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 September 30, 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 October 30, 2006: 151,939,337
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of September 30, 2006 and December 31, 2005............................. 3
Consolidated Statement of Operations for the three and nine months ended
September 30, 2006 and 2005......................................................................... 5
Consolidated Statement of Shareholders' Equity for the nine months ended
September 30, 2006 and 2005......................................................................... 6
Consolidated Statement of Cash Flows for the nine months ended September 30, 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............................................. 34
Overview ............................................................................................. 35
Critical Accounting Policies ......................................................................... 35
Results of Operations................................................................................. 40
Premium Collections................................................................................... 56
Liquidity and Capital Resources....................................................................... 61
Investments........................................................................................... 66
Investment in Variable Interest Entity................................................................ 72
New Accounting Standards ............................................................................. 73
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................................... 73
Item 4. Controls and Procedures............................................................................... 73
PART II - OTHER INFORMATION
Item 1. Legal Proceedings .................................................................................... 73
Item 1A. Risk Factors.......................................................................................... 74
Item 6. Exhibits ............................................................................................. 74
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
September 30, December 31,
2006 2005
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
September 30, 2006 - $22,818.8; December 31, 2005 - $22,380.2)....................... $22,662.4 $22,494.2
Equity securities at fair value (cost: September 30, 2006 - $23.7;
December 31, 2005 - $25.6)........................................................... 26.7 27.1
Mortgage loans......................................................................... 1,480.8 1,264.2
Policy loans........................................................................... 415.0 429.8
Trading securities..................................................................... 680.9 716.3
Other invested assets ................................................................. 101.8 109.6
--------- ---------
Total investments.................................................................. 25,367.6 25,041.2
Cash and cash equivalents:
Unrestricted........................................................................... 236.7 237.8
Restricted............................................................................. 14.9 35.2
Accrued investment income................................................................. 342.2 315.4
Value of policies inforce at the Effective Date........................................... 2,239.8 2,414.0
Cost of policies produced................................................................. 1,025.8 758.8
Reinsurance receivables................................................................... 855.6 887.5
Income tax assets, net.................................................................... 1,785.1 1,496.6
Assets held in separate accounts.......................................................... 28.9 29.8
Other assets.............................................................................. 409.6 341.0
--------- ---------
Total assets....................................................................... $32,306.2 $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
September 30, December 31,
2006 2005
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $12,894.2 $12,686.8
Traditional products................................................................... 11,981.0 11,872.2
Claims payable and other policyholder funds............................................ 796.7 842.1
Liabilities related to separate accounts............................................... 28.9 29.8
Other liabilities........................................................................ 706.4 440.0
Investment borrowings.................................................................... 380.7 315.1
Notes payable - direct corporate obligations............................................. 805.6 851.5
--------- ---------
Total liabilities.................................................................. 27,593.5 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: September 30, 2006 - 151,923,582;
December 31, 2005 - 151,513,434)....................................................... 1.5 1.5
Additional paid-in capital............................................................... 3,468.3 3,194.1
Accumulated other comprehensive income (loss)............................................ (71.8) 71.7
Retained earnings........................................................................ 646.9 584.7
--------- ---------
Total shareholders' equity......................................................... 4,712.7 4,519.8
--------- ---------
Total liabilities and shareholders' equity......................................... $32,306.2 $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 Nine months ended
September 30, September 30,
------------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Revenues:
Insurance policy income........................ $ 748.5 $ 745.7 $2,242.9 $2,201.9
Net investment income (loss):
General account assets....................... 360.6 356.9 1,069.2 1,042.7
Policyholder and reinsurer accounts.......... 26.2 5.4 26.6 (19.5)
Net realized investment gains (losses)......... (21.8) (6.4) (28.6) 3.1
Fee revenue and other income................... 4.8 11.9 14.0 20.0
-------- -------- -------- --------
Total revenues............................. 1,118.3 1,113.5 3,324.1 3,248.2
-------- -------- -------- --------
Benefits and expenses:
Insurance policy benefits...................... 772.6 725.2 2,204.6 2,099.6
Interest expense............................... 17.8 12.9 51.3 43.7
Amortization................................... 104.2 105.0 320.4 287.7
Loss on extinguishment of debt................. - 3.7 - 3.7
Costs related to the tentative litigation
settlement................................... - 2.5 174.7 8.4
Other operating costs and expenses............. 147.0 142.8 430.2 416.6
-------- -------- -------- --------
Total benefits and expenses................ 1,041.6 992.1 3,181.2 2,859.7
-------- -------- -------- --------
Income before income taxes................. 76.7 121.4 142.9 388.5
Income tax expense on period income............... 28.3 43.5 52.2 140.7
-------- -------- -------- --------
Net income................................. 48.4 77.9 90.7 247.8
Preferred stock dividends......................... 9.5 9.5 28.5 28.5
-------- -------- -------- --------
Net income applicable to
common stock............................. $ 38.9 $ 68.4 $ 62.2 $ 219.3
======== ======== ======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding.......... 151,663,000 151,114,000 151,566,000 151,077,000
=========== =========== =========== ===========
Net income................................... $.26 $.45 $.41 $1.45
==== ==== ==== =====
Diluted:
Weighted average shares outstanding.......... 152,529,000 185,178,000 152,547,000 185,648,000
=========== =========== =========== ===========
Net income................................... $.26 $.42 $.41 $1.33
==== ==== ==== =====
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...................................... 90.7 - - - 90.7
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $80.5)............................. (143.5) - - (143.5) -
--------
Total comprehensive loss.................... (52.8)
Reduction of deferred income tax valuation
allowance..................................... 260.0 - 260.0 - -
Stock option and restricted stock plans......... 12.1 - 12.1 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date.......................................... 2.1 - 2.1 - -
Dividends on preferred stock.................... (28.5) - - - (28.5)
-------- ------ -------- ------ ------
Balance, September 30, 2006.......................... $4,712.7 $667.8 $3,469.8 $(71.8) $646.9
======== ====== ======== ====== ======
Balance, January 1, 2005............................. $3,902.2 $667.8 $2,599.3 $337.3 $297.8
Comprehensive income, net of tax:
Net income...................................... 247.8 - - - 247.8
Change in unrealized appreciation of
investments (net of applicable income tax
benefit of $96.4)............................. (174.6) - - (174.6) -
--------
Total comprehensive income.................. 73.2
Stock option and restricted stock plans......... 7.3 - 7.3 - -
Dividends on preferred stock.................... (28.5) - - - (28.5)
-------- ------ -------- ------ ------
Balance, September 30, 2005.......................... $3,954.2 $667.8 $2,606.6 $162.7 $517.1
======== ====== ======== ====== ======
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)
Nine months ended
September 30,
----------------------
2006 2005
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 1,975.4 $ 1,924.3
Net investment income................................................................. 1,109.7 1,079.0
Fee revenue and other income.......................................................... 14.0 20.0
Net sales of trading securities....................................................... 28.3 161.1
Insurance policy benefits............................................................. (1,662.1) (1,540.8)
Interest expense...................................................................... (45.1) (33.5)
Policy acquisition costs.............................................................. (367.6) (305.3)
Other operating costs................................................................. (395.7) (422.8)
Loss on extinguishment of debt........................................................ - (.3)
Taxes................................................................................. 1.8 27.4
--------- ----------
Net cash provided by operating activities......................................... 658.7 909.1
--------- ----------
Cash flows from investing activities:
Sales of investments.................................................................. 4,082.8 9,526.5
Maturities and redemptions of investments............................................. 840.5 1,080.8
Purchases of investments.............................................................. (5,623.8) (11,503.0)
Change in restricted cash............................................................. 20.3 3.5
Other................................................................................. (2.6) (24.4)
--------- ----------
Net cash used by investing activities ............................................ (682.8) (916.6)
--------- ----------
Cash flows from financing activities:
Issuance of notes payable, net........................................................ - 773.7
Issuance of common stock.............................................................. 1.0 .2
Payments on notes payable............................................................. (46.3) (769.1)
Amounts received for deposit products................................................. 1,547.2 1,233.3
Withdrawals from deposit products..................................................... (1,516.0) (1,369.1)
Investment borrowings................................................................. 65.6 (420.6)
Dividends paid on preferred stock..................................................... (28.5) (28.5)
--------- ----------
Net cash (used) provided by financing activities.................................. 23.0 (580.1)
--------- ----------
Net decrease in cash and cash equivalents......................................... (1.1) (587.6)
Cash and cash equivalents, beginning of period........................................... 237.8 776.6
--------- ----------
Cash and cash equivalents, end of period................................................. $ 236.7 $ 189.0
========= ==========
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 $680.9 million and $716.3 million at September 30, 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 September 30, 2006 and December
31, 2005, were as follows (dollars in millions):
September 30, December 31,
2006 2005
---- ----
Net unrealized appreciation (depreciation) on investments............................. $(148.6) $120.9
Adjustment to value of policies inforce at the Effective Date......................... 24.6 (9.2)
Adjustment to cost of policies produced............................................... 11.4 (.3)
Deferred income tax asset (liability)................................................. 40.8 (39.7)
------- ------
Accumulated other comprehensive income (loss).................................... $ (71.8) $ 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 Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Net income.................................................. $48.4 $77.9 $ 90.7 $247.8
Preferred stock dividends................................... (9.5) (9.5) (28.5) (28.5)
----- ----- ------ ------
Net income applicable to common stock
for basic earnings per share......................... 38.9 68.4 62.2 219.3
Effect of dilutive securities:
Preferred stock dividends................................ - 9.5 - 28.5
----- ----- ------ ------
Net income applicable to common stock and
assumed conversions for diluted earnings per share... $38.9 $77.9 $ 62.2 $247.8
===== ===== ====== ======
Shares:
Weighted average shares outstanding
for basic earnings per share........................... 151,663 151,114 151,566 151,077
Effect of dilutive securities on weighted average shares:
Class B mandatorily convertible preferred stock........ - 33,015 - 33,706
Stock option and restricted stock plans................ 866 1,049 981 865
------- ------- ------- -------
Dilutive potential common shares....................... 866 34,064 981 34,571
------- ------- ------- -------
Weighted average shares outstanding for diluted earnings
per share.............................................. 152,529 185,178 152,547 185,648
======= ======= ======= =======
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and nine months ended September 30, 2006, because doing so would have been
antidilutive in such periods.
Three months Nine months
ended ended
September 30, 2006 September 30, 2006
------------------ ------------------
(shares in thousands)
Equivalent common shares that were antidilutive during the period:
Class B mandatorily convertible preferred stock........................ 32,565 31,515
====== ======
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
September 30, 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
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 or nine months ended September 30, 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).
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 nine months of 2006, we did not
capitalize any stock-based compensation expense as cost of policies produced or
any other asset category.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
A summary of the Company's stock option activity and related information
for the nine months ended September 30, 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................................................... 1,286 22.59
Exercised......................................................... (48) 20.80 $.3
Forfeited or terminated........................................... (336) 18.20
-----
Outstanding at the end of the period.............................. 4,438 7.9 years $28.6
===== ===
Options exercisable at the end of
the period..................................................... 1,788 6.8 years $11.8
===== ===
Available for future grant........................................ 3,598
=====
We recognized compensation expense related to stock options totaling $1.9
million and $4.8 million ($1.1 million and $3.0 million after income taxes) in
the three and nine months ended September 30, 2006, respectively. Compensation
expense related to stock options reduced both basic and diluted earnings per
share by: (i) less than 1 cent in the three months ended September 30, 2006; and
(ii) less than 2 cents in the nine months ended September 30, 2006. At September
30, 2006, the unrecognized compensation expense for non-vested stock options
totaled $13.7 million which is expected to be recognized over a weighted average
period of 2.9 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 Nine months ended
September 30, September 30,
2005 2005
---- ----
Net income, as reported............................................... $77.9 $247.8
Less stock-based employee compensation expense determined
under the fair value method for all awards, net of
income taxes..................................................... .8 2.5
----- ------
Pro forma net income.................................................. $77.1 $245.3
===== ======
Earnings per share:
Basic, as reported............................................... $.45 $1.45
Basic, pro forma................................................. .45 1.44
Diluted, as reported............................................. $.42 $1.33
Diluted, pro forma............................................... .42 1.32
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following table summarizes information about stock options outstanding
at September 30, 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 - $20.91................... 1,743 7.4 $19.19 981 $18.56
$21.00 - $25.45................... 2,695 8.3 21.83 807 21.06
----- -----
4,438 1,788
===== =====
A summary of the Company's non-vested restricted stock activity for the
nine months ended September 30, 2006, is presented below (shares in thousands):
Weighted
average
grant date
Shares fair value
------ ----------
Non-vested shares, beginning of period.............................. 1,392 $18.57
Granted.......................................................... 58 22.68
Vested.......................................................... (486) 20.62
Forfeited....................................................... (277) 17.53
-----
Non-vested shares, end of period.................................... 687 20.00
=====
At September 30, 2006, the unrecognized compensation expense for non-vested
restricted stock totaled $5.6 million which is expected to be recognized over a
weighted average period of 1.4 years. We recognized compensation expense related
to restricted stock awards totaling $3.1 million and $2.7 million in the three
months ended September 30, 2006 and 2005, respectively, and $9.1 million and
$7.8 million in the nine months ended September 30, 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:
Nine months
ended
September 30,
--------------------------------
2006 Grants 2005 Grants
----------- -----------
Weighted average risk-free interest rates.................................. 5.0% 3.8%
Weighted average dividend yields........................................... 0.0% 0.0%
Volatility factors......................................................... 22% 25%
Weighted average expected life............................................. 6.2 years 6.2 years
Weighted average fair value per share...................................... $7.91 $7.25
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 $1.0 million and $.2
million during the nine months ended September 30, 2006 and 2005, respectively.
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 Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities...................................... $ 15.9 $ 18.2 $ 45.9 $ 43.7
Supplemental health............................ 313.5 304.8 936.3 910.9
Life........................................... 65.5 61.8 186.7 156.9
Other.......................................... 24.3 3.0 69.9 9.2
Net investment income (a)........................... 143.6 124.7 408.3 358.2
Fee revenue and other income (a).................... 1.5 .3 5.2 .7
Net realized investment losses (a).................. (6.4) (3.1) (8.1) (.6)
-------- -------- -------- --------
Total Bankers Life revenues................ 557.9 509.7 1,644.2 1,479.0
-------- -------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities...................................... 3.7 4.3 12.2 15.0
Supplemental health............................ 151.0 163.8 462.2 499.5
Life........................................... 88.6 95.2 266.7 284.2
Other.......................................... 2.6 3.5 8.6 10.1
Net investment income (a)........................... 189.3 190.5 532.6 526.1
Fee revenue and other income (a).................... .8 .5 1.1 1.6
Net realized investment gains (losses) (a).......... (4.4) (3.0) (13.5) .8
-------- -------- -------- --------
Total Conseco Insurance Group revenues..... 431.6 454.8 1,269.9 1,337.3
-------- -------- -------- --------
Other Business in Run-off:
Insurance policy income - supplemental health....... 83.4 91.1 254.4 272.4
Net investment income (a)........................... 44.6 45.4 133.9 133.4
Fee revenue and other income (a).................... .1 .1 .3 .4
Net realized investment gains (losses) (a).......... (10.8) (.3) (6.8) 4.2
-------- -------- -------- --------
Total Other Business in Run-off revenues... 117.3 136.3 381.8 410.4
-------- -------- -------- --------
Corporate:
Net investment income............................... 9.3 1.7 21.0 5.5
Fee and other income................................ 2.4 11.0 7.4 17.3
Net realized investment losses...................... (.2) - (.2) (1.3)
-------- -------- -------- --------
Total corporate revenues................... 11.5 12.7 28.2 21.5
-------- -------- -------- --------
Total revenues............................. $1,118.3 $1,113.5 $3,324.1 $3,248.2
-------- -------- -------- --------
(continued on next page)
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits.......................... $ 390.6 $357.4 $1,140.5 $1,028.0
Amortization....................................... 56.6 53.9 178.1 145.8
Interest expense on investment borrowings.......... - .2 .1 1.7
Other operating costs and expenses................. 43.9 40.3 126.9 116.0
-------- ------ -------- --------
Total Bankers Life expenses................... 491.1 451.8 1,445.6 1,291.5
-------- ------ -------- --------
Conseco Insurance Group:
Insurance policy benefits.......................... 268.6 277.2 769.5 806.8
Amortization....................................... 42.0 43.6 129.7 123.8
Interest expense on investment borrowings.......... .1 .6 .6 4.8
Costs related to the tentative litigation
settlement....................................... - 1.2 165.8 4.2
Other operating costs and expenses................. 66.5 67.9 204.9 198.6
-------- ------ -------- --------
Total Conseco Insurance Group expenses........ 377.2 390.5 1,270.5 1,138.2
-------- ------ -------- --------
Other Business in Run-off:
Insurance policy benefits.......................... 113.4 90.6 294.6 264.8
Amortization....................................... 5.6 7.5 12.6 18.1
Other operating costs and expenses................. 22.1 22.1 66.0 64.0
-------- ------ -------- --------
Total Other Business in Run-off expenses...... 141.1 120.2 373.2 346.9
-------- ------ -------- --------
Corporate:
Interest expense on corporate debt................. 12.5 12.1 36.9 37.2
Interest expense on debt of variable interest
entity........................................... 5.2 - 13.7 -
Loss on extinguishment of debt..................... - 3.7 - 3.7
Costs related to the tentative litigation
settlement....................................... - 1.3 8.9 4.2
Other operating costs and expenses................. 14.5 12.5 32.4 38.0
-------- ------ -------- --------
Total corporate expenses...................... 32.2 29.6 91.9 83.1
-------- ------ -------- --------
Total expenses................................ 1,041.6 992.1 3,181.2 2,859.7
-------- ------ -------- --------
Income (loss) before income taxes:
Bankers Life.................................. 66.8 57.9 198.6 187.5
Conseco Insurance Group....................... 54.4 64.3 (.6) 199.1
Other Business in Run-off..................... (23.8) 16.1 8.6 63.5
Corporate operations.......................... (20.7) (16.9) (63.7) (61.6)
-------- ------ -------- --------
Income before income taxes................ $ 76.7 $121.4 $ 142.9 $ 388.5
======== ====== ======== ========
<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 a specified 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 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
$6.7 million and $(13.9) million in the nine months ended September 30, 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 $64.1 million and $44.5 million at September 30, 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 $240.1 million and $210.7
million at September 30, 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 September 30, 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 $10.6 million and $17.4 million at September 30, 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 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 loans. The
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 credit
worthiness of the participants and the current status of various legal actions
we have taken to collect the D&O loans. At September 30, 2006, we have estimated
that approximately $22.8 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.
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
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. As of September 30, 2006, we had paid $13.7
million to the former holders of TOPrS and we have established a liability of
$10.3 million (which is included in other liabilities), representing our
estimate of the additional 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 September
30, 2006 and December 31, 2005 was $22.8 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 $165.0 million and $176.1 million in
the first nine months of 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 $176.0
million and $183.4 million in the first nine months of 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 $103.4 million and $43.3 million in the first nine months of
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 (benefit) were as follows (dollars in
millions):
Three months ended Nine months ended
September 30, September 30,
-------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Current tax provision.......................................... $ - $ - $ - $ -
Deferred tax provision......................................... 28.3 43.5 52.2 140.7
----- ----- ----- ------
Income tax expense on period income................... $28.3 $43.5 $52.2 $140.7
===== ===== ===== ======
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Nine months ended
September 30,
-----------------------
2006 2005
---- ----
U.S. statutory corporate rate............................................................... 35.0% 35.0%
Other nondeductible expenses................................................................ 1.3 .6
State taxes................................................................................. .8 .6
Provision for tax issues, tax credits and other............................................. (.6) -
---- ----
Effective tax rate................................................................. 36.5% 36.2%
==== ====
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
September 30, December 31,
2006 2005
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries.................................................... $ 789.5 $ 812.8
Non-life companies............................................................. 788.2 796.5
Capital loss carryforwards........................................................ 393.4 397.3
Deductible temporary differences:
Insurance liabilities.......................................................... 1,355.3 1,433.2
Unrealized depreciation of investments......................................... 40.8 -
Reserve for loss on loan guarantees............................................ 143.1 155.5
-------- ---------
Gross deferred tax assets.................................................... 3,510.3 3,595.3
-------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (48.2) (67.8)
Value of policies inforce at the Effective Date and cost of policies produced.. (770.1) (752.7)
Unrealized appreciation of investments......................................... - (39.7)
Other.......................................................................... (118.4) (186.9)
-------- ---------
Gross deferred tax liabilities............................................... (936.7) (1,047.1)
-------- ---------
Net deferred tax assets before valuation allowance........................... 2,573.6 2,548.2
Valuation allowance................................................................... (779.6) (1,043.8)
-------- ---------
Net deferred tax assets...................................................... 1,794.0 1,504.4
Current income taxes accrued.......................................................... (8.9) (7.8)
-------- ---------
Net income tax assets, net................................................... $1,785.1 $ 1,496.6
======== =========
The Internal Revenue Service ("IRS") is in the process of finalizing the
audit of the Company's tax returns for the year ended December 31, 2003. We have
recorded all proposed changes from the audit in our financial statements. In
July 2006, the Joint Committee on Taxation accepted the audit and the settlement
described in our previous filings with the SEC which characterized $2.1 billion
of the tax losses on our Predecessor's investment in Conseco Finance Corp.
("CFC") (the "CFC loss") as life company losses and the remaining amount as
non-life losses prior to the application of the cancellation of indebtedness
attribute reductions described below. As a result of the approval of the
settlement, we concluded it was appropriate to reduce our valuation allowance by
$260 million in the second quarter of 2006, which was accounted for as an
addition to paid-in capital.
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 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. This assessment requires significant
judgment. 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. In
addition, the use of the Company's NOLs is dependent, in part, on whether the
IRS
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
does not take an adverse position in the future regarding the tax position we
have taken in our tax returns with respect to the allocation of cancellation of
indebtedness income.
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. We are required to
continue to record a valuation allowance of $779.6 million at September 30, 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.
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.
As of September 30, 2006, we had $4.5 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 $ 5.0 $ 5.1 $ 5.1 $ -
2007....... - .1 449.0 449.1 449.1 -
2008 ...... - .1 583.7 583.8 583.8 -
2009....... - .9 86.2 87.1 .9 86.2
2010....... - 2.4 - 2.4 2.4 -
2011....... - .4 - .4 .4 -
2012....... - 4.4 - 4.4 4.4 -
2016....... 27.7 - - 27.7 27.7 -
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....... - - - - - -
2021....... 24.2 - - 24.2 - 24.2
2023....... - 2,079.8 (a) - 2,079.8 61.9 2,017.9
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 29.1 - 29.1 - 29.1
-------- -------- -------- -------- -------- --------
Total...... $2,255.7 $2,252.0 $1,123.9 $5,631.6 $1,225.7 $4,405.9
======== ======== ======== ======== ======== ========
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
- -------------
(a) The allocation of the NOLs summarized above assumes 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. If the IRS 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.
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 $0.6 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital if realized.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of September 30, 2006 and December 31, 2005 (dollars in millions):
September 30, December 31,
2006 2005
---- ----
3.50% convertible debentures............................................................ $330.0 $330.0
Secured credit agreement................................................................ 478.3 524.6
Unamortized discount on convertible debentures.......................................... (2.7) (3.1)
------ ------
Direct corporate obligations....................................................... $805.6 $851.5
====== ======
In August 2005, we completed the private offering of $330 million of 3.50%
Convertible Debentures due September 30, 2035 (the "Debentures"). 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 September 30, 2006,
unamortized issuance costs (classified as other assets) related to the
Debentures were $6.2 million and are 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.
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
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 which 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
Company recognized a $3.7 million loss on the extinguishment of debt during the
third quarter of 2005 for the write-off of certain debt issuance costs related
to the reduction of the principal amount borrowed under the Amended 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 nine 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 $4.7 million and $5.6 million of unamortized
issuance costs (classified as other assets) related to our Amended Credit
Facility at September 30, 2006 and December 31, 2005, respectively.
On October 10, 2006, we entered into a $675.0 million secured credit
agreement (the "Second Amended Credit Facility"). The proceeds from the Second
Amended Credit Facility were used to repay the remaining principal amount of the
Amended Credit Facility and will be used to strengthen the capital of our
insurance subsidiaries. The Company expects to recognize an immaterial loss on
the extinguishment of debt during the fourth quarter of 2006 for the write-off
of certain debt issuance costs. The Second Amended Credit Facility extends the
maturity date from June 22, 2010 to October 10, 2013. Under the terms of the
Second Amended Credit Facility, we are required to make minimum quarterly
principal payments of $1.7 million, commencing December 31, 2006. The remaining
unpaid principal balance is due on October 10, 2013.
The amounts outstanding under the Second Amended Credit Facility and the
Amended Credit Facility bear interest, payable at least quarterly, based on
either a Eurodollar rate or a base rate. The Eurodollar rate on the Second
Amended Credit Facility and 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 Second Amended Credit Facility and 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. Under the terms of the Amended Credit Facility, 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",
resulting in a .25 percent interest rate reduction. Under the terms of the
Second Amended Credit Facility, if the Company's senior secured long-term debt
is rated at least "Ba2" by 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. At September 30, 2006, the interest rate on our Amended
Credit Facility was 7.1 percent.
Pursuant to the Second Amended Credit Facility, as long as the debt to
total capitalization ratio (as defined in the Second Amended Credit Facility) is
greater than 20 percent and certain insurance subsidiaries (as defined in the
Second Amended Credit Facility) have financial strength ratings of less than A-
from A.M. Best Company ("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 Second Amended Credit Facility (the first such
payment, if applicable, would not be paid prior to the first quarter of 2008).
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.
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The Second Amended Credit Facility and the Amended Credit Facility require
the Company to maintain various financial ratios and balances, as defined in the
agreements, including:
Second Amended Amended
Credit Facility Credit Facility
--------------- ---------------
(i) debt to total capitalization ratio............... not more than 30% not more than 25%
(ii) interest coverage ratio.......................... greater than or equal to greater than or equal to
2.00 to 1 for each rolling 2.00 to 1 for each rolling
four quarters four quarters ending
June 30, 2007, and 2.50
to 1 for each rolling four
quarters thereafter
(iii) an aggregate risk-based capital ratio............ greater than or equal to greater than or equal to
250% for each quarter 250% for each quarter
(iv) combined statutory capital and surplus level..... greater than $1,270.0 greater than $1,270.0
million million
The Company was in compliance with all covenants as defined in the Amended
Credit Facility at September 30, 2006.
The Amended Credit Facility and the Second Amended Credit Facility both
include 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 September 30, 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 Second Amended Credit Facility.
The Second Amended Credit Facility provides for a one time increase in the
facility or the addition of a new facility of up to $330.0 million. Such
increase would be effective as of a date that is at least 90 days prior to the
scheduled maturity date.
The Second Amended Credit Facility prohibits or restricts, among other
things: (i) the payment of cash dividends on our common stock; (ii) the
repurchase of our common stock; (iii) the issuance of additional debt or capital
stock; (iv) liens; (v) certain asset dispositions; (vi) affiliate transactions;
(vii) certain investment activities; (viii) change in business; and (ix)
prepayment of indebtedness (other than the Second Amended Credit Facility). The
obligations under our Second Amended Credit Facility are guaranteed by Conseco's
current and future domestic subsidiaries, other than: (i) its insurance
companies; (ii) subsidiaries of the insurance companies; or (iii) certain
immaterial subsidiaries as defined in the Second Amended Credit Facility. This
guarantee was secured by granting liens on substantially all the assets of the
guarantors, including the capital stock of our top tier insurance company,
Conseco Life Insurance Company of Texas. Under the Second Amended Credit
Facility, we may pay cash dividends on our common stock or repurchase our common
stock in an aggregate amount of up to $150.0 million over the term of the
facility (compared to a limitation of $50.0 million under 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 $48.5 million and $15.7 million during the nine
months ended September 30, 2006 and 2005, respectively. Amounts amortized
totaled $14.1 million and $3.9 million during the nine months ended September
30, 2006 and 2005, respectively. The unamortized
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
balance of deferred sales inducements at September 30, 2006 and December 31,
2005 was $104.5 million and $70.1 million, respectively. The balance of
insurance liabilities for persistency bonus benefits was $304.3 million and
$320.7 million at September 30, 2006 and December 31, 2005, respectively.
RECENTLY ISSUED ACCOUNTING STANDARDS
Pending Accounting Standards
In September 2006, the FASB issued SFAS No. 158, "Employers Accounting for
Defined Benefit and Other Retirement Plans - an amendment of FASB Statements No.
87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires employers to recognize
the overfunded or underfunded status of defined benefit pension and other
postretirement benefit plans as an asset or liability in its statement of
financial position, measured as the difference between the fair value of plan
assets and the projected benefit obligation as of the end of our fiscal year
end. In addition, SFAS 158 requires employers to recognize changes in the funded
status of defined benefit pension and other post retirement plans in the year in
which the changes occur through other accumulated comprehensive income. SFAS 158
is effective for fiscal years ending after December 15, 2006. The Company is
currently evaluating the impact of adopting SFAS 158, however, it is not
expected to have a material impact on our consolidated financial position or
results of operations.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
("SFAS 157"). SFAS 157 defines fair value, establishes a framework for measuring
fair value and expands disclosures of fair value measurements. SFAS 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007. The Company is currently evaluating the effect SFAS 157 will
have on our results of operations and financial condition.
In September 2006, the SEC released Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108
provides guidance on how the effects of prior year uncorrected financial
statement misstatements should be considered in quantifying a current year
misstatement. SAB 108 requires companies to quantify misstatements using both an
income statement ("rollover") and balance sheet ("iron curtain") approach and
evaluate whether either approach results in a misstatement that, when all
relevant quantitative and qualitative factors are considered, is material. If
prior year errors that had been previously considered immaterial now are
considered material based on either approach, no restatement is required as long
as the company properly applied its previous approach and all relevant facts and
circumstances were considered. If prior years are not restated, the cumulative
effect adjustment is recorded in retained earnings as of the beginning of the
fiscal year of adoption. The provisions of SAB 108 must be applied no later than
the annual financial statements of the Company for the year ended December 31,
2006. Our adoption of SAB 108 is not expected to have an effect on our results
of operations or financial position because we currently use an approach
consistent with the new requirement.
In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN
48"). FIN 48 creates a comprehensive model which addresses how a company should
recognize, measure, present and disclose in its financial statements uncertain
tax positions that the company has taken or expects to take on a tax return.
This guidance is effective for fiscal years beginning after December 15, 2006.
We are currently evaluating the impact of FIN 48 on our consolidated results of
operations and financial position.
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
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. Management is 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.
Based on our initial assessment of the standard, we do not expect it to have a
material impact on our results of operations or financial position. However, the
insurance industry has identified several implementation issues during their
evaluation of SOP 05-1. As a result, the standard is currently under review by
an expert panel formed by the American Institute of Certified Public Accountants
and clarifications or revisions may be issued which could affect our initial
assessment.
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 related insurance
policies.
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 and allege material omissions and
dissemination of materially misleading statements regarding, among other things,
the liquidity of Old 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 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 limited to $3 million in the aggregate under such plan.
Our liability to indemnify individual defendants who were serving as an officer
or director on the Effective Date, of which there is one such defendant, is not
limited by 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 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. The Company announced on August 1,
2006, that it has reached a tentative settlement of this case. Under the
tentative settlement, inforce policyholders will have an option to choose a form
of policy benefit enhancement and certain former policyholders will share in a
settlement fund by either reinstating their policies with enhanced benefits, or
electing to receive cash. Finalizing the settlement will require court review
and approval, a fairness hearing, notice to all class members,
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
election of options by the class members, implementation of the settlement and
is subject to other conditions. We expect to implement the settlement with the
inforce and certain former policyholders in the first quarter of 2007.
As a result of the settlement, we recorded $157.0 million of costs (before
income taxes) related to the tentative settlement in the second quarter of 2006.
In addition, we had previously recognized costs related to this litigation of
$17.7 million in the three months ended March 31, 2006, and $18.3 million and
$9.8 million in the years ended December 31, 2005 and 2004, respectively.
The liability we have established related to the tentative settlement at
September 30, 2006, includes our best estimate of: (i) the cost of the benefits
to be provided to inforce policyholders; (ii) the value of the settlement fund
for former policyholders; (iii) plaintiff attorney fees; (iv) the cost to settle
other cases pending with respect to the cost of insurance litigation; and (v)
other costs and professional fees required to implement the settlement. While we
believe the liabilities we have established are adequate to cover these costs,
our estimates are subject to significant judgment (including the form of policy
benefit enhancement chosen by the inforce policyholders) and it is possible that
our estimates will prove to be insufficient to cover our actual costs. In
addition, the actual cost we incur is dependent on: (i) the release of no less
than 1,000,000 shares of our common stock which were reserved for distribution
pursuant to the bankruptcy plan of our Predecessor to satisfy the prepetition
claims of the plaintiffs; and (ii) the value of such shares realized by the
plaintiffs. In determining our current estimate of the net costs related to the
tentative settlement, these shares were valued based on the September 30, 2006
closing price of a share of our common stock. The implementation of the
tentative settlement includes enhanced benefits to the inforce insurance
policies, which eliminates the future estimated profits from these policies in
periods subsequent to the tentative settlement date, if the experience of the
policies is consistent with our expectations. We recognized income before income
taxes on these policies of approximately $6.0 million in the six months ended
June 30, 2006. We recognized a loss before income taxes on these policies of
approximately $2.7 million in the three months ended September 30, 2006 (a
post-tentative settlement date period), primarily due to adverse mortality
experience.
Other cases that remain pending with respect to life insurance policies
sold primarily under the names "Lifestyle" and "Lifetime" 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, on
February 11, 2005 Mr. Schwartz filed a purported nationwide class action
captioned William Schwartz and Rebeca R. Frankel, Trustee of the Robert M.
Frankel Irrevocable Insurance Trust v. Conseco Life Ins. Co. et al., Case No. GD
05-3742 (Court of Common Pleas, Allegheny County, Pennsylvania). On May 12, 2006
these two Schwartz cases were consolidated under both original case numbers. On
May 24, 2005 a purported class action lawsuit was filed in Illinois on behalf of
a putative statewide class captioned William J. Harte, individually and on
behalf of all others similarly situated v. Conseco Life Insurance Company, Case
No. 05CH08925 (Circuit Court of Cook County, Illinois, Chancery Division), which
has been removed to the United States District Court for the Northern District
of Illinois, transferred to California and consolidated and coordinated with MDL
1610.
Other non-class action cases regarding these policies include a lawsuit
filed on September 14, 2005 in Hawaii captioned AE Ventures for Archie
Murakami, et al. v. Conseco, Inc., Conseco Life Insurance Company; And Doe
Defendants 1-100, Case No. CV05-00594 (United States District Court, District of
Hawaii). This suit involves 724 plaintiffs all of who opted out of the In Re
Conseco Life Insurance Co. Cost of Insurance Litigation multi-district action.
The complaint alleges nondisclosure, breach of fiduciary duty, violations of HRS
480 (unfair and/or deceptive business practices), declaratory and injunctive
relief, insurance bad faith, punitive damages, and seeks to impose alter ego
liability. Additionally, a lawsuit was filed on December 22, 2005 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).
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The ultimate outcome of these cost of insurance lawsuits cannot be
predicted with certainty and an adverse outcome could exceed the amount we have
accrued and could have a material impact on the Company's consolidated financial
condition, cash flows or results of operations.
Agent Litigation
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, Molly 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 was set
for a jury trial commencing July 31, 2006. However, plaintiffs filed a motion to
add an additional count to the complaint and a motion for summary judgment on
that new count. The court denied plaintiffs' motion for summary judgment, and
plaintiffs are appealing that denial. As a result, the court continued the trial
pending a ruling from the Indiana Court of Appeals. 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 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 a motion requesting that the case be moved to
the U.S. District Court in Indianapolis. The court refused to change the venue
of the action, and CMIC's motion for summary judgment is still pending. 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 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. CMIC has filed a motion for summary
judgment that is currently pending. 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.
Other Litigation
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:
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. On August 25, 2006 the court awarded the
plaintiff judgment in the sum of $3.8 million plus interest from December 16,
1997. We will be appealing the judgment.
A civil complaint dated December 5, 2005 was filed with the Piraeus Court
in Greece on December 22, 2005 by Blue Wave Maritime S.A., Adriatic Spirit S.A.,
Aegean Spirit S.A., and Ocean Challenger S.A., all companies which are part of
the Adriatic Holding Corporation Ltd. group of companies ("Adriatic") which each
owned one vessel, against United States Trust Company of New York, Teachers
Insurance and Annuity Association of America, Nightingale & Associates, Fairwind
Shipping Limited, Aegon USA Investment Management, CIGNA Investments Inc.,
Kemper Financial Services Inc., Conseco Capital Management Co., Northwestern
Mutual Life Insurance Company, John Hancock Mutual Life Insurance Company, New
England Mutual Life Insurance Company, Combined States Holding Corporation,
Douglas Hopkins, executive of the company Nightingale & Associates, and Brad
Scher, executive of the company Teachers Insurance and Annuity Association of
America (collectively "Noteholders") alleging various tort claims arising out of
the foreclosure and/or repossession in 1996 by the Noteholders of four vessels
allegedly owned by the plaintiffs and seeking damages in the approximate amount
of $32 million. Conseco was served on or about August 30, 2006. The suit
concerns various Notes issued by Adriatic in April 1994 which were purchased by
the Noteholders and secured in part by preferred ship mortgages on various
vessels owned by Adriatic. In 1996, Adriatic defaulted on the Notes and the
Noteholders exercised their rights pursuant to the applicable loan documentation
to foreclose and/or take possession of the four vessels that secured Adriatic's
obligations to the Noteholders. 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 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. The jury
trial which was set for September 18, 2006 has been continued, and a new trial
date has not been set by the court at this time. 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. In an order dated April 14, 2006, the court consolidated the two cases
under the original Hansen cause number and retitled the consolidated action: In
re Conseco Insurance Co. Annuity Marking & Sales Practices Litig. A motion to
dismiss the amended complaint was filed on July 28, 2006 and was heard on
October 27, 2006. The court has set plaintiff's motion for class certification
for hearing on March 30, 2007, and the case is set for trial commencing November
13, 2007. 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.
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
On May 10, 2000, a complaint was filed in the Court of Common Pleas of
Lancaster County, Pennsylvania, Civil Action-Law No. CI-00-04822 captioned
Frederick C. Wolf, Executor of the Estate of Louis P. Kretschman v. Bankers Life
and Casualty Company, and Timothy O. Cochran. On September 12, 2001, the
plaintiff filed an amended complaint. The amended complaint seeks damages for
the alleged improper sale of a fixed annuity and a life insurance policy. The
specific allegations are intentional misrepresentation, negligent
misrepresentation, negligence, breach of contract, fraud, unfair trade practices
and consumer law violations, and bad faith. On April 18, 2006, a bench trial was
held. At the conclusion of the trial, the plaintiff asked the judge to find that
Bankers Life and Casualty acted in bad faith and engaged in unfair trade
practices and consumer protection law violations as defined by statute. The
plaintiff asked the court to award treble damages, unspecified punitive damages,
and attorney fees. Actual damages are less than $.1 million. The judge ordered
the parties to submit proposed findings of facts and conclusions of law. Along
with those filings, the plaintiff also filed an application for attorney fees in
the amount of $.5 million. Bankers Life and Casualty filed motions asserting
attorney fees should not be allowed because the plaintiff failed to present the
appropriate evidence at trial or in the alternative that Bankers Life and
Casualty be able to conduct discovery and present expert testimony as to the
reasonableness of the amounts asserted. We believe the action is without merit
and intend to defend it vigorously. The outcome of the action cannot be
determined with certainty.
On September 24, 2004, a purported statewide class action was filed in the
18th Judicial District Court, Parish of Iberville, Louisiana, Diana Doiron,
Individually And On Behalf of All Others Similarly Situated v. Conseco Health
Insurance Company, Case No. 61,534. In her complaint, plaintiff claims that she
was damaged due to Conseco Health's failure to pay claims made under her cancer
policy, and seeks compensatory and statutory damages along with declaratory and
injunctive relief. Conseco caused the case to be removed to the United States
District Court for the Middle District of Louisiana on November 3, 2004, and it
was assigned case number 04-784-D-M2. This case is now in the discovery stage,
and the court has not yet set a hearing for plaintiff's class certification
motion. We believe the action is without merit, and we intend to defend the case
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On October 3, 2005, an action was filed in Superior Court for San Francisco
County, California, Anita D. Paratley v. Conseco Health Insurance Company et al,
Case No. C-05-44379. On Conseco Health Insurance Company's motion, the case was
removed to the United States District Court for the Northern District of
California and issued Case No. C-05-4312 (MMC). In her complaint, plaintiff
claims that she was damaged due to Conseco Health Insurance Company's failure to
pay claims made under her cancer policy, and seeks compensatory and punitive
damages and her attorney's fees along with declaratory relief. These claims are
based on plaintiff's allegation of breach of contract, bad faith and unfair
business practices. The complaint was subsequently amended adding Conseco, Inc.
as a defendant, but Conseco, Inc. was subsequently replaced by Conseco Services,
LLC ("Conseco Services") as a party defendant. This case is now in the discovery
stage. Plaintiff has filed a motion for summary judgment that is set to be heard
on November 17, 2006, and the court has set the case for a jury trial commencing
April 23, 2007. We believe the action without merit, and we intend to defend the
case vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
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.
On May 3, 2006, Himco answered the complaint and filed a counterclaim seeking
unspecified damages and alleging breach of contract, breach of the duty of good
faith and fair dealing, as well as seeking declaratory relief. In addition they
sought a change of venue to Elkhart County, Indiana. The matter is now in
Elkhart Circuit Court, Case No. 20CO1-2606-PL-46. The ultimate outcome of this
action cannot be predicted with certainty.
29
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Beneficial Standard Life Insurance Company, a predecessor company to
Conseco Insurance Company, filed suit for declaratory judgment against J.C.
Penney Life Insurance Company a/k/a Stonebridge Life Insurance Company
("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 to J.C. Penney
Company, Inc. The subject of the case is whether Conseco Insurance Company must
indemnify Stonebridge for losses and expenses incurred as a result of claims
arising under presale BF&C insurance policies. Conseco Insurance Company filed
suit in April 1998 seeking a judicial declaration that: (1) it is not generally
obligated to indemnify Stonebridge under the terms of the agreement governing
the 1967 sale; and (2) that it is not obligated to indemnify Stonebridge for
losses or expenses incurred in connection with specific known claims. Penney
counterclaimed for breach of contract and declaratory relief. The counterclaim
did not specify the damages sought by Penney on the breach of contract claims.
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 upholding a trial-court determination that the
terms of the 1967 sale generally require Conseco Insurance Company to indemnify
Stonebridge for net losses arising from pre-sale BF&C policies, but only after
Stonebridge pursues and exhausts available reinsurance. The Ninth Circuit
remanded the case to the trial court for further proceedings. The trial court
had previously found against Stonebridge on its breach of contract claims,
ruling that Stonebridge could not assert such claims until it pursued and
exhausted available reinsurance. Stonebridge did not appeal that specific
ruling. The remaining issue before the trial court is whether Conseco Insurance
Company's indemnification obligation with respect to certain environmental
claims asserted by the Port of Oakland is excused by Stonebridge's conduct in
handling the claims. On July 25, 2006, a second action was filed in the Circuit
Court of Hamilton County, Indiana, captioned Conseco Insurance Company v.
Stonebridge Life Insurance Company and J.C. Penney Life Insurance Company, Case
No. 29 C0 10607 MI 765. Penney removed the case to federal court on August 16,
2006, Case No. 1:06-CV-1229 SEB-VSS (Southern District, Indiana) and filed a
motion to dismiss. The subject of this second action is whether Conseco
Insurance Company's indemnification obligation with respect to specific known
claims is excused by Stonebridge's failure to pursue available reinsurance.
Conseco Insurance Company alternatively seeks equitable relief requiring
Stonebridge to take affirmative steps to preserve the availability of
reinsurance on such claims. The ultimate outcomes of the actions cannot be
predicted with certainty.
On January 9, 2004, a six count complaint was filed against Conseco Life
Insurance Company, styled Laura G. Bailey vs. Conseco Life Insurance Company, an
Indiana corporation; Debbie L. Sipe; Does 1 through 15; and, Roe Corporations 1
through 15, inclusive. The suit is pending in the District Court of Clark
County, Nevada, Cause No. A478843, Dept. No. VIII, and is set for a jury trial
beginning on May 29, 2007. Ms. Bailey's suit centers around her request for
disability benefits in the spring of 2003 and alleges breach of contract, bad
faith, unfair claim settlement practices, breach of fiduciary relationship,
misrepresentation, and punitive damages. When Ms. Bailey submitted her request,
Conseco Life Insurance Company investigated and found that Ms. Bailey was only
issued a life insurance policy. Conseco Life Insurance Company intends to file a
summary judgment in this matter. We believe the action is without merit, and
intend to defend it rigorously. 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. Conseco has filed a
motion for partial summary judgment on the issue of whether RLI was obligated to
provide it a defense in the Russell case. The case is set to be tried commencing
April 2, 2007. 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.
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
30
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
Director and Officer Loan Program Litigation
Collection efforts by the Company and Conseco Services related to the
1996-1999 director and officer loan programs are ongoing 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 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. 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). James S. Adams filed for
bankruptcy on July 29, 2005, Case No. 1:02-cv-1332-DFH-TAB (Southern District,
Indiana). On July 17, 2006 a Chapter 7 Involuntary Bankruptcy Petition was filed
by Conseco against James D. Massey, Case No. 06-03895-7 (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 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. On July 14,
2006 Mr. Hilbert filed a Petition for Writ of Certiorari in the Supreme Court of
the United States. On October 2, 2006, the Supreme Court denied the petition. We
are now proceeding to execute on our judgment.
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. As of September 30, 2006, we have paid $13.7 million to the
former holders of trust preferred securities under this arrangement. 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 September 30, 2006, we estimated that
approximately $22.8 million, net of collection costs, of the remaining amounts
due under the loan program will be collected and that $10.3 million will be paid
to the former holders of our Predecessor's trust preferred securities.
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, subject to various examinations,
inquiries and information requests from state and other authorities. The
ultimate outcome of these regulatory actions 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.
31
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
In 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 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. We
have sent a notice to the approximately 2,000 affected policyholders and advised
them of their options.
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.
Certain state insurance regulators have requested information with respect
to actions of the Company related to the cost of insurance charges for life
insurance policies sold primarily under the names "Lifestyle" and "Lifetime".
Such policies are subject to the tentative litigation settlement described above
under "Cost of Insurance Litigation". The ultimate outcome of such inquiries and
the effect any regulator actions could have on the tentative litigation
settlement cannot be predicted with certainty.
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Nine months ended
September 30,
----------------------
2006 2005
---- ----
Cash flows from operating activities:
Net income........................................................................... $ 90.7 $ 247.8
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization and depreciation.................................................... 337.1 303.1
Income taxes..................................................................... 54.0 168.1
Insurance liabilities............................................................ 275.0 281.2
Accrual and amortization of investment income.................................... 13.9 55.8
Deferral of policy acquisition costs............................................. (367.6) (305.3)
Net realized investment (gains) losses........................................... 28.6 (3.1)
Net sales of trading securities.................................................. 28.3 161.1
Loss on extinguishment of debt................................................... - 3.4
Other............................................................................ 198.7 (3.0)
------ -------
Net cash provided by operating activities...................................... $658.7 $ 909.1
====== =======
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............................................ $11.1 $7.1
===== ====
32
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
At September 30, 2006 and December 31, 2005, restricted cash and cash
equivalents consisted of: (i) $6.6 million and $33.3 million, respectively, held
by a variable interest entity; (ii) $.1 million and $1.9 million, respectively,
of segregated cash held for the benefit of the former holders of TOPrS; and
(iii) $8.2 million and nil, respectively, held in an escrow account pursuant to
a litigation settlement.
SUBSEQUENT EVENT
On October 10, 2006, the Company completed the refinancing of its Amended
Credit Facility. Refer to the note entitled "Notes Payable - Direct Corporate
Obligations" for further information related to the refinancing.
33
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at September 30, 2006, and the consolidated results of operations for the three
and nine months ended September 30, 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, the
adequacy of our previous reserve estimates 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;
34
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;
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; and
o our ability to realize our deferred income tax assets by generating
sufficient future taxable income during the period in which our
temporary differences become deductible and before the carryforward
periods expire.
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" and "Washington
National" (a wholly-owned insurance subsidiary of Conseco) brand
names.
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
We have updated our critical accounting policy related to the value of
policies inforce at the Effective Date and cost of policies produced to
summarize our estimates of cumulative adjustments resulting from hypothetical
revisions to certain
35
CONSECO, INC. AND SUBSIDIARIES
-------------------
assumptions. In addition, we have added a critical accounting policy on the
accounting for the marketing and quota-share agreements with Coventry Health
Care ("Coventry"). These critical accounting policies are presented below.
Refer to "Critical Accounting Policies" in Conseco's 2005 Annual Report on
Form 10-K for information on our other accounting policies.
Value of Policies Inforce at the Effective Date and Cost of Policies
Produced
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of Old Conseco's cost of policies purchased
and cost of policies produced as of the Effective Date and replaced them with
the value of policies inforce at the Effective Date.
The value assigned to the right to receive future cash flows from policies
existing at the Effective Date 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. The
balance of this account is amortized, evaluated for recovery, and adjusted for
the impact of unrealized gains (losses) in the manner described below. We expect
to amortize approximately 12 percent of the December 31, 2005 balance of value
of policies inforce in 2006, 11 percent in 2007, 10 percent in 2008, 8 percent
in 2009 and 8 percent in 2010.
The cost of policies produced are those costs that vary with, and are
primarily related to, producing new insurance business in the period after the
Effective Date. These costs include commissions in excess of ultimate renewal
commissions, printing costs, sales materials, underwriting and policy issuance
expenses. The value of policies inforce and the cost of policies produced are
collectively referred to as "insurance acquisition costs."
Insurance acquisition costs are amortized to expense over the lives of the
underlying policies in relation to future anticipated premiums or gross profits.
The insurance acquisition costs for policies other than universal life and
investment-type products are amortized with interest (using the projected
investment earnings rate) over the estimated premium-paying period of the
policies, in a manner which recognizes amortization expense in proportion to
each year's premium income. Limited-payment policies are amortized over the
contract period. The insurance acquisition costs for universal life and
investment-type products are amortized with interest (using the interest rate
credited to the underlying policy) in proportion to estimated gross profits. The
interest, mortality, morbidity and persistency assumptions used to amortize
insurance acquisition costs are consistent with those assumptions used to
estimate liabilities for insurance products. For universal life and
investment-type products, these assumptions are reviewed on a regular basis.
When actual profits or our current best estimates of future profits are
different from previous estimates, we adjust cumulative amortization of
insurance acquisition costs to maintain amortization expense as a constant
percentage of gross profits over the entire life of the policies.
When lapses of our insurance products exceed levels assumed in determining
the amortization of insurance intangibles, we adjust amortization to reflect the
change in future premiums or estimated gross profits resulting from the
unexpected lapses. We recognized additional amortization expense of $7.9 million
during the first six months of 2006 as a result of higher than expected lapses
of our Medicare supplement products. We believe the unexpected lapses were
primarily related to premium rate increases and competition from companies
offering Medicare Advantage products. During the first nine months of 2006, we
changed our estimates of the future gross profits of certain universal life
products, which under certain circumstances are eligible for interest bonuses in
addition to the declared base rate. These interest bonuses are not required in
the current crediting rate environment and our estimates of future gross profits
have been changed to reflect the discontinuance of the bonus. We reduced
amortization expense by $4.0 million during the first six months of 2006 as a
result of this change. During 2005, we conducted a review of our methodology for
identifying and capitalizing deferred acquisition costs related to the
traditional life block of business in our Bankers Life segment. Based on our
review, we reduced the total cost capitalized in prior years by $1.1 million,
which was reflected as an increase in amortization expense for the year ended
December 31, 2005. During 2004, differences between actual and expected
investment income caused us to change our assumptions used to estimate gross
profits for universal life and investment-type products. The changes we made
primarily relate to the timing of investment income and had the effect of
lowering near term expected profits and increasing longer term profits based on
a more precise modeling of the investment portfolio. The changes we made did not
affect our expectations for the total estimated profits to be earned on this
business, but did affect how we expect these profits to emerge over time. The
new assumptions resulted in a reduction to insurance amortization of
approximately $4.6 million during 2004. There have been no other significant
changes to assumptions used to amortize insurance acquisition costs during the
first nine
36
CONSECO, INC. AND SUBSIDIARIES
-------------------
months of 2006 or during 2005 and 2004. Revisions to assumptions in future
periods could have a significant adverse or favorable effect on our results of
operations and financial position.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization of insurance acquisition
costs 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
decreased amortization expense for such changes by $6.0 million and $1.2 million
in the first nine months of 2006 and 2005, respectively. In addition, we
increased (decreased) amortization expense for such changes by $(2.8) million,
$13.4 million, $1.1 million and $(.4) million during the years ended December
31, 2005 and 2004, the four months ended December 31, 2003 and the eight months
ended August 31, 2003, respectively. We also adjust insurance acquisition costs
for the change in amortization that would have been recorded if actively managed
fixed maturity securities had been sold at their stated aggregate fair value and
the proceeds reinvested at current yields. We include the impact of this
adjustment in accumulated other comprehensive income (loss) within shareholders'
equity. The total pre-tax impact of such adjustments on accumulated other
comprehensive income (loss) was an increase of $36.0 million at September 30,
2006.
At September 30, 2006, the balance of insurance acquisition costs was $3.3
billion. The recoverability of this amount is dependent on the future
profitability of the related business. Each year, we evaluate the recoverability
of the unamortized balance of insurance acquisition costs. These evaluations are
performed to determine whether estimates of the present value of future cash
flows, in combination with the related liability for insurance products, will
support the unamortized balance. These future cash flows are based on our best
estimate of future premium income, less benefits and expenses. The present value
of these cash flows, plus the related balance of liabilities for insurance
products, is then compared with the unamortized balance of insurance acquisition
costs. In the event of a deficiency, such amount would be charged to
amortization expense. The determination of future cash flows involves
significant judgment. Revisions to the assumptions which determine such cash
flows could have a significant adverse effect on our results of operations and
financial position.
The table presented below summarizes our estimates of cumulative
adjustments to insurance acquisition costs resulting from hypothetical revisions
to certain assumptions. Although such hypothetical revisions are not currently
required or anticipated, we believe they could occur based on past variances in
experience and our expectations of the ranges of future experience that could
reasonably occur. We have assumed that revisions to assumptions resulting in the
adjustments summarized below would occur equally among policy types, ages and
durations within each product classification. Any actual adjustment would be
dependent on the specific policies affected and, therefore, may differ from the
estimates summarized below. In addition, the impact of actual adjustments would
reflect the net effect of all changes in assumptions during the period.
Estimated adjustment to
income before
income taxes based on
Change in assumptions(1) revisions to certain assumptions
- --------------------- --------------------------------
(dollars in millions)
Universal life-type products(2):
5% increase to assumed mortality.................................. $(35.8)
5% decrease to assumed mortality.................................. 27.6
15% increase to assumed expenses.................................. (8.9)
15% decrease to assumed expenses.................................. 7.9
10 basis point decrease to assumed spread......................... (7.6)
10 basis point increase to assumed spread......................... 7.1
Investment-type products:
20% increase to assumed surrenders................................ $(8.7)
20% decrease to assumed surrenders................................ 10.3
15% increase to assumed expenses.................................. (2.4)
15% decrease to assumed expenses.................................. 2.3
10 basis point decrease to assumed spread......................... (7.1)
10 basis point increase to assumed spread......................... 6.6
<FN>
- --------
(1) We have excluded the effect of reasonably likely changes in
assumptions for policies other than universal life and investment-type
products. Our estimates indicate such changes would not result in any
portion of the $2.4 billion balance of unamortized insurance
acquisition costs related to these policies being unrecoverable.
(2) We have excluded the effect of reasonably likely changes in
assumptions for universal life-type policy lapses. Our estimates
indicate such changes would not have a significant effect on income
before income taxes.
</FN>
37
CONSECO, INC. AND SUBSIDIARIES
-------------------
Accounting for marketing and quota-share agreements with Coventry
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
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 policy
benefits subject to a risk corridor. 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 based
upon negotiated percentages of collected premiums on the underlying
Medicare Part D contracts.
o We also pay commissions to our agents who sell the plans on behalf of
Coventry. These payments are deferred and amortized over the remaining
term of the initial enrollment period (the one-year life of the
initial policy).
Our accounting for the quota-share agreement
o We recognize premium revenue 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 (the "CMS"), as if the quarter represented an entire contract
period.
38
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the income before income taxes recognized on this
business (primarily in the Bankers Life segment) (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
2006 2006
---- ----
Insurance policy income............................................. $21.5 (a) $61.3 (a)
Fee revenue and other............................................... 1.2 4.1
----- -----
Total revenues.................................................... 22.7 65.4
----- -----
Insurance policy benefits........................................... 17.7 54.0
Amortization expense................................................ 2.4 6.4
Other operating expense (primarily ceding
commissions)...................................................... 1.9 4.7
----- -----
Total expense..................................................... 22.0 65.1
----- -----
Income before income tax.......................................... $ .7 $ .3
===== =====
<FN>
- -----------
(a) Such amounts for the three and nine months ended September 30, 2006,
include our quota-share of premiums collected by Coventry summarized
as follows (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
2006 2006
---- ----
Premiums from the CMS............................................... $16.2 $39.3
CMS risk share premium.............................................. (2.8) 1.2
Premiums from the policyholders..................................... 8.1 20.8
----- -----
$21.5 $61.3
===== =====
</FN>
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.
39
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 Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Income (loss) before net realized investment gains (losses),
net of related amortization, and income taxes
(a non-GAAP measure) (a):
Bankers Life............................................. $ 73.0 $ 60.4 $205.5 $187.6
Conseco Insurance Group.................................. 58.5 67.1 8.1 197.6
Other Business in Run-off................................ (13.0) 16.4 15.4 59.3
Corporate operations..................................... (20.6) (16.9) (63.6) (60.3)
------ ------ ------ ------
97.9 127.0 165.4 384.2
------ ------ ------ ------
Net realized investment gains (losses), net of related
amortization:
Bankers Life............................................. (6.2) (2.5) (6.9) (.1)
Conseco Insurance Group.................................. (4.1) (2.8) (8.7) 1.5
Other Business in Run-off................................ (10.8) (.3) (6.8) 4.2
Corporate operations..................................... (.1) - (.1) (1.3)
------ ------ ------ ------
(21.2) (5.6) (22.5) 4.3
------ ------ ------ ------
Income (loss) before income taxes:
Bankers Life............................................. 66.8 57.9 198.6 187.5
Conseco Insurance Group.................................. 54.4 64.3 (.6) 199.1
Other Business in Run-off................................ (23.8) 16.1 8.6 63.5
Corporate operations..................................... (20.7) (16.9) (63.7) (61.6)
------ ------ ------ ------
Income before income taxes............................ $ 76.7 $121.4 $142.9 $388.5
====== ====== ====== ======
<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.
Our results were significantly affected by $157.0 million of costs related to
the tentative litigation settlement recognized by the Conseco Insurance Group
segment in the second quarter of 2006. In addition, the earnings in the Other
Business in Run-off segment reflected adverse development of prior period claim
reserves and an increase in initial claims during the second and third quarters
of 2006. Refer to the analysis which follows for more information.
40
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
---------------------- ----------------------
2006 2005 2006 2005
---- ---- ---- ----
Premium collections:
Annuities................................................ $ 278.2 $ 226.7 $ 749.9 $ 687.0
Supplemental health...................................... 318.1 302.9 989.7 921.0
Life..................................................... 73.2 65.8 208.0 170.1
-------- -------- -------- --------
Total collections...................................... $ 669.5 $ 595.4 $1,947.6 $1,778.1
======== ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 365.9 $ 357.9 $ 363.9 $ 356.2
Equity-indexed....................................... 527.9 326.3 468.6 312.4
Deposit based........................................ 4,469.2 4,147.3 4,407.0 4,037.1
Health................................................. 3,350.6 3,091.8 3,296.2 3,028.0
Life:
Interest sensitive................................... 378.8 356.7 372.8 351.2
Non-interest sensitive............................... 805.7 754.9 793.8 747.0
-------- -------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded................. $9,898.1 $9,034.9 $9,702.3 $8,831.9
======== ======== ======== ========
Revenues:
Insurance policy income.................................. $ 419.2 $ 387.8 $1,238.8 $1,120.7
Net investment income:
General account invested assets........................ 140.0 123.4 406.8 360.7
Equity-indexed products based on the change in
value of options..................................... 3.6 1.3 1.5 (2.5)
Trading account income related to policyholder
and reinsurer accounts............................... 9.5 (7.0) (4.5) (4.2)
Change in value of embedded derivatives related
to modified coinsurance agreements................... (9.5) 7.0 4.5 4.2
Fee revenue and other income............................. 1.5 .3 5.2 .7
-------- -------- -------- --------
Total revenues....................................... 564.3 512.8 1,652.3 1,479.6
-------- -------- -------- --------
Expenses:
Insurance policy benefits................................ 338.5 312.5 1,001.5 904.4
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than equity-indexed products.......... 44.4 42.7 129.6 122.9
Equity-indexed products based on change in
value of indices..................................... 7.7 2.2 9.4 .7
Amortization related to operations....................... 56.8 54.5 179.3 146.3
Interest expense on investment borrowings................ - .2 .1 1.7
Other operating costs and expenses....................... 43.9 40.3 126.9 116.0
-------- -------- -------- --------
Total expenses....................................... 491.3 452.4 1,446.8 1,292.0
-------- -------- -------- --------
Income before net realized investment losses,
net of related amortization and income taxes............... 73.0 60.4 205.5 187.6
-------- -------- -------- --------
Net realized investment losses........................... (6.4) (3.1) (8.1) (.6)
Amortization related to net realized investment
losses................................................. .2 .6 1.2 .5
-------- -------- -------- --------
Net realized investment losses, net of related
amortization....................................... (6.2) (2.5) (6.9) (.1)
-------- -------- -------- --------
Income before income taxes.................................... $ 66.8 $ 57.9 $ 198.6 $ 187.5
======== ======== ======== ========
(continued)
41
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................ $274.4 $251.9 $818.6 $748.4
Benefit ratio (a).................................... 81.2% 81.8% 81.4% 81.3%
Medicare supplement:
Insurance policy benefits............................ $106.7 $117.4 $331.0 $353.7
Benefit ratio (a).................................... 65.7% 71.8% 67.0% 72.0%
Long-term care:
Insurance policy benefits............................ $148.4 $132.6 $428.7 $389.2
Benefit ratio (a).................................... 98.2% 93.9% 97.0% 92.7%
Interest-adjusted benefit ratio (b).................. 68.8% 65.1% 67.5% 64.4%
Other:
Insurance policy benefits............................ $19.3 $1.9 $58.9 $5.5
Benefit ratio (a).................................... 79.2% 61.4% 84.2% 59.1%
<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 $44.5 million and $40.7 million in
the three months ended September 30, 2006 and 2005, respectively, and
$130.3 million and $118.9 million in the nine months ended September 30,
2006 and 2005, respectively.
</FN>
Total premium collections were $669.5 million in the third quarter of 2006,
up 12 percent from 2005 and were $1,947.6 million in the first nine months of
2006, up 9.5 percent from 2005. Premium collections in the three and nine months
ended September 30, 2006 include $20.8 million and $58.9 million, respectively,
of premiums collected pursuant to the quota-share agreement with Coventry
described above under "Accounting for the marketing and quota-share agreement
with Coventry". See "Premium Collections" for further analysis of Bankers Life's
premium collections.
Average liabilities for insurance products, net of reinsurance ceded were
$9.9 billion in the third quarter of 2006, up 9.6 percent from 2005. Average
liabilities for insurance products, net of reinsurance ceded were $9.7 billion
in the first nine months of 2006, up 9.9 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 traditional
insurance policies which provide mortality or morbidity coverage and fees and
other charges assessed on other policies. Insurance policy income in the three
and nine months ended September 30, 2006 includes $21.5 million and $61.3
million, respectively, of premium income from the quota-share agreement with
Coventry described above under "Accounting for the marketing and quota-share
agreement with Coventry". Such amount in the three and nine months ended
September 30, 2006 includes $(2.8) million and $1.2 million,
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
respectively, of risk-share premiums due (to) from Coventry consistent with the
obligations under our quota-share agreement, as if the periods represented an
entire contract period. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $140.0 million in the third
quarter of 2006, up 13 percent from 2005 and was $406.8 million in the first
nine months of 2006, up 13 percent from 2005. The average balance of general
account invested assets was $9.7 billion and $8.7 billion in the third quarters
of 2006 and 2005, respectively. The average yield on these assets was 5.8
percent and 5.7 percent in the third quarters of 2006 and 2005, respectively.
The average balance of general account invested assets was $9.5 billion and $8.5
billion in the first nine months of 2006 and 2005, respectively. The average
yield on these assets was 5.7 percent and 5.6 percent in the first nine months
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 gains (losses) related to
equity-indexed products were $3.6 million and $1.3 million in the third quarters
of 2006 and 2005, respectively; and $1.5 million and $(2.5) million in the first
nine months 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 third quarter of
2006, compared to $.3 million in the same period of 2005 and increased to $5.2
million in the first nine months of 2006, compared to $.7 million in the same
period of 2005. During the three and nine months ended September 30, 2006, we
recognized fee income of $1.2 million and $4.1 million, respectively, pursuant
to the agreements described above under "Accounting for the marketing and
quota-share agreement with Coventry".
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, as
determined in accordance with statutory accounting principles. The benefit ratio
in the first nine months of 2006 reflected a $10.1 million claim reserve
redundancy while the 2005 period reflected a $2.3 million claim reserve
deficiency resulting from the development of our prior period reserve estimates.
Excluding the benefit recognized from the prior period redundancy of our claim
reserves, our benefit ratio would have been 69.0 percent in the first nine
months of 2006, consistent with our expectations as a result of the premium rate
increases implemented in recent periods.
The net cash flows from our long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
typically increases, but the increase in reserves is partially offset
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 lower-priced products. These new
products have been approved by the regulatory authorities in 49 states and the
District of Columbia. The benefit ratio on our entire block of long-term care
business in the Bankers Life segment was 98.2 percent and 93.9 percent in the
third quarters of 2006 and 2005, respectively, and 97.0 percent and 92.7 percent
in the first nine months of 2006 and 2005, respectively. The interest-adjusted
benefit ratio for long-term care products is calculated by dividing the
insurance product's insurance policy benefits less interest income on the
accumulated assets backing the insurance liabilities by insurance policy income.
The interest-adjusted benefit ratio on this business was 68.8 percent and 65.1
percent in the third quarters of 2006 and 2005, respectively, and 67.5 percent
and 64.4 percent in the first nine months of 2006 and 2005, respectively. We
experienced an increase in the number of incurred claims in the second and third
quarters of 2006.
As a result of higher persistency in our long-term care block in the
Bankers Life segment than assumed in the original pricing, our premium rates
were too low. Accordingly, we began a program to seek approval from regulatory
authorities for rate increases on approximately 65 percent of this block. This
rate increase process is proceeding according to plan and, to date, we have
received approval for approximately 80 percent of the total dollar amount of our
requested rate increases. The rate increases became effective for approximately
75 percent of the impacted inforce block through September 30, 2006. We expect
the execution of our premium rate increases will continue for the next three
quarters given the timing of the implementation as a result of the regulatory
approvals. 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.
During the second quarter of 2005, we made certain adjustments to the
assumptions we use to calculate insurance liabilities for future long-term care
benefits, resulting in a net reduction to insurance liabilities of $6.4 million.
The primary change related to policies that provide for increased benefits to
reflect inflation. Our previous assumptions had reflected the increased
projected benefit costs for the inflation benefit in insurance liabilities at
the time of billing immediately prior to the policy anniversary date which was
earlier than the actual terms of the policy. Our new method calculates the
increased projected benefit costs on the policy anniversary date which is in
accordance with the actual terms of the policy.
The 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 agreements with Coventry". During the three and nine
months ended September 30, 2006, we recognized insurance policy income of $21.5
million and $61.3 million, respectively, related to the Part D program. The
benefit ratio on this business was 82.1 percent and 88.1 percent in the three
and nine months ended September 30, 2006, respectively, and is expected to
decline throughout the remainder of the year.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $44.4 million in the third quarter of
2006, up 4.0 percent from 2005 and were $129.6 million in the first nine months
of 2006, up 5.5 percent from 2005. The increase is primarily due to increases in
annuity reserves (resulting from higher sales of these products). The weighted
average crediting rates for these products were 3.7 percent and 3.8 percent in
the third quarters of 2006 and 2005, respectively, and 3.6 percent and 3.7
percent in the first nine months 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 $56.8 million and
$54.5 million in the third quarters of 2006 and 2005, respectively, and $179.3
million and $146.3 million in the first nine months of 2006 and 2005,
respectively. Such amounts were generally consistent with the related premium
revenue and gross profits for such periods and the assumptions we made when we
established the value of policies inforce as of the Effective Date. However,
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
during the first six months 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 $7.9 million in the first six months of 2006.
The lapses of our Medicare supplement products in the first six months of 2006
were higher than our historical lapse experience. We believe such increases were
partially related to the premium rate increases we implemented in recent periods
and competition from companies offering Medicare Advantage products. Our lapse
experience in the third quarter of 2006 was consistent with our expectations.
A review of our traditional life business resulted in the recognition of
additional amortization expense of $4.4 million in the third quarter of 2005 to
reflect revisions to our calculations related to prior period amounts. 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 $43.9
million in the third quarter of 2006, up 8.9 percent from 2005 and were $126.9
million in the first nine months of 2006, up 9.4 percent from 2005. Other
operating costs and expenses include the following (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Expenses related to distribution and quota-share
reinsurance agreements with Coventry................ $ 4.3 $ - $ 11.1 $ -
Commission expense..................................... 7.1 6.6 20.5 14.8
Other operating expenses............................... 32.5 33.7 95.3 101.2
----- ----- ------ ------
Total............................................... $43.9 $40.3 $126.9 $116.0
===== ===== ====== ======
Net realized investment losses fluctuate each period. During the nine
months ended September 30, 2006, net realized investment losses in this segment
included $7.7 million of net losses from the sales of investments (primarily
fixed maturities), and $.4 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. During the
nine months ended September 30, 2005, net realized investment losses in this
segment included $.6 million of net losses from the sales of investments
(primarily fixed maturities). There were no writedowns of investments in the
first nine months 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 the proceeds at a different yield, we increase (reduce) the
amortization of insurance acquisition costs in order to reflect the change in
estimated gross profits due to the gains (losses) realized and the resulting
effect on estimated future yields. Sales of fixed maturity investments resulted
in a decrease in the amortization of insurance acquisition costs of $.2 million
and $.6 in the third quarters of 2006 and 2005, respectively, and $1.2 million
and $.5 million in the first nine months of 2006 and 2005, respectively.
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Premium collections:
Annuities.............................................. $ 182.8 $ 43.3 $ 311.4 $ 96.7
Supplemental health.................................... 145.5 160.2 458.4 500.8
Life................................................... 78.3 86.0 240.7 258.7
--------- --------- --------- ---------
Total collections.................................... $ 406.6 $ 289.5 $ 1,010.5 $ 856.2
========= ========= ========= =========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 240.1 $ 264.6 $ 242.4 $ 277.1
Equity-indexed....................................... 1,270.4 1,330.4 1,291.3 1,362.1
Deposit based........................................ 3,099.4 3,426.0 3,192.3 3,503.0
Separate accounts and investment trust liabilities... 28.9 30.0 29.4 30.9
Health................................................. 2,377.3 2,374.1 2,379.6 2,374.3
Life:
Interest sensitive................................... 3,046.4 3,116.2 3,059.4 3,128.3
Non-interest sensitive............................... 1,407.3 1,422.0 1,428.8 1,427.1
--------- --------- --------- ---------
Total average liabilities for insurance products,
net of reinsurance ceded......................... $11,469.8 $11,963.3 $11,623.2 $12,102.8
========= ========= ========= =========
Revenues:
Insurance policy income.................................. $ 245.9 $ 266.8 $ 749.7 $ 808.8
Net investment income:
General account invested assets........................ 174.9 186.4 525.6 543.1
Equity-indexed products................................ 12.1 2.8 3.1 (14.9)
Trading account income related to policyholder
and reinsurer accounts............................... 5.6 (1.0) 3.4 (3.4)
Change in value of embedded derivatives related
to modified coinsurance agreements................... (3.3) 2.3 .5 1.3
Fee revenue and other income............................. .8 .5 1.1 1.6
--------- --------- --------- ---------
Total revenues....................................... 436.0 457.8 1,283.4 1,336.5
--------- --------- --------- ---------
Expenses:
Insurance policy benefits................................ 184.1 203.1 560.2 608.6
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products................... 62.0 64.3 183.4 193.2
Equity-indexed products................................ 22.5 9.8 25.9 5.0
Amortization related to operations....................... 42.3 43.8 134.5 124.5
Interest expense on investment borrowings................ .1 .6 .6 4.8
Costs related to the tentative litigation
settlement............................................. - 1.2 165.8 4.2
Other operating costs and expenses....................... 66.5 67.9 204.9 198.6
--------- --------- --------- ---------
Total expenses....................................... 377.5 390.7 1,275.3 1,138.9
--------- --------- --------- ---------
Income before net realized investment gains (losses),
net of related amortization, and income taxes............ 58.5 67.1 8.1 197.6
--------- --------- --------- ---------
Net realized investment gains (losses)................... (4.4) (3.0) (13.5) .8
Amortization related to net realized investment
gains (losses)......................................... .3 .2 4.8 .7
--------- --------- --------- ---------
Net realized investment gains (losses), net of related
amortization....................................... (4.1) (2.8) (8.7) 1.5
--------- --------- --------- ---------
Income (loss) before income taxes........................... $ 54.4 $ 64.3 $ (.6) $ 199.1
========= ========= ========= =========
(continued)
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits.............................. $109.9 $115.3 $332.7 $347.3
Benefit ratio (a)...................................... 71.5% 69.0% 70.7% 68.2%
Medicare supplement:
Insurance policy benefits.............................. $41.2 $45.3 $119.0 $137.2
Benefit ratio (a)...................................... 66.8% 60.9% 61.3% 59.6%
Specified disease:
Insurance policy benefits.............................. $65.7 $67.7 $206.3 $202.2
Benefit ratio (a)...................................... 73.6% 75.8% 77.0% 75.1%
Interest-adjusted benefit ratio (b).................... 41.2% 44.5% 45.1% 44.1%
Other:
Insurance policy benefits.............................. $3.0 $2.3 $7.4 $7.9
Benefit ratio(a)....................................... 108.9% 64.5% 85.1% 77.8%
<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 $28.9 million and
$28.0 million in the three months ended September 30, 2006 and 2005,
respectively, and $85.4 million and $83.5 million in the nine months
ended September 30, 2006 and 2005, respectively.
</FN>
Total premium collections were $406.6 million in the third quarter of 2006,
up 40 percent from 2005 and were $1,010.5 million in the first nine months of
2006, up 18 percent from 2005. This increase was primarily due to higher premium
collections from our equity-indexed products partially offset by lower premium
collections 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
$11.5 billion in the third quarter of 2006, down 4.1 percent from 2005. Average
liabilities for insurance products, net of reinsurance ceded were $11.6 billion
in the first nine months of 2006, down 4.0 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 traditional
insurance 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 $174.9 million in the third
quarter of 2006, down 6.2 percent from 2005 and was $525.6 million in the first
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
nine months of 2006, down 3.2 percent from 2005. The average balance of general
account invested assets was $11.7 billion and $11.9 billion in the third
quarters of 2006 and 2005, respectively. The average yield on these assets was
6.0 percent and 6.2 percent in the third quarters of 2006 and 2005,
respectively. The average balance of general account invested assets was $11.8
billion and $12.2 billion in the first nine months of 2006 and 2005,
respectively. The average yield on these assets was 6.0 percent in both the
first nine months of 2006 and 2005. This segment's investment income in the
first nine months of 2006 included the recognition in income of $5.6 million
($.4 million in the third quarter of 2006) related to: (i) investments (which
had a par value in excess of the cost basis) which were called or prepaid by the
issuer; and (ii) income on defaulted investments. Investment income in the first
nine months of 2005 included the recognition in income of $17.5 million ($10.5
million in the third quarter of 2005) related to investments which were called
or prepaid by the issuer. The yield in the 2006 periods also reflects general
increases in investment interest rates in recent periods. The additional
investment income was partially offset by approximately $2.7 million and $7.3
million of additional amortization expense in the first nine months of 2006 and
2005, respectively, ($.2 million and $5.0 million in the third quarters of 2006
and 2005, respectively) to reflect the higher resulting gross profits for
universal life and investment-type products.
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 gains (losses) related to equity-indexed products were
$7.8 million and $5.4 million in the third quarters of 2006 and 2005,
respectively; and $5.2 million and $(11.4) million in the nine months ended
September 30, 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 gains (losses) were
$4.3 million and $(2.6) million in the third quarters of 2006 and 2005,
respectively and were $(2.1) million and $(3.5) million in the first nine months
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 six months
of 2006 and in the 2005 periods 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 these periods (although such release
was substantially offset by additional amortization of insurance acquisition
costs). The lapse experience in the third quarter of 2006 returned to levels
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
that were in line with our expectations. Without the release of policy reserves
for higher-than-expected lapses, the loss ratio increased in the three months
ended September 30, 2006 (with a corresponding decrease in amortization of
insurance acquisition costs). The benefit ratio in the first nine months of 2006
and 2005 reflected claim reserve redundancies of $5.4 million and $6.3 million,
respectively, resulting from the favorable development of our prior period
reserve estimates. 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, as determined in accordance with statutory accounting
principles.
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 in force for a
specified number of years or upon the policyholder reaching a specified age, we
will pay to the policyholder, or a beneficiary under the policy, the aggregate
amount of all premiums paid under the policy, without interest, less the
aggregate amount of all claims incurred under the policy. The cash value rider
is similar to the return of premium rider, but also provides for payment of a
graded portion of the return of premium benefit if the policy terminates before
the return of premium benefit is earned. Accordingly, the net cash flows from
these products generally result in the accumulation of amounts in the early
years of a policy (accounted for as reserve increases) which will be paid out as
benefits in later policy years (accounted for as reserve decreases).
Accordingly, as the policies age, the benefit ratio will typically increase, but
the increase in the change in reserve will be partially offset by investment
income earned on the accumulated assets. The benefit ratio for the first six
months of 2006 was unfavorably affected by higher persistency of older policies
which have higher benefit ratios than newer policies. In addition, the benefit
ratio in the first six months of 2006 reflects an increase in reported claims.
We have reflected the new pattern of reported claims in the assumptions we use
to estimate the reserves for claims that have occurred but have not yet been
reported to the Company. During the third quarter of 2006, the benefit ratio
decreased, reflecting lower paid claims. 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 $62.0 million in the third quarter of
2006, down 3.6 percent from 2005 and were $183.4 million in the first nine
months of 2006, down 5.1 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 4.0 percent in both the first nine months 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.
During the second quarter of 2006, we changed our estimates of the future
gross profits of certain universal life products, which under certain
circumstances are eligible for interest bonuses in addition to the declared base
rate. These interest bonuses are not required in the current crediting rate
environment and our estimates of future gross profits have been changed to
reflect the discontinuance of the bonus. We reduced amortization expense by $4.0
million during the second quarter of 2006 as a result of this change. 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
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
Costs related to the tentative litigation settlement include legal fees and
estimated amounts related to the tentative settlement in the class action case
referred to as In Re Conseco Life Insurance Company Cost of Insurance
Litigation. The settlement is subject to a court fairness hearing and other
conditions. For further information related to this case, refer to the caption
entitled "Cost of Insurance Litigation" included in the note to our consolidated
financial statements entitled "Litigation and Other Legal Proceedings". A
portion of the legal and other costs related to this litigation were incurred by
the Corporate Operations segment to defend the non-insurance company allegations
made in such lawsuits.
Other operating costs and expenses were $66.5 million in the third quarter
of 2006, down 2.1 percent from 2005 and were $204.9 million in the first nine
months of 2006, up 3.2 percent from 2005. Operating expenses in the first nine
months of 2005 reflected reductions related to expense recoveries associated
with the Predecessor's bankruptcy of $7.6 million. Other operating costs and
expenses include commission expense of $21.8 million and $22.6 million in the
three months ended September 30, 2006 and 2005, respectively and $65.9 million
and $71.1 million in the nine months ended September 30, 2006 and 2005,
respectively.
Net realized investment gains (losses) fluctuate each period. During the
first nine months of 2006, net realized investment losses included $10.3 million
of net losses from the sales of investments (primarily fixed maturities), and
$3.2 million of writedowns of investments resulting from declines in fair values
that we concluded were other than temporary. During the nine months ended
September 30, 2005, net realized investment gains included $3.6 million of net
gains from the sales of investments (primarily fixed maturities), net of $2.8
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary.
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 estimated gross profits due to the gains (losses) realized and the resulting
effect on estimated future yields. Sales of fixed maturity investments resulted
in a decrease in the amortization of insurance acquisition costs of $.3 million
and $.2 million in the third quarters of 2006 and 2005, respectively and $4.8
million and $.7 million in the nine months ended September 30, 2006 and 2005,
respectively.
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-off (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
-------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Premium collections:
Long-term care........................................ $ 79.6 $ 86.4 $ 247.1 $ 266.4
Major medical......................................... .8 .7 4.1 2.0
-------- -------- -------- --------
Total collections................................. $ 80.4 $ 87.1 $ 251.2 $ 268.4
======== ======== ======== ========
Average liabilities for insurance products:
Long-term care......................................... $3,212.2 $3,285.2 $3,225.9 $3,297.4
Major medical.......................................... 29.4 37.8 29.4 44.9
-------- -------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded...................... $3,241.6 $3,323.0 $3,255.3 $3,342.3
======== ======== ======== ========
Revenues:
Insurance policy income................................ $ 83.4 $ 91.1 $ 254.4 $ 272.4
Net investment income on general account invested
assets............................................... 44.6 45.4 133.9 133.4
Fee revenue and other income........................... .1 .1 .3 .4
-------- -------- -------- --------
Total revenues..................................... 128.1 136.6 388.6 406.2
-------- -------- -------- --------
Expenses:
Insurance policy benefits.............................. 113.4 90.6 294.6 264.8
Amortization related to operations..................... 5.6 7.5 12.6 18.1
Other operating costs and expenses..................... 22.1 22.1 66.0 64.0
-------- -------- -------- --------
Total expenses..................................... 141.1 120.2 373.2 346.9
-------- -------- -------- --------
Income (loss) before net realized investment
gains (losses) and income taxes.................. (13.0) 16.4 15.4 59.3
Net realized investment gains (losses)................. (10.8) (.3) (6.8) 4.2
-------- -------- -------- --------
Income (loss) before income taxes.................. $ (23.8) $ 16.1 $ 8.6 $ 63.5
======== ======== ======== ========
Health benefit ratios:
Insurance policy benefits............................ $113.4 $90.6 $294.6 $264.8
Benefit ratio (a).................................... 136.0% 99.5% 115.8% 97.2%
Interest-adjusted benefit ratio (b).................. 83.1% 50.5% 63.8% 49.1%
<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 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 $44.1 million
and $44.7 million in the three months ended September 30, 2006 and 2005,
respectively and $132.3 million and $131.1 million in the nine months
ended September 30, 2006 and 2005, respectively.
</FN>
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections were $80.4 million in the third quarter of 2006,
down 7.7 percent from 2005 and were $251.2 million in the first nine months of
2006, down 6.4 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 for insurance products, net of reinsurance ceded were
$3.2 billion in the third quarter of 2006, down 2.2 percent from 2005. Average
liabilities of insurance products, net of reinsurance ceded were $3.3 billion in
the first nine months of 2006, down 2.6 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 $44.6 million
and $45.4 million in the third quarters of 2006 and 2005, respectively, and was
$133.9 million in the first nine months of 2006, up .4 percent from 2005. The
average balance of general account invested assets was $3.0 billion and $2.9
billion in the third quarters of 2006 and 2005, respectively. The average yield
on these assets was 5.9 percent and 6.2 percent in the third quarters of 2006
and 2005, respectively. The average balance of general account invested assets
was $3.0 billion in both the first nine months of 2006 and 2005. The average
yield on these assets was 5.9 percent and 6.0 percent in the first nine months
of 2006 and 2005, respectively. The yield in 2006 was impacted by income of $.6
million ($.1 million in the third quarter of 2006) related to investments that
were in default or which were called or prepaid by the issuer. The yield in the
2005 periods was impacted by income of $2.8 million ($2.1 million in the third
quarter of 2005) for investments (which had a par value in excess of the cost
basis) which were called or prepaid during the first nine months of 2005.
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 the
higher insurance policy benefits experienced in the second and third quarters of
2006. In addition, we experienced higher than expected persistency in this block
of business in the third quarter of 2006. A small variance in persistency can
have a significant impact on our earnings during a quarter, as reserves
accumulated over the life of a policy are released when coverage terminates. The
effect of changes in persistency will vary based on the mix of business that
persists. For example, if policies with higher reserves are persisting and
policies with lower reserves are lapsing, our earnings could be adversely
affected. We estimate that our income before income taxes would be adversely
affected by approximately $10 million in any period that persistency is 40 basis
points higher than our original assumptions and such variance is spread evenly
over the mix of business in this block. We also estimate that persistency, which
is 40 basis points lower than our assumptions, would favorably affect earnings
by a similar amount. The increase in insurance policy benefits in the third
quarter of 2006 reflected:
(i) The lapse experience on this block of business has been less than our
expectations, resulting in approximately $9 million less reserve
releases for terminated policies than expected.
(ii) Prior period estimates of claim reserves proved to be deficient (net of
the positive impact of certain refinements to estimates of approximately
$6 million), resulting in an increase to insurance policy benefits of
approximately $11 million.
(iii) An increased number of initial claims were incurred in the third
quarter of 2006, resulting in an increase to insurance policy benefits
of approximately $2 million.
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
We have been aggressively seeking rate increases and pursuing other actions
on such long-term care policies. We have filed, or plan to file, approximately
350 requests for rate increases on various long-term care products in this
segment as we believe the existing rates are too low. In many instances, we are
requesting three years of consecutive rate increases. We estimate that our
revenue could ultimately increase by approximately $35 million per year as a
result of the first round of rate increases, if the rate increases are approved
and the policyholders accept the increases as we expect (some policyholders will
choose to reduce benefits (and therefore their premiums) and others will choose
to allow their policies to lapse). The impact of the second and third year rate
increases will be somewhat smaller as the block continues to run off. To date,
we have received approvals to increase rates equivalent to approximately 20
percent of our $35 million estimate. The effects of the approved rate increases
are expected to be realized over the next year, as we are only able to increase
rates on a policy's anniversary date. The remaining first round rate increase
filings are expected to be filed and approved over the next 15 months, and the
full effect of the first year of rate increases will take approximately two
years to be fully realized. The full effect of all three years of rate increases
will take as long as five years to be fully realized. It is possible that it
will take more time than we expect to prepare rate increase filings and obtain
approval from the state insurance regulators. In addition, it is possible that
we will not be able to obtain approval for rate increases currently pending or
for the additional rate increases we plan to file. Most of our long-term care
business is guaranteed renewable, and, if necessary rate increases are not
approved, we may be required to establish a premium deficiency reserve. If,
however, we are successful in obtaining regulatory approval to raise premium
rates, the increased premium rates may cause existing policyholders to allow
their policies to lapse. This could result in a significantly higher ratio of
claim costs to premiums if healthier policyholders who get coverage elsewhere
allow their policies to lapse, while policies of less healthy policyholders
continue inforce. We believe that the series of smaller rate increases we are
seeking could mitigate these effects.
We have recently started several projects that we believe will improve our
claim adjudication procedures and could improve the profitability of this block
over time.
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. The implementation of these premium adjustments will be substantially
complete at December 31, 2006. We did not make any adjustments to the insurance
liabilities when these elections were made. 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
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.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
The benefit ratio on our Other Business in Run-off segment was 136.0
percent and 99.5 percent in the third quarters of 2006 and 2005, respectively,
and 115.8 percent and 97.2 percent in the first nine months of 2006 and 2005,
respectively. These ratios reflect the significantly higher level of incurred
claims experienced in the second and third quarters of 2006 resulting from an
increase in the number of new claims reported to the Company during the quarter
and adverse development of prior period claim reserves. During the second
quarter of 2006, we recognized additional expense of approximately $4 million
related to an increase in new claims over our expectations and approximately $20
million for the adverse development of prior period reserves.
During the second quarter of 2006, we recognized a non-recurring benefit of
$9.4 million related to the release of certain other redundant reserve
liabilities. 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. Fluctuations in amortization of insurance acquisition costs
in this segment generally correspond with changes in lapse experience.
Other operating costs and expenses in the third quarter of 2006 were
comparable to the same period in 2005 and were $66.0 million in the first nine
months of 2006, up 3.1 percent from 2005. Other operating costs and expenses
include commission expense of $8.9 million and $10.0 million in the three months
ended September 30, 2006 and 2005, respectively, and $27.6 million and $30.0
million in the nine months ended September 30, 2006 and 2005, respectively.
Net realized investment gains (losses) fluctuate each period. During the
first nine months of 2006, net realized investment gains included $.9 million of
net gains from the sales of investments (primarily fixed maturities), net of
$7.7 million of writedowns of investments resulting from declines in fair values
that we concluded were other than temporary. During the nine months ended
September 30, 2005, we recognized net realized investment gains in this segment
of $4.2 million from the sales of investments (primarily fixed maturities).
There were no such writedowns in the first nine months of 2005.
Corporate Operations (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2006 2005 2006 2005
---- ---- ---- ----
Corporate operations:
Interest expense on corporate debt........................ $(12.5) $(12.1) $(36.9) $(37.2)
Net investment income .................................... 1.1 1.7 2.9 5.5
Fee revenue and other income.............................. 2.3 11.0 7.2 17.3
Net operating results of variable interest entity......... 2.8 - 3.8 -
Costs related to the tentative litigation settlement...... - (1.3) (8.9) (4.2)
Loss on extinguishment of debt............................ - (3.7) - (3.7)
Other operating costs and expenses........................ (14.3) (12.5) (31.7) (38.0)
------ ------ ------ ------
Loss before net realized investment losses and
income taxes.......................................... (20.6) (16.9) (63.6) (60.3)
Net realized investment losses............................ (.1) - (.1) (1.3)
------ ------ ------ -------
Loss before income taxes................................ $(20.7) $(16.9) $(63.7) $(61.6)
====== ====== ====== ======
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 $823.4 million and $769.1 million during the first nine
months of 2006 and 2005, respectively. The average interest rate on our debt was
5.5 percent and 6.1 percent during the first nine months 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. During the third quarter of 2005, our wholly owned
investment management subsidiary recognized a performance-based fee of $8.1
million earned in conjunction with its management of a $510 million portfolio of
loans for an issuer of structured securities. This portfolio was liquidated and
the related securities were redeemed on September 1, 2005, resulting in the
receipt of this fee which was largely based on the market value of the managed
loan portfolio at the redemption date. Excluding such performance-based fee, 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 operating
results of 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.
Costs related to the tentative litigation settlement include legal and
other costs incurred by the Corporate Operations segment to defend the
non-insurance company allegations made in the class action case referred to as
In Re Conseco Life Insurance Company Cost of Insurance Litigation. The Company
announced on August 1, 2006, that it has reached a tentative settlement of this
case. Refer to the captions entitled: (i) "Costs related to the tentative
litigation settlement" included in the results of operations section for the
Conseco Insurance Group segment; and (ii) "Cost of Insurance Litigation"
included in the note to our consolidated financial statements entitled
"Litigation and Other Legal Proceedings" for further information related to this
case.
Loss on extinguishment of debt of $3.7 million in the three and nine months
ended September 30, 2005, resulted from the write-off of certain debt issuance
costs related to the reduction of the principal amount borrowed under the
Amended Credit Facility.
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 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 three and nine months ended September
30, 2006, we recognized compensation expense related to stock options totaling
$1.9 million and $4.8 million, respectively. Refer to the note to our
consolidated financial statements entitled "Stock-Based Compensation" for
further discussion of our share-based payments.
Net realized investment losses in the first nine months of 2006 and 2005
included $.1 million of losses from the sale of an investment and $1.3 million
of writedowns due to an other-than-temporary decline in value of certain
investments, respectively.
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
PREMIUM COLLECTIONS
In accordance with GAAP, insurance policy income in our consolidated
statement of operations consists of premiums earned for traditional insurance
policies that have life contingencies or morbidity features. For annuity and
universal life contracts, 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.
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, Medicare Part D contracts, 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, 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. On October 2, 2006, A.M. Best
affirmed the financial strength ratings of our primary insurance subsidiaries
and indicated the likely timeframe for an upgrade was 18-24 months. A.M. Best
also provided likely metrics Conseco would need to meet to: (i) maintain a
positive outlook; or (ii) receive an upgrade. 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.
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
-------------------- ---------------------
2006 2005 2006 2005
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................. $ 81.8 $ 29.7 $ 210.4 $ 69.8
------ ------ -------- --------
Other fixed (first-year)................................ 195.5 197.0 536.7 614.9
Other fixed (renewal)................................... .9 - 2.8 2.3
------ ------ -------- --------
Subtotal - other fixed annuities...................... 196.4 197.0 539.5 617.2
------ ------ -------- --------
Total annuities....................................... 278.2 226.7 749.9 687.0
------ ------ -------- --------
Supplemental health:
Medicare supplement (first-year)........................ 23.2 18.2 72.5 53.5
Medicare supplement (renewal)........................... 126.2 140.9 407.6 435.2
------ ------ -------- --------
Subtotal - Medicare supplement........................ 149.4 159.1 480.1 488.7
------ ------ -------- --------
Long-term care (first-year)............................. 12.0 15.9 39.3 50.1
Long-term care (renewal)................................ 133.0 124.9 402.9 373.0
------ ------ -------- --------
Subtotal - long-term care............................. 145.0 140.8 442.2 423.1
------ ------ -------- --------
Other health (first-year)............................... 21.2 .3 59.7 .8
Other health (renewal).................................. 2.5 2.7 7.7 8.4
------ ------ -------- --------
Subtotal - other health............................... 23.7 3.0 67.4 9.2
------ ------ -------- --------
Total supplemental health............................. 318.1 302.9 989.7 921.0
------ ------ -------- --------
Life insurance:
First-year.............................................. 30.2 27.4 85.4 66.5
Renewal................................................. 43.0 38.4 122.6 103.6
------ ------ -------- --------
Total life insurance.................................. 73.2 65.8 208.0 170.1
------ ------ -------- --------
Collections on insurance products:
Total first-year premium collections on
insurance products................................... 363.9 288.5 1,004.0 855.6
Total renewal premium collections on
insurance products.................................... 305.6 306.9 943.6 922.5
------ ------ -------- --------
Total collections on insurance products............... $669.5 $595.4 $1,947.6 $1,778.1
====== ====== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections
increased 23 percent, to $278.2 million, in the third quarter of 2006, and 9.2
percent, to $749.9 million, in the first nine months of 2006, as compared to the
same periods in 2005. Premium collections from our equity-indexed products were
favorably impacted in 2006 by: (i) the introduction of new equity-indexed
products in late 2005; and (ii) the general stock market performance in recent
periods which has made these products attractive to certain customers.
Supplemental health products include Medicare supplement, long-term care
and other insurance products distributed through our career agents.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
Collected premiums on Medicare supplement policies in the Bankers Life
segment decreased 6.1 percent, to $149.4 million, in the third quarter of 2006,
and 1.8 percent, to $480.1 million, in the first nine months of 2006, as
compared to the same periods in 2005. During the first six months of 2006, we
experienced higher lapses than we anticipated. We believe the increase was
partially due to the premium rate increases implemented in recent periods and
competition from companies offering Medicare Advantage products. Our lapse
experience in the third quarter of 2006 was consistent with our expectations.
Premiums collected on Bankers Life's long-term care policies increased 3.0
percent, to $145.0 million, in the third quarter of 2006, and 4.5 percent, to
$442.2 million, in the first nine months of 2006, compared to the same periods
in 2005 primarily due to higher premiums associated with the policies that were
impacted by the rate increases which became effective in the second and third
quarters of 2006.
Other health products in the three and nine months ended September 30, 2006
include $20.8 million and $58.9 million, respectively, 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." 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 11 percent, to $73.2 million, in
the third quarter of 2006, and 22 percent, to $208.0 million, in the first nine
months of 2006, compared to the same periods 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
$11.0 million and $13.0 million of our collected premiums in the third quarters
of 2006 and 2005, respectively, and $32.9 million and $24.1 million, in the
first nine months of 2006 and 2005, respectively. Graded benefit life products
sold through our direct response marketing channel accounted for $24.3 million
and $21.5 million of our total collected premiums in the third quarters of 2006
and 2005, respectively, and $66.7 million and $58.1 million, in the first nine
months of 2006 and 2005, respectively.
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
---------------------- -----------------------
2006 2005 2006 2005
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year).............................. $166.3 $ 24.9 $ 264.2 $ 64.7
Equity-indexed (renewal)................................. 1.9 2.1 7.2 7.7
------ ------ -------- ------
Subtotal - equity-indexed annuities.................... 168.2 27.0 271.4 72.4
------ ------ -------- ------
Other fixed (first-year)................................. 12.5 14.4 33.2 16.5
Other fixed (renewal).................................... 2.1 1.9 6.8 7.8
------ ------ -------- ------
Subtotal - other fixed annuities....................... 14.6 16.3 40.0 24.3
------ ------ -------- ------
Total annuities........................................ 182.8 43.3 311.4 96.7
------ ------ -------- ------
Supplemental health:
Medicare supplement (first-year)......................... 6.5 4.1 22.7 10.5
Medicare supplement (renewal)............................ 48.1 64.4 159.7 209.9
------ ------ -------- ------
Subtotal - Medicare supplement......................... 54.6 68.5 182.4 220.4
------ ------ -------- ------
Specified disease (first-year)........................... 6.8 7.2 21.0 23.2
Specified disease (renewal).............................. 81.3 81.3 247.3 247.8
------ ------ -------- ------
Subtotal - specified disease........................... 88.1 88.5 268.3 271.0
------ ------ -------- ------
Other health (renewal)................................... 2.8 3.2 7.7 9.4
------ ------ -------- ------
Total supplemental health.............................. 145.5 160.2 458.4 500.8
------ ------ -------- ------
Life insurance:
First-year............................................... 1.7 1.7 5.1 6.6
Renewal.................................................. 76.6 84.3 235.6 252.1
------ ------ -------- ------
Total life insurance................................... 78.3 86.0 240.7 258.7
------ ------ -------- ------
Collections on insurance products:
Total first-year premium collections on
insurance products.................................... 193.8 52.3 346.2 121.5
Total renewal premium collections on
insurance products..................................... 212.8 237.2 664.3 734.7
------ ------ -------- ------
Total collections on insurance products................ $406.6 $289.5 $1,010.5 $856.2
====== ====== ======== ======
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity premiums
collected in this segment increased 322 percent, to $182.8 million, in the third
quarter of 2006, and 222 percent, to $311.4 million, in the first nine months of
2006, compared to the same periods in 2005, due to: (i) increased sales efforts
in this segment; (ii) expanded product offerings; (iii) attractive crediting
rates on certain products; and (iv) the general stock market performance in
recent periods which has made these products attractive to certain customers.
The accumulation value of equity-indexed annuities is credited with
interest at an annual guaranteed minimum rate of 3 percent (or, including the
effect of applicable sales loads, a 1.7 percent compound average interest rate
over the term of the contracts). These annuities provide for potentially higher
returns based on a percentage of the change in one of several equity market
indices during each year of their term. We purchase options in an effort to
hedge increases to policyholder benefits resulting from increases in the
indices. Total collected premiums for these products increased 523 percent, to
$168.2 million, in the third quarter of 2006, and 275 percent, to $271.4
million, in the first nine months of 2006, compared to the same periods in 2005
due to the recent introduction of several new products.
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. SPDA and FPDA policies typically have an interest
rate that is guaranteed for the first policy year, after which we have the
discretionary ability to change the crediting rate to any rate not below a
guaranteed minimum rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products decreased 10 percent, to $14.6
million, in the third quarter of 2006, and increased 65 percent to $40.0 million
in the first nine months of 2006, compared to the same periods in 2005. During
the last six months of 2005, sales of these products increased primarily due to
attractive crediting rates on certain products. Sales of these products in the
first nine months of 2006 increased over the comparable period in 2005 primarily
due to increased sales efforts.
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 20 percent, to $54.6 million, in the third quarter of
2006, and 17 percent to $182.4 million in the first nine months of 2006,
compared to the same periods in 2005. We have experienced higher lapses of these
products due to premium rate increases implemented in recent periods and
competition from companies offering Medicare Advantage products.
Premiums collected on specified disease products in the 2006 periods were
slightly lower than the comparable periods in 2005.
Premiums collected from other health products decreased 13 percent, to $2.8
million, in the third quarter of 2006, and 18 percent to $7.7 million in the
first nine months of 2006, compared to the same periods 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 9.0
percent, to $78.3 million, in the third quarter of 2006, and 7.0 percent to
$240.7 million in the first nine months of 2006, compared to the same periods in
2005.
Other Business in Run-off (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
-------------------- --------------------
2006 2005 2006 2005
---- ---- ---- ----
Premiums collected by product:
Long-term care (renewal).................................... $79.6 $86.4 $247.1 $266.4
Major medical (renewal)..................................... .8 .7 4.1 2.0
----- ----- ------ ------
Total renewal premium collections on insurance products... $80.4 $87.1 $251.2 $268.4
===== ===== ====== ======
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 7.9 percent, to
$79.6 million, in the third quarter of 2006, and 7.2 percent to $247.1 million
in the first nine months of 2006, compared to the same periods 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.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between September 30, 2006 and
December 31, 2005, primarily reflect: (i) our net income for the nine months
ended September 30, 2006; (ii) a reduction to our deferred income tax valuation
allowance recorded in additional paid-in capital; and (iii) changes in the fair
value of actively managed fixed maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At September 30, 2006, we decreased the
carrying value of such investments by $148.6 million as a result of this fair
value adjustment.
Our capital structure as of September 30, 2006, and December 31, 2005, was
as follows (dollars in millions):
September 30, December 31,
2006 2005
---- ----
Total capital:
Corporate notes payable................................................ $ 805.6 $ 851.5
Shareholders' equity:
Preferred stock..................................................... 667.8 667.8
Common stock........................................................ 1.5 1.5
Additional paid-in capital.......................................... 3,468.3 3,194.1
Accumulated other comprehensive income (loss)....................... (71.8) 71.7
Retained earnings................................................... 646.9 584.7
-------- --------
Total shareholders' equity....................................... 4,712.7 4,519.8
-------- --------
Total capital.................................................... $5,518.3 $5,371.3
======== ========
The following table summarizes certain financial ratios as of and for the
nine months ended September 30, 2006, and as of and for the year ended December
31, 2005:
September 30, December 31,
2006 2005
---- ----
Book value per common share................................................................... $26.62 $25.42
Book value per common share, excluding accumulated other comprehensive
income (loss) (a).......................................................................... 27.10 24.95
Ratio of earnings to fixed charges............................................................ 1.38x 2.03x
Ratio of earnings to fixed charges and preferred dividends.................................... 1.23x 1.81x
Debt to total capital ratios:
Corporate debt to total capital............................................................ 15% 16%
Corporate debt to total capital, excluding accumulated other comprehensive
income (loss) (a)........................................................................ 14% 16%
Corporate debt and preferred stock to total capital........................................ 27% 28%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (loss) (a).......................................................... 26% 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>
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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.
The Company announced on August 1, 2006, that it has reached a tentative
settlement in the class action case referred to as In Re Conseco Life Insurance
Company Cost of Insurance Litigation. The settlement is subject to a court
fairness hearing and other conditions. Based on our estimates of the ultimate
cash payments required to implement the tentative settlement, we believe there
are adequate sources of liquidity to satisfy such requirements. Such estimates
are subject to significant judgment, including the form of policy benefit
enhancement chosen by the inforce policyholders. For further information related
to this case, refer to the caption entitled "Cost of Insurance Litigation"
included in the note to our consolidated financial statements entitled
"Litigation and Other Legal Proceedings".
On October 2, 2006, A.M. Best affirmed the financial strength rating of
"B++ (Very Good)" of our primary insurance subsidiaries, except Conseco Senior,
whose "B (Fair)" rating was affirmed by A.M. Best. A.M. Best also affirmed the
outlook for the ratings of our primary insurance subsidiaries is positive,
except for Conseco Senior, whose outlook of stable was affirmed. A.M. Best also
noted that the likely timeframe for a potential upgrade of our primary insurance
subsidiaries would be 18 to 24 months. A.M. Best also provided likely metrics
Conseco would need to meet to: (i) maintain a positive outlook; or (ii) receive
an upgrade. A.M. Best stated they would likely revise our current positive
outlook rating to stable if one or more of the following occur:
- The long-term care business in the Business in Run-off segment generates
GAAP operating earnings less than $40 million in 2006 or 2007, or
requires aggregate capital infusions greater than $50 million over the
next two years. (The pre-tax operating earnings for this segment were
$15.4 million for the nine months ended September 30, 2006).
- Failure to achieve combined pre-tax statutory operating earnings growth
(excluding surplus note interest) of at least 15 percent in 2007.
- A decline in the Conseco Insurance Group segment's GAAP operating
earnings (excluding the one-time litigation settlement charge) below
$200 million for 2006 and $220 million for 2007. (The pre-tax operating
earnings for this segment (excluding the one-time litigation settlement
charge) were $165.1 million for the nine months ended September 30,
2006).
A.M. Best stated they would likely upgrade Conseco's ratings if the
following occur:
- Consolidated and stand-alone statutory capitalization levels generally
meet or exceed present levels (including planned capital contributions
from the refinancing transactions which occurred in October 2006). This
assumes positive statutory earnings trends on an aggregate basis.
- The long-term care business in the Business in Run-off segment continues
to generate GAAP operating earnings in excess of $50 million with no
material (greater than $50 million) statutory capital infusions required
over the next two years. (The pre-tax operating earnings for this
segment were $15.4 million for the nine months ended September 30,
2006).
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CONSECO, INC. AND SUBSIDIARIES
-------------------
- GAAP operating earnings for the Bankers Life segment of at least $270
million for 2006 and 2007. (The pre-tax operating earnings for this
segment were $205.5 million for the nine months ended September 30,
2006).
- GAAP operating earnings for the Conseco Insurance Group segment of at
least $220 million for 2006 (excluding the one-time litigation
settlement charge) and $240 million for 2007 with improving expense
ratios. (The pre-tax operating earnings for this segment (excluding the
one-time litigation settlement charge) were $165.1 million for the nine
months ended September 30, 2006).
- Overall annual sales growth of 8 to 10 percent with positive sales
trends in the Bankers Life and Conseco Insurance Group segments. (Our
overall sales growth exceeded this metric in the third quarter of 2006).
- Maintain financial leverage below 25 percent with EBIT interest coverage
of at least five times. (We are exceeding these requirements at
September 30, 2006).
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.
State laws generally give state insurance regulatory agencies broad
authority to protect policyholders in their
63
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 September 30, 2006, Conseco Inc. and CDOC held unrestricted cash of
$75.7 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, 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. We made capital contributions totaling $37.0 million to our top tier
insurance subsidiary in the first nine months of 2006.
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. During the first nine months of
2006, our top tier insurance subsidiary paid dividends of $37.5 million to CDOC.
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 nine months of 2006, we made principal payments totaling
$46.3 million on our Amended Credit Facility, including 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.
As further described in the note to the consolidated financial statements
entitled "Notes Payable - Direct Corporate Obligations", we entered into the
Second Amended Credit Facility in October 2006. As a result of the refinancing,
the principal amount outstanding under the credit facility was increased from
$478.3 million to $675.0 million and the maturity extended from 2010 to 2013.
The interest rate on the Second Amended Credit Facility will be 200 basis points
over LIBOR, an increase of 25 basis points over the Amended Credit Facility.
Approximately $195 million of the proceeds will be used to strengthen the
capital of our insurance subsidiaries.
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
The scheduled repayment of our Second Amended Credit Facility is as follows
(dollars in millions):
2006.......................................... $ 1.7
2007.......................................... 6.8
2008.......................................... 6.7
2009.......................................... 6.8
2010.......................................... 6.7
2011.......................................... 6.8
2012.......................................... 6.7
2013.......................................... 632.8
------
$675.0
======
The Amended Credit Facility and the Second Amended Credit Facility both
include 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 September 30, 2006. The
Company pays a commitment fee equal to .50 percent of the unused portion of the
revolving credit facility on an annualized basis.
Pursuant to the Second Amended Credit Facility, as long as the debt to
total capitalization ratio (as defined in the Second Amended Credit Facility) is
greater than 20 percent and certain insurance subsidiaries (as defined in the
Second 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 Second Amended Credit Facility (the first such payment, if
applicable, would not be paid prior to the first quarter of 2008). 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 the Second Amended Credit Facility, we may pay cash dividends on our
common stock or repurchase our common stock in an aggregate amount of up to
$150.0 million over the term of the facility (compared to a limitation of $50.0
million under the Amended Credit Facility).
Under our Second 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.
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At September 30, 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................................................ $13,298.7 $141.2 $203.5 $13,236.4
United States Treasury securities and obligations of
United States government corporations and agencies................. 1,447.5 17.2 20.3 1,444.4
States and political subdivisions................................... 738.2 6.3 11.3 733.2
Debt securities issued by foreign governments....................... 117.7 3.1 .6 120.2
Structured securities .............................................. 6,059.8 10.2 92.2 5,977.8
Below-investment grade (primarily corporate securities)................ 1,156.9 17.6 24.1 1,150.4
--------- ------ ------ ---------
Total actively managed fixed maturities............................. $22,818.8 $195.6 $352.0 $22,662.4
========= ====== ====== =========
Equity securities...................................................... $23.7 $3.1 $.1 $26.7
===== ==== === =====
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 September 30, 2006 (dollars in
millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 5,992.2 26.4%
Manufacturing........................................................................ 2,779.8 12.3
Bank and finance..................................................................... 2,278.4 10.1
Services............................................................................. 1,768.5 7.8
Utilities............................................................................ 1,574.0 6.9
U.S. Government...................................................................... 1,444.4 6.4
Communications....................................................................... 1,168.0 5.2
Holding and other investment offices................................................. 1,059.3 4.7
Agriculture, forestry and mining..................................................... 845.4 3.7
States and political subdivisions.................................................... 744.7 3.3
Retail and wholesale................................................................. 683.0 3.0
Transportation....................................................................... 656.4 2.9
Asset-backed securities.............................................................. 576.3 2.5
Other................................................................................ 1,092.0 4.8
--------- -----
Total actively managed fixed maturities........................................... $22,662.4 100.0%
========= =====
Below-Investment Grade Securities
At September 30, 2006, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,156.9 million, or 5.1 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,150.4 million, or 99 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$401.1 million and an estimated fair value of $398.3 million are securities held
by a VIE that we are required to consolidate. These fixed maturity securities
are legally
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 September 30,
2006, our total investment in the VIE was $48.9 million, and $47.0 million of
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 nine months of 2006, we recognized net realized investment
losses of $28.6 million, which were comprised of $17.3 million of net losses
from the sales of investments (primarily fixed maturities) with proceeds of $4.1
billion, and $11.3 million of writedowns of investments for other than temporary
declines in fair value. During the nine months ended September 30, 2005, we
recognized net realized investment gains of $3.1 million, which were comprised
of $7.2 million of net gains from the sales of investments (primarily fixed
maturities) with proceeds of $9.5 billion, net of $4.1 million of writedowns of
investments resulting from a decline in the fair value of investments that we
concluded were other than temporary. At September 30, 2006, investments in
default as to the payment of principal or interest had an aggregate amortized
cost of $18.0 million and a carrying value of $19.1 million.
During the nine months ended September 30, 2006, we sold $2.0 billion of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $64.3 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. 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.
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 nine months of 2006, we recorded writedowns of fixed
maturity securities and other invested assets totaling $11.3 million as a result
of analysis that led us to conclude that the declines in the values of these
investments were other than temporary.
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CONSECO, INC. AND SUBSIDIARIES
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The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at September
30, 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................................................................... $ 251.0 $ 249.3
Due after one year through five years..................................................... 1,995.0 1,966.8
Due after five years through ten years.................................................... 4,369.0 4,281.9
Due after ten years....................................................................... 4,662.1 4,519.3
--------- ---------
Subtotal............................................................................... 11,277.1 11,017.3
Structured securities..................................................................... 5,145.1 5,052.9
--------- ---------
Total.................................................................................. $16,422.2 $16,070.2
========= =========
At September 30, 2006, we held one investment in our fixed maturity
portfolio which was rated below-investment grade and had an unrealized loss
position exceeding 20 percent of its cost basis. At September 30, 2006, such
investment had an amortized cost and estimated fair value of $.2 million and $.1
million, respectively.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we have both the ability and intent to hold securities with
unrealized losses until they mature or recover in value, we may sell securities
at a loss in the future because of actual or expected changes in our view of the
particular investment, its industry, its type or the general investment
environment.
68
CONSECO, INC. AND SUBSIDIARIES
-------------------
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
September 30, 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...... $ 207.0 $ (2.0) $1,151.5 $ (18.3) $ 1,358.5 $ (20.3)
States and political subdivisions. 205.4 (2.9) 198.7 (8.4) 404.1 (11.3)
Debt securities issued by
foreign governments............ 46.1 (.5) 8.8 (.3) 54.9 (.8)
Corporate securities.............. 5,254.3 (80.9) 3,945.5 (146.5) 9,199.8 (227.4)
Structured securities............. 2,252.7 (23.9) 2,800.2 (68.3) 5,052.9 (92.2)
-------- ------- -------- ------- --------- -------
Total actively managed
fixed maturities............... $7,965.5 $(110.2) $8,104.7 $(241.8) $16,070.2 $(352.0)
======== ======= ======== ======= ========= =======
Equity securities................. $ - $ - $3.5 $(.1) $3.5 $(.1)
======= ======= ==== ==== ==== ====
Based on management's current assessment of investments with unrealized
losses at September 30, 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.
69
CONSECO, INC. AND SUBSIDIARIES
-------------------
Structured Securities
At September 30, 2006, fixed maturity investments included $6.0 billion of
structured securities (or 26 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations and commercial mortgage-backed securities. The yield
characteristics of structured securities differ in some respects from those of
traditional fixed-income securities. For example, interest and principal
payments on mortgage-backed securities occur more frequently, often monthly. In
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 yield recognized on
structured securities purchased at a discount to par will increase (relative to
the stated rate) when the underlying mortgages prepay faster than expected. The
yield recognized on structured securities purchased at a premium will decrease
(relative to the stated rate) 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 may 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 it 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 September 30, 2006 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 213.3 $ 213.2 $ 209.6
4 percent - 5 percent............................................................... 1,373.8 1,331.7 1,308.2
5 percent - 6 percent............................................................... 3,914.2 3,865.8 3,811.1
6 percent - 7 percent............................................................... 467.0 480.2 479.3
7 percent - 8 percent............................................................... 150.5 155.3 155.4
8 percent and above................................................................. 27.2 27.9 28.6
-------- -------- --------
Total structured securities (a).............................................. $6,146.0 $6,074.1 $5,992.2
======== ======== ========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $14.3 million and $14.4 million,
respectively.
</FN>
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CONSECO, INC. AND SUBSIDIARIES
-------------------
The amortized cost and estimated fair value of structured securities at
September 30, 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............ $3,556.0 $3,501.5 15%
Planned amortization classes and accretion-directed bonds................. 1,000.3 986.2 4
Commercial mortgage-backed securities..................................... 1,501.4 1,488.1 7
Other..................................................................... 16.4 16.4 -
-------- -------- --
Total structured securities (a).................................... $6,074.1 $5,992.2 26%
======== ======== ==
<FN>
- ----------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $14.3 million and $14.4 million,
respectively.
</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.
71
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 September 30, 2006, our total investment in Fall
Creek was $48.9 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):
September 30,
2006
-------------
Assets:
Actively managed fixed maturities............................ $406.3
Cash and cash equivalents - restricted....................... 6.6
Accrued investment income.................................... 3.5
Other assets................................................. 9.6
------
Total assets............................................. $426.0
======
Liabilities:
Other liabilities............................................ $ 9.8
Investment borrowings due to others.......................... 363.7
Investment borrowings due to the Company..................... 47.0
------
Total liabilities........................................ 420.5
------
Equity:
Capital provided by the Company.............................. 1.9
Capital provided by others................................... 5.2
Accumulated other comprehensive loss......................... (2.9)
Retained earnings............................................ 1.3
------
Total equity............................................. 5.5
------
Total liabilities and equity............................. $426.0
======
Three months ended Nine months ended
September 30, September 30,
2006 2006
------------------ ------------------
Revenues:
Net investment income - deposit accounts..................... $8.2 $18.1
Net realized investment losses............................... (.1) (.1)
Fee revenue and other income................................. .1 .2
---- -----
Total revenues........................................... 8.2 18.2
---- -----
Expenses:
Interest expense............................................. 5.2 13.7
Other operating expenses..................................... .2 .7
---- -----
Total expenses........................................... 5.4 14.4
---- -----
Income before income taxes............................... $2.8 $ 3.8
==== =====
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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 nine months
of 2006 to such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Interim Disclosure Controls and Procedures. Conseco's
management, under the supervision and with the participation of the Chief
Executive Officer and the Chief Financial Officer, evaluated the effectiveness
of Conseco's disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on
this evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that, as of September 30, 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 first nine months of 2006, we
implemented new actuarial valuation systems for our long-term care products in
our Other Business in Run-off segment, our traditional life, equity-indexed and
Medicare supplement products in our Bankers Life segment, and certain universal
life products in our Conseco Insurance Group segment. In addition, we
implemented a new mortgage loan processing system. 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 described above, no significant changes in Conseco's
internal controls over financial reporting have occurred during the nine months
ended September 30, 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.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
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 nine months of 2006 to such risks.
ITEM 6. EXHIBITS.
10.1 Second Amended and Restated Credit Agreement dated as of October
10, 2006 among Conseco, Inc., Bank of America, N.A., as Agent,
JPMorgan Chase Bank, N.A., as Syndication Agent, and other parties,
incorporated by reference to Exhibit 10.1 of our Current Report on
Form 8-K filed October 11, 2006.
10.23 Employment Agreement dated as of August 9, 2006 between Conseco,
Inc. and C. James Prieur, incorporated by reference to Exhibit
10.23 of our Current Report on Form 8-K filed August 9, 2006.
10.24 Conseco Inc. Deferred Compensation Plan effective January 1, 2007.
10.25 Employment Agreement dated as of May 3, 2005 between Conseco
Services, LLC and Susan L. Menzel.
10.26 Employment Agreement dated as of January 17, 2006 between Conseco
Services, LLC and William D. Fritts, Jr.
10.27 Employment Agreement dated as of September 8, 2005 between Conseco
Services, LLC and Chris Nickele.
10.28 Employment Agreement dated as of October 1, 2004 between Conseco
Services, LLC and Scott Perry.
10.29 Employment Agreement dated as of April 1, 2006 between Conseco
Services, LLC and Daniel G. Walseth.
10.30 Employment Agreement dated as of November 6, 2006 between Conseco
Services, LLC and Michael Dubes.
10.31 Employment Agreement dated as of March 7, 2005 between Conseco
Services, LLC and Russell M. Bostick.
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.
74
CONSECO, INC. AND SUBSIDIARIES
-------------------
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: November 7, 2006 By: /s/ Eugene M. Bullis
--------------------
Eugene M. Bullis
Executive Vice President and
Chief Financial Officer
(authorized officer and principal
financial officer)
75