well as a mandatory
prepayment of $45.0 million based on the Company's excess cash flows at December
31, 2005, as defined in the Amended Credit Facility. Under the terms of the
Amended Credit Facility, we are required to make quarterly principal payments of
..25 percent of the remaining principal amount through March 31, 2010. However,
as a result of the mandatory prepayment discussed above, our next scheduled
principal payment is due June 30, 2007.
The Amended Credit Facility includes an $80.0 million revolving credit
facility that can be used for general corporate purposes and that would mature
on June 22, 2009. There were no amounts outstanding under the revolving credit
facility at March 31, 2006. The Company pays a commitment fee equal to .50
percent of the unused portion of the revolving credit facility on an annualized
basis.
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
Pursuant to the Amended Credit Facility, as long as the debt to total
capitalization ratio (as defined in the Amended Credit Facility) is greater than
20 percent and certain insurance subsidiaries (as defined in the Amended Credit
Facility) have financial strength ratings of less than A- from A.M. Best, 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 Amended Credit
Facility. The Company may make optional prepayments at any time in minimum
amounts of $3.0 million or any multiple of $1.0 million in excess thereof.
Under our Amended 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.
INVESTMENTS
At March 31, 2006, 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................................................ $12,818.0 $ 99.9 $328.2 $12,589.7
United States Treasury securities and obligations of
United States government corporations and agencies................ 1,479.1 .7 36.1 1,443.7
States and political subdivisions................................... 795.2 6.3 19.0 782.5
Debt securities issued by foreign governments....................... 141.7 4.4 1.4 144.7
Structured securities .............................................. 6,284.6 3.5 186.5 6,101.6
Below-investment grade (primarily corporate securities)................ 1,049.3 22.7 17.4 1,054.6
--------- ------ ------ ---------
Total actively managed fixed maturities............................. $22,567.9 $137.5 $588.6 $22,116.8
========= ====== ====== =========
Equity securities...................................................... $31.2 $2.2 $.4 $33.0
===== ==== === =====
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our actively managed
fixed maturity securities by category as of March 31, 2006 (dollars in
millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 6,104.2 27.6%
Manufacturing........................................................................ 2,485.8 11.2
Bank and finance..................................................................... 2,398.2 10.9
Services............................................................................. 1,597.3 7.2
U.S. Government...................................................................... 1,443.7 6.5
Utilities............................................................................ 1,433.4 6.5
Communications....................................................................... 1,055.1 4.8
Holding and other investment offices................................................. 1,029.7 4.7
States and political subdivisions.................................................... 797.9 3.6
Agriculture, forestry and mining..................................................... 797.2 3.6
Asset-backed securities.............................................................. 690.2 3.1
Retail and wholesale................................................................. 611.3 2.8
Transportation....................................................................... 606.8 2.7
Other................................................................................ 1,066.0 4.8
--------- -----
Total actively managed fixed maturities........................................... $22,116.8 100.0%
========= =====
Below-Investment Grade Securities
At March 31, 2006, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,049.3 million, or 4.6 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,054.6 million, or 101 percent of the
amortized cost. The value of these securities varies based on the economic terms
of the securities, structural considerations and the creditworthiness of the
issuer of the securities.
Below-investment grade fixed maturity securities with an amortized cost of
$307.0 million and an estimated fair value of $306.1 million are securities held
by a VIE that we are required to consolidate. These fixed maturity securities
are legally isolated and are not available to the Company. The liabilities of
such VIE will be satisfied from the cash flows generated by these securities. At
March 31, 2006, our total investment in the VIE was $32.8 million, and such
investment was rated BBB.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of default by the borrower is
significantly greater for below-investment grade securities and in many cases,
severity of loss is relatively greater as such securities are generally
unsecured and often subordinated to other creditors of the issuer. Also, issuers
of below-investment grade securities usually have higher levels of debt and may
be more sensitive to adverse economic conditions, such as recession or
increasing interest rates. 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 (Losses)
During the first three months of 2006, we recognized net realized
investment losses of $3.1 million, which were comprised of $.4 million of net
gains from the sales of investments (primarily fixed maturities) with proceeds
of $1.9 billion, net of $3.5 million of writedowns of investments for other than
temporary declines in fair value. During the three months ended March 31, 2005,
we recognized net realized investment gains of $1.6 million from the sales of
investments (primarily fixed maturities) with proceeds of $3.1 billion. There
were no writedowns in the first quarter of 2005. At March 31, 2006, investments
in default as to the payment of principal or interest had an aggregate amortized
cost of $25.7 million and a carrying value of $26.7 million.
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
During the three months ended March 31, 2006, we sold $1.0 billion of fixed
maturity investments which resulted in gross investment losses (before income
taxes) of $26.0 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) changes in
expected liability cash flows.
We regularly evaluate our investments for possible impairment based on
current economic conditions, credit loss experience and other investee-specific
developments. When we conclude that a decline in a security's net realizable
value 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 information may become available, which may necessitate future
realized losses of securities in our portfolio. Significant losses in the
carrying values of our investments could have a material adverse effect on our
earnings in future periods.
During the first three months of 2006, we recorded writedowns of fixed
maturity securities and other invested assets totaling $3.5 million as a result
of analysis that led us to conclude that the declines in the values of these
investments were other than temporary.
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at March 31,
2006, by contractual maturity. Actual maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties. Most of the structured securities
shown below provide for periodic payments throughout their lives (dollars in
millions).
Estimated
Amortized fair
cost value
--------- ---------
Due in one year or less................................................................... $ 92.5 $ 91.9
Due after one year through five years..................................................... 1,983.7 1,943.1
Due after five years through ten years.................................................... 5,263.9 5,122.3
Due after ten years....................................................................... 5,709.4 5,490.1
--------- ---------
Subtotal............................................................................... 13,049.5 12,647.4
Structured securities..................................................................... 6,056.8 5,870.3
--------- ---------
Total.................................................................................. $19,106.3 $18,517.7
========= =========
At March 31, 2006, we held no investments in our fixed maturity portfolio
which were rated below-investment grade and had unrealized loss positions
exceeding 20 percent of the cost basis.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
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
March 31, 2006 (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...... $ 1,310.3 $ (32.0) $106.7 $ (4.1) $ 1,417.0 $ (36.1)
States and political subdivisions. 497.4 (15.5) 61.5 (3.7) 558.9 (19.2)
Debt securities issued by
foreign governments............ 59.8 (1.4) - - 59.8 (1.4)
Corporate securities.............. 10,019.7 (313.4) 585.5 (32.0) 10,605.2 (345.4)
Structured securities............. 5,713.9 (179.9) 156.4 (6.6) 5,870.3 (186.5)
--------- ------- ------ ------ --------- -------
Total actively managed
fixed maturities............... $17,601.1 $(542.2) $910.1 $(46.4) $18,511.2 $(588.6)
========= ======= ====== ====== ========= =======
Equity securities................. $.4 $(.1) $5.5 $(.3) $5.9 $(.4)
=== ==== ==== ==== ==== ====
Based on management's current assessment of investments with unrealized
losses at March 31, 2006, 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.
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
Structured Securities
At March 31, 2006, fixed maturity investments included $6.1 billion of
structured securities (or 28 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
many instances, we are subject to the risk that the timing of principal payments
may vary from expectations. 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 structured securities increases when
prevailing interest rates decline significantly in absolute terms and also
relative to the interest rates on the underlying loans. The yields on structured
securities purchased at a discount to par will increase when the underlying
mortgages prepay faster than expected. The yields on structured securities
purchased at a premium will decrease when the underlying mortgages prepay faster
than expected. When interest rates decline, the proceeds from prepayments may be
reinvested at lower rates than we were earning on the prepaid securities. When
interest rates increase, prepayments decrease as fewer underlying mortgages are
refinanced. When this occurs, the average maturity and duration of the
structured securities increase, which decreases the yield on structured
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.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral at March 31, 2006 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 213.3 $ 213.2 $ 205.7
4 percent - 5 percent............................................................... 1,372.9 1,328.8 1,284.2
5 percent - 6 percent............................................................... 4,056.4 4,005.4 3,881.1
6 percent - 7 percent............................................................... 532.4 547.7 541.9
7 percent - 8 percent............................................................... 169.1 174.4 172.7
8 percent and above................................................................. 16.9 17.7 18.6
-------- -------- --------
Total structured securities (a).............................................. $6,361.0 $6,287.2 $6,104.2
======== ======== ========
<FN>
- -----------
(a) Includes below-investment grade structured securities with both an
amortized cost and estimated fair value of $2.6 million.
</FN>
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CONSECO, INC. AND SUBSIDIARIES
-------------------
The amortized cost and estimated fair value of structured securities at
March 31, 2006, 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............ $3,759.2 $3,642.9 17%
Planned amortization classes and accretion-directed bonds................. 1,020.8 992.7 4
Commercial mortgage-backed securities..................................... 1,502.4 1,464.0 7
Other..................................................................... 4.8 4.6 -
-------- -------- --
Total structured securities (a).................................... $6,287.2 $6,104.2 28%
======== ======== ==
<FN>
- -------------
(a) Includes below-investment grade structured securities with both an
amortized cost and estimated fair value of $2.6 million.
</FN>
Pass-through securities and sequential and targeted amortization class
securities have different prepayment variability characteristics. Pass-through
securities typically return principal to the holders based on cash payments from
the underlying mortgage obligations. Sequential classes 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 mortgage loans 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 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. CMBS generally offer higher yields than corporate bonds with
similar credit ratings. 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 March 31, 2006, the mortgage loan balance was primarily comprised of
commercial loans. Substantially less than one percent of the mortgage loan
balance was noncurrent at March 31, 2006.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS IN VARIABLE INTEREST ENTITY
Fall Creek CLO Ltd. ("Fall Creek") is a collateralized loan trust that was
established to issue securities and use the proceeds to invest in loans and
other permitted investments. The assets held by the trust are legally isolated
and are not available to the Company. The liabilities of Fall Creek will be
satisfied from the cash flows generated by the underlying loans, not from the
assets of the Company, which has no legal obligation to satisfy those
liabilities. Repayment of the principal balance of the investment borrowings of
Fall Creek begin in 2012 based on available cash flows from the assets and such
borrowings mature in 2017. At March 31, 2006, our total investment in Fall Creek
was $32.8 million. The following tables provide supplemental information about
the assets, liabilities, revenues and expenses of Fall Creek which have been
consolidated in accordance with FIN 46R, after giving effect to the elimination
of our investment in Fall Creek and investment management fees earned by a
subsidiary of the Company (dollars in millions):
March 31,
2006
---------
Assets:
Actively managed fixed maturities............................ $280.7
Cash and cash equivalents - restricted....................... 19.8
Accrued investment income.................................... 1.6
Income tax assets............................................ .1
Other assets................................................. 7.9
------
Total assets............................................. $310.1
======
Liabilities:
Other liabilities............................................ $ 8.1
Investment borrowings........................................ 302.2
------
Total liabilities........................................ 310.3
------
Equity:
Accumulated other comprehensive loss......................... (.6)
Retained earnings............................................ .4
------
Total equity (deficit)................................... (.2)
------
Total liabilities and equity............................. $310.1
======
Three months ended
March 31,
2006
-------------------
Revenues:
Net investment income - deposit accounts..................... $4.5
Net realized investment losses............................... -
Fee revenue and other income................................. -
---
Total revenues........................................... 4.5
----
Expenses:
Interest expense............................................. 3.8
Other operating expenses..................................... -
----
Total expenses........................................... 3.8
----
Income before income taxes............................... $ .7
====
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
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, 2005. There have been no material changes in the first three months
of 2006 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 March 31, 2006, 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 SEC'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. During the quarter ended March 31, 2006, we
implemented a new actuarial valuation system for our long-term care products in
our business in run-off segment. 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 the new system conversion, no significant
changes in Conseco's internal controls over financial reporting have occurred
during the quarter ended March 31, 2006, that have materially affected, or are
reasonably likely to materially affect, Conseco's internal controls over
financial reporting.
PART II - OTHER INFORMATION
ITEM 1. 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 1A. 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. Refer to "Risk Factors" in Conseco's 2005 Annual
Report on Form 10-K for further discussion of such risk factors. There have been
no material changes in the first three months of 2006 to such risks.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 6. EXHIBITS.
12.1 Computation of Ratio of Earnings to Fixed Charges and Preferred
Dividends.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
63
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: May 8, 2006 By: /s/ Eugene M. Bullis
--------------------
Eugene M. Bullis
Executive Vice President and
Chief Financial Officer
(authorized officer and principal
financial officer)
64