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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
[ X ] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the fiscal year ended December 31, 2006 or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 [No Fee Required]
For the transition period from to
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Commission file number: 001-31792
Conseco, Inc.
Delaware No. 75-3108137
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State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
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Address of principal executive offices Telephone
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of Each Exchange on which Registered
------------------- -----------------------------------------
Common Stock, par value $0.01 per share New York Stock Exchange
Series A Warrants New York Stock Exchange
Class B Mandatorily Convertible Preferred New York Stock Exchange
Stock, par value $0.01 per share
Securities registered pursuant to Section 12(g) of the Act:
3.50% Convertible Debentures due September 30, 2035
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ X ] No [ ]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or 15(d) of the Act. Yes [ ] No [ X ]
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer or a non-accelerated filer (see definitions 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 ]
At June 30, 2006, the last business day of the Registrant's most recently
completed second fiscal quarter, the aggregate market value of the Registrant's
common equity held by nonaffiliates was approximately $3,490,200,000.
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 February 22, 2007: 150,931,637
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's definitive
proxy statement for the 2007 annual meeting of shareholders are incorporated by
reference into Part III of this report.
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TABLE OF CONTENTS
Page
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PART I
Item 1. Business of Conseco......................................................... 3
Item 1A. Risk Factors................................................................ 21
Item 1B. Unresolved Staff Comments................................................... 31
Item 2. Properties.................................................................. 31
Item 3. Legal Proceedings........................................................... 31
Item 4. Submission of Matters to a Vote of Security Holders......................... 32
Executive Officers of the Registrant........................................ 32
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities................................... 34
Item 6. Selected Consolidated Financial Data........................................ 35
Item 7. Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations............................... 36
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................. 89
Item 8. Consolidated Financial Statements and Supplementary Data.................... 89
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................................ 153
Item 9A. Controls and Procedures..................................................... 153
Item 9B. Other Information........................................................... 155
PART III
PART IV
Item 15. Exhibits and Financial Statement Schedules.................................. 155
2
PART I
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ITEM 1. BUSINESS OF CONSECO.
Conseco, Inc., a Delaware corporation ("CNO"), is the 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. The terms "Conseco," the
"Company," "we," "us," and "our" as used in this report refer to CNO and its
subsidiaries and, unless the context requires otherwise, Old Conseco and its
subsidiaries.
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.
As of December 31, 2006, we had shareholders' equity of $4.7 billion and assets
of $32.7 billion. For the year ended December 31, 2006, we had revenues of $4.5
billion and net income of $96.5 million. See our consolidated financial
statements and accompanying footnotes for additional financial information about
the Company and its segments.
We manage our business through the following: three primary operating
segments, Bankers Life, Conseco Insurance Group and Colonial Penn, which are
defined on the basis of product distributions; a fourth segment comprised of
other business in run-off; and corporate operations. These segments reflect the
addition of Colonial Penn as a separate segment resulting from a change in how
management disaggregates the Company's operations for making internal operating
decisions beginning in the fourth quarter of 2006. Colonial Penn's operations
were previously aggregated with the Bankers Life segment. We have restated all
prior period segment disclosures to conform to management's current view of the
Company's operating segments. Our segments are described below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company ("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 approximately 4,650
exclusive career agents and sales managers. Bankers Life and Casualty
markets its products under its own brand name and Medicare Part D
products through a marketing agreement with Coventry Health Care
("Coventry").
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 over
500 independent marketing organizations ("IMOs") that represent over
6,400 producing independent agents. This segment markets its products
under the "Conseco" and "Washington National" (a wholly-owned
insurance subsidiary of Conseco) brand names.
o Colonial Penn, which consists of the business of Colonial Penn Life
Insurance Company ("Colonial Penn"), markets graded benefit and
simplified issue life insurance directly to customers through
television advertising, direct mail, the internet and telemarketing.
Colonial Penn markets its products under its own brand name.
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.
o Corporate operations, which consists of holding company activities and
certain noninsurance company businesses that are not related to our
operating segments.
3
OUR STRATEGIC DIRECTION AND 2007 PRIORITIES
It is our vision to be a premier provider of insurance products to
America's middle-income families and seniors. Our insurance companies help
protect them from financial adversity: Medicare supplement, long-term care,
cancer, heart/stroke and accident policies protect people against unplanned
expenses; annuities and life products help people plan for their financial
future. We believe our products meet the needs of our target markets.
We believe our middle market target is underserved by a majority of financial
service providers and that the aging population will create strong growth in
these target markets. Important trends impacting middle market consumers
include:
o Increased life expectancy.
o Discontinuance or reduction in employer-sponsored benefit programs.
o Rising healthcare costs.
o Projected gaps between the annual costs and revenues of
government-sponsored plans such as Social Security and Medicare.
We believe our multiple distribution channels provide broad reach across the
market since consumers can access our products through an agent (Bankers Life or
Conseco Insurance Group), without an agent (Colonial Penn), and at the worksite
(Conseco Insurance Group).
We continue to make significant progress on the key initiatives that we outlined
a year ago:
o Increasing emphasis on sales and revenue growth.
- First-year collected premiums in 2006 increased by 32
percent over 2005, to $1,815.4 million. At Bankers Life, our
career agent distribution channel, first-year collected
premiums rose 13 percent to $1,311.6 million in 2006. At
Conseco Insurance Group, our independent channel, first-year
collected premiums rose by 145 percent to $480.9 million in
2006. At Colonial Penn, our direct distribution channel,
first-year collected premiums rose by 18 percent to $22.9
million in 2006.
o Further reducing operating expenses and improving the efficiency of
our operations.
- We have reduced our non-commission expenses (before the
effect of the 2005 expense reductions related to the
termination of a postretirement plan ($8.8 million) and
recoveries related to our bankruptcy ($7.6 million) and the
2006 expenses related to our quota-share agreement with
Coventry ($6.5 million) and compensation expense related to
stock options first recognized in 2006 ($6.5 million)) by
approximately $10 million in 2006, while increasing our
sales.
- In December 2006, we announced that we were reorganizing our
back office operations with the intent of further decreasing
operating expenses and increasing focus across the Company.
o Continuing to build best practices in governance and compliance.
- We continue to work to improve our compliance and governance
practices with the ultimate goal of applying best practices
across our organization.
OTHER INFORMATION
CNO is the successor to Old Conseco. We emerged from bankruptcy on
September 10, 2003 (the "Effective Date"). Old Conseco was organized in 1979 as
an Indiana corporation and commenced operations in 1982. Our executive offices
are located at 11825 N. Pennsylvania Street, Carmel, Indiana 46032, and our
telephone number is (317) 817-6100. Our annual reports on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K and amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities
Exchange Act are available free of charge on our website at
4
www.conseco.com as soon as reasonably practicable after they are electronically
filed with, or furnished to, the Securities and Exchange Commission (the "SEC").
These filings are also available on the SEC's website at www.sec.gov. In
addition, the public may read and copy any document we file at the SEC's Public
Reference Room located at 100 F Street, NE, Room 1580, Washington, D.C. 20549.
The public may obtain information on the operation of the Public Reference Room
by calling the SEC at 1-800-SEC-0330. Copies of these filings are also
available, without charge, from Conseco Investor Relations, 11825 N.
Pennsylvania Street, Carmel, IN 46032.
Our website also includes the charters of our Audit and Enterprise Risk
Committee, Executive Committee, Governance and Strategy Committee, Human
Resources and Compensation Committee and Investment Committee, as well as our
Corporate Governance Operating Principles and our Code of Business Conduct and
Ethics that applies to all officers, directors and employees. Copies of these
documents are available free of charge on our website at www.conseco.com or from
Conseco Investor Relations at the address shown above. Within the time period
specified by the SEC and the New York Stock Exchange, we will post on our
website any amendment to our Code of Business Conduct and Ethics and any waiver
applicable to our principal executive officer, principal financial officer or
principal accounting officer.
In June 2006, we filed with the New York Stock Exchange the Annual CEO
Certification regarding the Company's compliance with their Corporate Governance
listing standards as required by Section 303A.12(a) of the New York Stock
Exchange Listed Company Manual. In addition, we have filed as exhibits to this
2006 Form 10-K the applicable certifications of the Company's Chief Executive
Officer and Chief Financial Officer required under Section 302 of the
Sarbanes-Oxley Act of 2002 regarding the Company's public disclosures.
Data in Item 1 are provided as of or for the year ended December 31, 2006,
(as the context implies), unless otherwise indicated.
MARKETING AND DISTRIBUTION
Insurance
Our insurance subsidiaries develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We sell these products through three primary distribution channels:
career agents, professional independent producers (some of whom sell one or more
of our product lines exclusively) and direct marketing. We had premium
collections of $4.3 billion, $3.9 billion and $3.9 billion in 2006, 2005 and
2004, respectively.
Our insurance subsidiaries collectively hold licenses to market our
insurance products in all fifty states, the District of Columbia, and certain
protectorates of the United States. Sales to residents of the following states
accounted for at least five percent of our 2006 collected premiums: Florida (9.4
percent), California (7.4 percent), Texas (6.3 percent) and Pennsylvania (5.4
percent).
We believe that most purchases of life insurance, accident and health
insurance and annuity products occur only after individuals are contacted and
solicited by an insurance agent. Accordingly, the success of our distribution
system is largely dependent on our ability to attract and retain experienced and
highly motivated agents. A description of our primary distribution channels is
as follows:
Career Agents. This agency force of approximately 4,650 agents and sales
managers working from 160 branch offices, establishes one-on-one contact with
potential policyholders and promotes strong personal relationships with existing
policyholders. The career agents sell primarily Medicare supplement and
long-term care insurance policies, life insurance and annuities. In 2006, this
distribution channel accounted for $2,490.0 million, or 58 percent, of our total
collected premiums. These agents sell only Bankers Life and Casualty policies
and typically visit the prospective policyholder's home to conduct personalized
"kitchen-table" sales presentations. After the sale of an insurance policy, the
agent serves as a contact person for policyholder questions, claims assistance
and additional insurance needs.
Professional Independent Producers. Professional independent producers are
a diverse network of independent agents, insurance brokers and marketing
organizations. The general agency and insurance brokerage distribution system is
comprised of independent licensed agents doing business in all fifty states, the
District of Columbia, and certain protectorates of the United States. In 2006,
this distribution channel in our Conseco Insurance Group segment collected
$1,123.1 million, or 26 percent, of our total premiums, and in our Other
Business in Run-off segment collected $327.8 million, or 7.6 percent, of
Conseco's total collected premiums.
5
Marketing organizations typically recruit agents for the Conseco Insurance
Group segment by advertising our products and commission structure through
direct mail advertising or through seminars for agents and brokers. These
organizations bear most of the costs incurred in marketing our products. We
compensate the marketing organizations by paying them a percentage of the
commissions earned on new sales generated by agents recruited by such
organizations. Certain of these marketing organizations are specialty
organizations that have a marketing expertise or a distribution system related
to a particular product or market, such as educators. During 1999 and 2000, the
Conseco Insurance Group segment purchased four organizations that specialize in
marketing and distributing supplemental health products. One of these
organizations (which specialized in the sale of long-term care insurance through
independent agents) was sold in September 2003. In 2006, the remaining three
organizations accounted for $236.4 million, or 5.5 percent, of our total
collected premiums.
Direct Marketing. This distribution channel is engaged primarily in the
sale of graded benefit life insurance policies through Colonial Penn. In 2006,
this channel accounted for $109.2 million, or 2.5 percent, of our total
collected premiums.
Products
The following table summarizes premium collections by major category and
segment for the years ended December 31, 2006, 2005 and 2004 (dollars in
millions):
Total premium collections
2006 2005 2004
---- ---- ----
Supplemental health:
Bankers Life............................................................ $1,308.3 $1,213.7 $1,172.9
Conseco Insurance Group................................................. 611.6 661.5 729.6
Colonial Penn........................................................... 12.0 13.8 15.6
Other Business in Run-off............................................... 327.8 351.9 395.9
-------- -------- --------
Total supplemental health............................................ 2,259.7 2,240.9 2,314.0
-------- -------- --------
Annuities:
Bankers Life............................................................ 997.5 951.1 950.5
Conseco Insurance Group................................................. 433.3 161.7 63.7
-------- -------- --------
Total annuities...................................................... 1,430.8 1,112.8 1,014.2
-------- -------- --------
Life:
Bankers Life............................................................ 184.2 152.1 101.2
Conseco Insurance Group................................................. 314.6 335.0 372.3
Colonial Penn........................................................... 97.2 85.1 79.7
-------- -------- --------
Total life........................................................... 596.0 572.2 553.2
-------- -------- --------
Total premium collections.................................................. $4,286.5 $3,925.9 $3,881.4
======== ======== ========
6
Our insurance companies collected premiums from the following products:
Supplemental Health
Supplemental Health Premium Collections (dollars in millions)
2006 2005 2004
---- ---- ----
Medicare supplement:
Bankers Life................................................................. $ 629.1 $ 638.8 $ 625.9
Conseco Insurance Group...................................................... 244.2 288.8 351.7
Colonial Penn................................................................ 10.9 12.4 14.1
-------- -------- --------
Total..................................................................... 884.2 940.0 991.7
-------- -------- --------
Long-term care:
Bankers Life ................................................................ 592.4 564.2 536.3
Conseco Insurance Group (a) ................................................. N/A N/A N/A
Other Business in Run-off ................................................... 323.0 349.1 380.1
-------- -------- --------
Total..................................................................... 915.4 913.3 916.4
-------- -------- --------
Specified disease products included in
Conseco Insurance Group...................................................... 357.7 359.5 361.7
-------- -------- --------
Major medical business included in Other Business in Run-off..................... 4.8 2.8 15.8
-------- -------- --------
Other:
Bankers Life ................................................................ 86.8 10.7 10.7
Conseco Insurance Group...................................................... 9.7 13.2 16.2
Colonial Penn................................................................ 1.1 1.4 1.5
-------- -------- --------
Total..................................................................... 97.6 25.3 28.4
-------- -------- --------
Total supplemental health premium collections.................................... $2,259.7 $2,240.9 $2,314.0
======== ======== ========
<FN>
- --------------------
(a) We have ceased writing long-term care insurance through Conseco
Insurance Group and all major medical insurance. Accordingly, we
classify the associated collected premiums in "Other Business in
Run-off."
</FN>
The following describes our major supplemental health products:
Medicare Supplement. Medicare supplement collected premiums were $884.2
million during 2006 or 21 percent of our total collected premiums. Medicare is a
federal health insurance program for disabled persons and senior citizens (age
65 and older). Part A of the program provides protection against the costs of
hospitalization and related hospital and skilled nursing home care, subject to
an initial deductible, related coinsurance amounts and specified maximum benefit
levels. The deductible and coinsurance amounts are subject to change each year
by the federal government. Part B of Medicare covers doctor's bills and a number
of other medical costs not covered by Part A, subject to deductible and
coinsurance amounts for "approved" charges.
Medicare supplement policies provide coverage for many of the medical
expenses which the Medicare program does not cover, such as deductibles,
coinsurance costs (in which the insured and Medicare share the costs of medical
expenses) and specified losses which exceed the federal program's maximum
benefits. Our Medicare supplement plans automatically adjust coverage to reflect
changes in Medicare benefits. In marketing these products, we currently
concentrate on individuals who have recently become eligible for Medicare by
reaching the age of 65. We offer higher commissions in the early years to agents
for sales to these policyholders and competitive premium pricing for our
policyholders. Approximately 38 percent of new sales of Medicare supplement
policies in 2006 were to individuals who had recently reached the age of 65.
7
The Medicare Prescription Drug, Improvement and Modernization Act of 2003
(the "Modernization Act") provided for the introduction of a prescription drug
benefit (Part D) effective January 1, 2006. 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 number of
plans sold through our distribution channels. In addition, Conseco has a
quota-share reinsurance agreement with Coventry for Conseco enrollees that
provides Conseco with 50 percent of net premiums and related profits subject to
a risk corridor. During 2006, we recognized insurance policy income of $74.4
million related to this product.
Conseco expanded its strategic alliance with Coventry by entering into a
national distribution agreement under which our career agents will distribute
Coventry's Private-Fee-For-Service plan, Advantra Freedom, beginning January 1,
2007. The Advantra Freedom product is a Medicare Advantage plan designed to
provide seniors with more choices and better coverage at lower cost than
original Medicare and Medicare Advantage plans offered through HMOs. Under the
agreement, we will receive a fee based on the number of Private-Fee-For-Service
plans sold through our distribution channels. In addition, Conseco has a
quota-share reinsurance agreement with Coventry for Conseco enrollees that
provides Conseco in 2007 with more than 50 percent of the net premiums and
related profits. To date, our career channel has enrolled in excess of 14,000
members for coverage effective in 2007.
Both Bankers Life and Conseco Insurance Group sell Medicare supplement
insurance.
Long-Term Care. Long-term care collected premiums were $915.4 million
during 2006, or 22 percent of our total collected premiums. Long-term care
products provide coverage, within prescribed limits, for nursing homes, home
healthcare, or a combination of both. We sell the long-term care plans primarily
to retirees and, to a lesser degree, to older self-employed individuals and
others in middle-income levels.
Current nursing home care policies cover incurred and daily fixed-dollar
benefits with an elimination period (which, similar to a deductible, requires
the insured to pay for a certain number of days of nursing home care before the
insurance coverage begins), subject to a maximum benefit. Home healthcare
policies cover the usual and customary charges after a deductible or elimination
period and are subject to a daily or weekly maximum dollar amount, and an
overall benefit maximum. We monitor the loss experience on our long-term care
products and, when necessary, apply for rate increases in the jurisdictions in
which we sell such products. Regulatory approval is required to increase our
premiums on these products.
The long-term care insurance blocks of business sold through the
professional independent producer distribution channel were largely underwritten
by certain of our subsidiaries prior to their acquisitions by Conseco in 1996
and 1997. The performance of these blocks of business did not meet the
expectations we had when the blocks were acquired. As a result, we ceased
selling new long-term care policies through this distribution channel.
We continue to sell long-term care insurance through the career agent
distribution channel. The long-term care business sold through Bankers Life's
career agents is underwritten using stricter underwriting and pricing standards
than our acquired blocks of long-term care business included in the Other
Business in Run-off segment.
Specified Disease Products. Specified disease collected premiums were
$357.7 million during 2006, or 8 percent of our total collected premiums. These
policies generally provide fixed or limited benefits. Cancer insurance and
heart/stroke products are guaranteed renewable individual accident and health
insurance policies. 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. Heart/stroke policies provide for
payments directly to the policyholder for treatment of a covered heart disease,
heart attack or stroke. Accident products combine insurance for accidental death
with limited benefit disability income insurance. The benefits provided under
the specified disease policies do not necessarily reflect the actual cost
incurred by the insured as a result of the illness, or accident, and benefits
are not reduced by any other medical insurance payments made to or on behalf of
the insured.
Approximately 78 percent of the total number of our specified disease
policies inforce was 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 in some cases, 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.
8
Major Medical. Our major medical business is included in our Other Business
in Run-off segment. Sales of our major medical health insurance products were
targeted to self-employed individuals, small business owners, large employers
and early retirees. Various deductible and coinsurance options were available,
and most policies require certain utilization review procedures. The
profitability of this business depended largely on the overall persistency of
the business inforce, claim experience and expense management. During 2001, we
decided to discontinue a large block of major medical business by not renewing
these policies because this business was not profitable. The remaining major
medical block, except for certain business that is guaranteed renewable, was
discontinued by not renewing the policies in 2002. During 2006, we collected
major medical premiums of $4.8 million.
Other Supplemental Health Products. Other supplemental health product
collected premiums were $97.6 million during 2006, or 2 percent of our total
collected premiums. Other supplemental health products in 2006 include Medicare
Part D premiums collected pursuant to the quota-share agreement with Coventry.
These products include various other products such as disability income
insurance which we no longer actively market.
Annuities
Annuity premium collections (dollars in millions)
2006 2005 2004
---- ---- ----
Equity-indexed annuity:
Bankers Life ............................................................ $ 276.5 $ 130.3 $ 47.5
Conseco Insurance Group.................................................. 378.5 104.4 44.3
-------- -------- --------
Total equity-indexed annuity premium collections ..................... 655.0 234.7 91.8
-------- -------- --------
Other fixed annuity:
Bankers Life ............................................................ 721.0 820.8 903.0
Conseco Insurance Group.................................................. 54.8 57.3 19.4
-------- -------- --------
Total fixed annuity premium collections .............................. 775.8 878.1 922.4
-------- -------- --------
Total annuity premium collections........................................... $1,430.8 $1,112.8 $1,014.2
======== ======== ========
During 2006, we collected annuity premiums of $1,430.8 million or 33
percent of our total premiums collected. Annuity products include equity-indexed
annuity, traditional fixed rate annuity and single premium immediate annuity
products sold through both Bankers Life and Conseco Insurance Group. Annuities
offer a tax-deferred means of accumulating savings for retirement needs, and
provide a tax-efficient source of income in the payout period. Our major source
of income from fixed rate annuities is the spread between the investment income
earned on the underlying general account assets and the interest credited to
contractholders' accounts. For equity-indexed annuities, our major source of
income is the spread between the investment income earned on the underlying
general account assets and the cost of the index options purchased to provide
index-based credits to the contractholders' accounts.
Sales of many of our annuity products have been affected by the financial
strength ratings assigned to our insurance subsidiaries by independent rating
agencies. Many of our professional independent agents discontinued marketing our
annuity products after A.M. Best Company ("A.M. Best") lowered the financial
strength ratings assigned to our insurance subsidiaries in 2002. In 2006,
annuity sales in our Conseco Insurance Group segment increased due to increased
sales efforts, expanded product offerings and attractive crediting rates on
certain products. In 2007, we expect to increase our annuity sales efforts in
this segment. Career agents selling annuity products in the Bankers Life segment
are less sensitive in the near-term to A.M. Best ratings, since these agents
only sell our products. However, the increase in short-term interest rates
during 2006 resulted in lower fixed annuity sales, since certain other competing
products such as certificates of deposits have become more attractive.
Sales of our equity-indexed products in both segments were favorably
impacted in 2006 due in part to general stock market conditions which made these
products relatively attractive. In addition, we introduced several new products.
9
The following describes the major annuity products:
Equity-Indexed Annuities. These products accounted for $655.0 million, or
15 percent, of our total premium collections during 2006. The account value (or
"accumulation value") of these annuities is credited with an interest rate that
is based on changes in a particular index during a specified period of time.
Within each contract issued, each equity-indexed annuity specifies:
o The index to be used;
o The time period during which the change in the index is measured, and
at the end of which, the change in the index is applied to the account
value. The time period of the contract ranges from 1 to 4 years.
o The method used to measure the change in the index.
o The measured change in the index may be multiplied by a "participation
rate" (percentage of change in the index) before the credit is
applied. Some policies guarantee the initial participation rate for
the life of the contract, and some vary the rate for each period.
o The measured change in the index may also be limited to a "cap" before
the credit is applied. Some policies guarantee the initial cap for the
life of the contract, and some vary the cap for each period.
o The measured change in the index may also be limited to the excess in
the measured change over a "margin" before the credit is applied. Some
policies guarantee the initial margin for the life of the contract,
and some vary the margin for each period.
These products have guaranteed minimum cash surrender values, regardless of
actual index performance and the resulting indexed-based interest credits
applied.
We buy call options on the applicable indices (primarily the Standard & Poor's
500 Index) in an effort to hedge potential increases to policyholder benefits
resulting from increases in the indices to which the product's return is linked.
Fixed Rate Annuities. These products include fixed rate single-premium
deferred annuities ("SPDAs"), flexible premium deferred annuities ("FPDAs") and
single-premium immediate annuities ("SPIAs"). These products accounted for
$775.8 million, or 18 percent, of our total premium collections during 2006. Our
fixed rate SPDAs and FPDAs typically have an interest rate (the "crediting
rate") that is guaranteed by the Company 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 guaranteed rates on annuities written
recently range from 2.5 percent to 4.0 percent, and the rates, on all policies
inforce range from 2.5 percent to 6.0 percent. The initial crediting rate is
largely a function of:
o the interest rate we can earn on invested assets acquired with the new
annuity fund deposits;
o the costs related to marketing and maintaining the annuity products;
and
o the rates offered on similar products by our competitors.
For subsequent adjustments to crediting rates, we take into account current and
prospective yields on investments, annuity surrender assumptions, competitive
industry pricing and the crediting rate history for particular groups of annuity
policies with similar characteristics.
In 2006, substantially all of our new annuity sales were "bonus"
products. The initial crediting rate on these products specifies a bonus
crediting rate generally ranging from 1.0 percent to 3.0 percent of the annuity
deposit for the first policy year only. After the first year, the bonus interest
portion of the initial crediting rate is automatically discontinued, and the
renewal crediting rate is established. As of December 31, 2006, the average
crediting rate, excluding bonuses, on our outstanding traditional annuities was
3.6 percent.
Withdrawals from deferred annuities (including equity-indexed annuities)
are generally subject to a surrender charge
10
of 8 percent to 22 percent in the first year, declining to zero over a 5 to 15
year period, depending on issue age and product. Surrender charges are set at
levels intended to protect us from loss on early terminations and to reduce the
likelihood that policyholders will terminate their policies during periods of
increasing interest rates. This practice is intended to lengthen the duration of
policy liabilities and to enable us to maintain profitability on such policies.
Penalty-free withdrawals from deferred annuities of up to 10 percent of
either premiums or account value are available in most plans after the first
year of the annuity's term.
Some deferred annuity products apply a market value adjustment during the
surrender charge period. This adjustment is determined by a formula specified in
the annuity contract, and may increase or decrease the cash surrender value
depending on changes in the amount and direction of market interest rates or
credited interest rates at the time of withdrawal. The resulting cash surrender
values will be at least equal to the guaranteed minimum values.
SPIAs accounted for $39.1 million, or .9 percent, of our total premiums
collected in 2006. SPIAs are designed to provide a series of periodic payments
for a fixed period of time or for life, according to the policyholder's choice
at the time of issuance. Once the payments begin, the amount, frequency and
length of time over which they are payable are fixed. SPIAs often are purchased
by persons at or near retirement age who desire a steady stream of payments over
a future period of years. The single premium is often the payout from a
terminated annuity contract. The implicit interest rate on SPIAs is based on
market conditions when the policy is issued. The implicit interest rate on our
outstanding SPIAs averaged 6.9 percent at December 31, 2006.
Life Insurance
Life insurance premium collections (dollars in millions)
2006 2005 2004
---- ---- ----
Interest-sensitive life products:
Bankers Life............................................................... $ 62.2 $ 50.9 $ 47.5
Conseco Insurance Group.................................................... 235.0 251.1 274.7
Colonial Penn.............................................................. .6 .6 .6
------ ------ ------
Total interest-sensitive life premium collections....................... 297.8 302.6 322.8
------ ------ ------
Traditional life:
Bankers Life............................................................... 122.0 101.2 53.7
Conseco Insurance Group.................................................... 79.6 83.9 97.6
Colonial Penn.............................................................. 96.6 84.5 79.1
------ ------ ------
Total traditional life premium collections.............................. 298.2 269.6 230.4
------ ------ ------
Total life insurance premium collections...................................... $596.0 $572.2 $553.2
====== ====== ======
Life products include traditional, interest-sensitive and other life
insurance products. These products are currently sold through Bankers Life,
Conseco Insurance Group and Colonial Penn. During 2006, we collected life
insurance premiums of $596.0 million, or 14 percent, of our total collected
premiums. Sales of life products are affected by the financial strength ratings
assigned to our insurance subsidiaries by independent rating agencies. See
"Competition" below.
Interest-Sensitive Life Products. These products include universal life and
other interest-sensitive life products that provide whole life insurance with
adjustable rates of return related to current interest rates. They accounted for
$297.8 million, or 6.9 percent, of our total collected premiums in 2006. These
products are marketed by professional independent producers and, to a lesser
extent, career agents (including those specializing in worksite sales). The
principal differences between universal life products and other
interest-sensitive life products are policy provisions affecting the amount and
timing of premium payments. Universal life policyholders may vary the frequency
and size of their premium payments, and policy benefits may also fluctuate
according to such payments. Premium payments under other interest-sensitive
policies may not be varied by the policyholders.
Traditional Life. These products accounted for $298.2 million, or 7.0
percent, of our total collected premiums in 2006. Traditional life policies,
including whole life, graded benefit life and term life products, are marketed
through
11
professional independent producers, career agents and direct response marketing.
Under whole life policies, the policyholder generally pays a level premium over
an agreed period or the policyholder's lifetime. The annual premium in a whole
life policy is generally higher than the premium for comparable term insurance
coverage in the early years of the policy's life, but is generally lower than
the premium for comparable term insurance coverage in the later years of the
policy's life. These policies, which we continue to market on a limited basis,
combine insurance protection with a savings component that gradually increases
in amount over the life of the policy. The policyholder may borrow against the
savings component generally at a rate of interest lower than that available from
other lending sources. The policyholder may also choose to surrender the policy
and receive the accumulated cash value rather than continuing the insurance
protection. Term life products offer pure insurance protection for life with a
guaranteed level premium for a specified period of time -- typically 10, 15, 20
or 30 years. In some instances, these products offer an option to return the
premium at the end of the guaranteed period. We ceased most term life product
sales through the professional independent producer distribution channel during
the second quarter of 2003, but reentered the market in 2006.
Traditional life products also include graded benefit life insurance
products. Graded benefit life products accounted for $92.3 million, or 2.2
percent, of our total collected premiums in 2006. Graded benefit life insurance
products are offered on an individual basis primarily to persons age 50 to 80,
principally in face amounts of $350 to $30,000, without medical examination or
evidence of insurability. Premiums are paid as frequently as monthly. Benefits
paid are less than the face amount of the policy during the first two years,
except in cases of accidental death. Our Colonial Penn segment markets graded
benefit life policies under its own brand name using direct response marketing
techniques. New policyholder leads are generated primarily from television,
print advertisements and direct response mailings.
Traditional life products also include single premium whole life insurance.
This product requires one initial lump sum payment in return for providing life
insurance protection for the insured's entire lifetime. Single premium whole
life products accounted for $42.9 million, or 1.0 percent, of our total
collected premiums in 2006.
INVESTMENTS
40|86 Advisors, Inc. ("40|86 Advisors"), a registered investment adviser
and wholly-owned subsidiary of Conseco, Inc., manages the investment portfolios
of our insurance subsidiaries. 40|86 Advisors had approximately $27.5 billion of
assets (at fair value) under management at December 31, 2006, of which $25.6
billion were assets of our subsidiaries and $1.9 billion were assets managed for
third parties. Our general account investment strategies are to:
o maintain a largely investment-grade, diversified fixed-income
portfolio;
o maximize the spread between the investment income we earn and the
yields we pay on investment products within acceptable levels of risk;
o provide adequate liquidity;
o construct our investment portfolio considering expected liability
durations, cash flows and other requirements; and
o maximize total return through active investment management.
During 2006, 2005 and 2004, we recognized net realized investment gains
(losses) of $(47.2) million, $(2.9) million and $40.6 million, respectively.
Investment activities are an integral part of our business because
investment income is a significant component of our revenues. The profitability
of many of our insurance products is significantly affected by spreads between
interest yields on investments and rates credited on insurance liabilities.
Although substantially all credited rates on SPDAs and FPDAs may be changed
annually (subject to minimum guaranteed rates), changes in crediting rates may
not be sufficient to maintain targeted investment spreads in all economic and
market environments. In addition, competition, minimum guaranteed rates and
other factors, including the impact of surrenders and withdrawals, may limit our
ability to adjust or to maintain crediting rates at levels necessary to avoid
narrowing of spreads under certain market conditions. As of December 31, 2006,
the average yield, computed on the cost basis of our actively managed fixed
maturity portfolio, was 5.7 percent, and the average interest rate credited or
accruing to our total insurance liabilities was 4.6 percent.
We manage the equity-based risk component of our equity-indexed annuity
products by:
12
o purchasing equity-based call options with similar payoff
characteristics; and
o adjusting the participation rate to reflect the change in the cost of
such options (such cost varies based on market conditions).
We seek to manage the interest rate risk inherent in our invested assets
with the interest rate characteristics of our insurance liabilities. We attempt
to minimize this exposure by managing the durations and cash flows of our fixed
maturity investments and insurance liabilities. For example, duration measures
the expected change in the fair value of assets and liabilities for a given
change in interest rates. If interest rates increase by 1 percent, the fair
value of a fixed maturity security with a duration of 5 years is typically
expected to decrease in value by approximately 5 percent. When the estimated
durations of assets and liabilities are similar, a change in the value of assets
should be largely offset by a change in the value of liabilities.
We calculate asset and liability durations using our estimates of future
asset and liability cash flows. At December 31, 2006, the duration of our fixed
maturity investments (as modified to reflect prepayments and potential calls)
was approximately 7.0 years and the duration of our insurance liabilities was
approximately 7.4 years. The difference between these durations indicates that
our investment portfolio had a shorter duration and, consequently, was less
sensitive to interest rate fluctuations than that of our liabilities at that
date. We generally seek to minimize the gap between asset and liability
durations.
For information regarding the composition and diversification of the
investment portfolio of our subsidiaries, see "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations --
Investments."
COMPETITION
The markets in which we operate are highly competitive. Our current ratings
have had a material adverse impact on our ability to compete in certain markets.
Compared to Conseco, many companies in the financial services industry are
larger, have greater capital, technological and marketing resources, have better
access to capital and other sources of liquidity at a lower cost, offer broader
and more diversified product lines and have larger staffs. An expanding number
of banks, securities brokerage firms and other financial intermediaries also
market insurance products or offer competing products, such as mutual fund
products, traditional bank investments and other investment and retirement
funding alternatives. We also compete with many of these companies and others in
providing services for fees. In most areas, competition is based on a number of
factors, including pricing, service provided to distributors and policyholders
and ratings. Conseco's subsidiaries must also compete to attract and retain the
allegiance of agents, insurance brokers and marketing companies.
In the individual health insurance business, companies compete primarily on
the bases of marketing, service and price. Pursuant to federal regulations, the
Medicare supplement products offered by all companies have standardized policy
features. This increases the comparability of such policies and intensifies
competition based on other factors. See "Insurance Underwriting" and
"Governmental Regulation." In addition to competing with the products of other
insurance companies, commercial banks, thrifts, mutual funds and broker dealers,
our insurance products compete with health maintenance organizations, preferred
provider organizations and other health care-related institutions which provide
medical benefits based on contractual agreements.
An important competitive factor for life insurance companies is the ratings
they receive from nationally recognized rating organizations. Agents, insurance
brokers and marketing companies who market our products and prospective
purchasers of our products use the ratings of our insurance subsidiaries as one
factor in determining which insurer's products to market or purchase. Ratings
have the most impact on our annuity, interest-sensitive life insurance and
long-term care products. Insurance financial strength ratings are opinions
regarding an insurance company's financial capacity to meet the obligations of
its insurance policies in accordance with their terms. They are not directed
toward the protection of investors, and such ratings are not recommendations to
buy, sell or hold securities.
On October 2, 2006, A.M. Best affirmed the financial strength rating of
"B++ (Very Good)" of our primary insurance subsidiaries, except Conseco Senior
Health Insurance Company ("Conseco Senior") (the issuer of most of our long-term
care business in our Other Business in Run-off segment), 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 as 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
13
rating to stable if one or more of the following occur:
- The long-term care business in the Other Business in Run-off segment
generates operating earnings based on generally accepted accounting
principles ("GAAP") of 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 loss for this segment was $41.9
million for the year ended December 31, 2006 and we contributed
capital of $110 million to Conseco Senior in 2006, including $80
million which was accrued at December 31, 2006 and paid in February
2007).
- 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 $189.0 million for the year ended December 31,
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 Other 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
loss for this segment was $41.9 million for the year ended December
31, 2006 and we contributed capital of $110 million to Conseco Senior
in 2006, including $80 million which was accrued at December 31, 2006
and paid in February 2007).
- 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 $258.4 million for the year ended December 31, 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 $189.0 million for the
year ended December 31, 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 was 6 percent in 2006).
- Maintain financial leverage below 25 percent with EBIT interest
coverage of at least five times. (We are exceeding these requirements
at December 31, 2006).
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 February 23, 2007, Standard & Poor's Corporation ("S&P") affirmed the
financial strength ratings of our core insurance subsidiaries and Conseco Senior
and revised its outlook on our primary insurance subsidiaries to stable from
positive, except Conseco Senior, for which the outlook was revised to negative
from stable. 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
14
"CCC" rating from S&P are the eleventh and eighteenth highest of twenty-one
possible ratings.
On March 8, 2006, Moody's Investor Services, Inc. ("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.
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 classified as "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
"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.
A.M. Best, S&P and Moody's review our ratings from time to time. We cannot
provide any assurance that the ratings of our insurance subsidiaries will remain
at their current levels or predict the impact of any future rating changes on
our business.
INSURANCE UNDERWRITING
Under regulations promulgated by the National Association of Insurance
Commissioners ("NAIC") (an association of state regulators and their staffs) and
adopted as a result of the Omnibus Budget Reconciliation Act of 1990, we are
prohibited from underwriting our Medicare supplement policies for certain
first-time purchasers. If a person applies for insurance within six months after
becoming eligible by reason of age, or disability in certain limited
circumstances, the application may not be rejected due to medical conditions.
Some states prohibit underwriting of all Medicare supplement policies. For other
prospective Medicare supplement policyholders, such as senior citizens who are
transferring to our products, the underwriting procedures are relatively
limited, except for policies providing prescription drug coverage.
Before issuing long-term care products, we generally apply detailed
underwriting procedures to assess and quantify the insurance risks. We require
medical examinations of applicants (including blood and urine tests, where
permitted) for certain health insurance products and for life insurance products
which exceed prescribed policy amounts. These requirements vary according to the
applicant's age and may vary by type of policy or product. We also rely on
medical records and the potential policyholder's written application. In recent
years, there have been significant regulatory changes with respect to
underwriting certain types of health insurance. An increasing number of states
prohibit underwriting and/or charging higher premiums for substandard risks. We
monitor changes in state regulation that affect our products, and consider these
regulatory developments in determining the products we market and where we
market them.
Our specified disease policies are individually underwritten using a
simplified issue application. Based on an applicant's responses on the
application, the underwriter either: (i) approves the policy as applied for;
(ii) approves the policy with reduced benefits; or (iii) rejects the
application.
Most of our life insurance policies are underwritten individually, although
standardized underwriting procedures have been adopted for certain low
face-amount life insurance coverages. After initial processing, insurance
underwriters obtain the information needed to make an underwriting decision
(such as medical examinations, doctors' statements and special medical tests).
After collecting and reviewing the information, the underwriter either: (i)
approves the policy as applied for; (ii) approves the policy with an extra
premium charge because of unfavorable factors; or (iii) rejects the application.
We underwrite group insurance policies based on the characteristics of the
group and its past claim experience. Graded benefit life insurance policies are
issued without medical examination or evidence of insurability. There is minimal
underwriting on annuities.
LIABILITIES FOR INSURANCE PRODUCTS
At December 31, 2006, the total balance of our liabilities for insurance
products was $26.0 billion. These liabilities are generally payable over an
extended period of time. The profitability of our insurance products depends on
pricing and other factors. Differences between our expectations when we sold
these products and our actual experience could result in future losses.
15
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on actuarial assumptions. For all of our
insurance products, we establish an active life reserve, a liability for due and
unpaid claims, claims in the course of settlement and incurred but not reported
claims. In addition, for our supplemental health insurance business, we
establish a reserve for the present value of amounts not yet due on incurred
claims. Many factors can affect these reserves and liabilities, such as economic
and social conditions, inflation, hospital and pharmaceutical costs, changes in
doctrines of legal liability and extra-contractual damage awards. Therefore, our
reserves and liabilities are necessarily based on extensive estimates,
assumptions and historical experience. Establishing reserves is an uncertain
process, and it is possible that actual claims will materially exceed our
reserves and have a material adverse effect on our results of operations and
financial condition. Our financial results depend significantly upon the extent
to which our actual claims experience is consistent with the assumptions we used
in determining our reserves and pricing our products. If our assumptions with
respect to future claims are incorrect, and our reserves are insufficient to
cover our actual losses and expenses, we would be required to increase our
liabilities, which would negatively affect our operating results.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and standard actuarial tables, of
mortality, morbidity, lapse rates, investment experience and expense levels.
REINSURANCE
Consistent with the general practice of the life insurance industry, our
subsidiaries enter into both facultative and treaty agreements of indemnity
reinsurance with other insurance companies in order to reinsure portions of the
coverage provided by our insurance products. Indemnity reinsurance agreements
are intended to limit a life insurer's maximum loss on a large or unusually
hazardous risk or to diversify its risk. Indemnity reinsurance does not
discharge the original insurer's primary liability to the insured. Our reinsured
business is ceded to numerous reinsurers. Based on our periodic review of their
financial statements, insurance industry reports and reports filed with state
insurance departments, we believe the assuming companies are able to honor all
contractual commitments.
As of December 31, 2006, the policy risk retention limit of our insurance
subsidiaries was generally $.8 million or less. Reinsurance ceded by Conseco
represented 24 percent of gross combined life insurance inforce and reinsurance
assumed represented 1.6 percent of net combined life insurance inforce. Our
principal reinsurers at December 31, 2006 were as follows (dollars in millions):
Ceded life A.M. Best
Name of Reinsurer insurance inforce rating
- ----------------- ----------------- ----------------
Swiss Re Life and Health America Inc.................................... $ 4,094.4 A+
Security Life of Denver Insurance Company............................... 3,645.4 A+
Reassure America Life Insurance Company................................. 2,553.8 A+
RGA Reinsurance Company................................................. 1,026.4 A+
Munich American Reassurance Company..................................... 954.6 A+
Lincoln National Life Insurance Company................................. 803.8 A+
Revios Reinsurance U.S. Inc............................................. 654.1 A-
Hannover Life Reassurance Company....................................... 492.1 A
All others.............................................................. 2,358.8
---------
$16,583.4
=========
<FN>
- --------------------
(a) No other single reinsurer assumed greater than 3 percent of the total
ceded business inforce.
</FN>
EMPLOYEES
At December 31, 2006, we had approximately 4,000 full time employees,
including 1,000 employees supporting our Bankers Life segment, 300 employees
supporting our Colonial Penn segment and 2,700 employees supporting our Conseco
Insurance Group segment, Other Business in Run-off segment and corporate
segment. None of our employees are covered by a collective bargaining agreement.
We believe that we have good relations with our employees.
16
GOVERNMENTAL REGULATION
Our insurance businesses are subject to extensive regulation and
supervision by the insurance regulatory agencies of the jurisdictions in which
they operate. This regulation and supervision is primarily for the benefit and
protection of customers, and not for the benefit of investors or creditors.
State laws generally establish supervisory agencies that have broad regulatory
authority, including the power to:
o grant and revoke business licenses;
o regulate and supervise trade practices and market conduct;
o establish guaranty associations;
o license agents;
o approve policy forms;
o approve premium rates for some lines of business;
o establish reserve requirements;
o prescribe the form and content of required financial statements and
reports;
o determine the reasonableness and adequacy of statutory capital and
surplus;
o perform financial, market conduct and other examinations;
o define acceptable accounting principles; and
o regulate the types and amounts of permitted investments.
In addition, the NAIC issues model laws and regulations, many of which have
been adopted by state insurance regulators, relating to:
o reserve requirements;
o risk-based capital ("RBC") standards;
o codification of insurance accounting principles;
o investment restrictions;
o restrictions on an insurance company's ability to pay dividends; and
o product illustrations.
In addition to the regulations described above, most states have also
enacted laws or regulations regarding the activities of insurance holding
company systems, including acquisitions, the terms of surplus debentures, the
terms of transactions between insurance companies and their affiliates and other
related matters. Various notice and reporting requirements generally apply to
transactions between insurance companies and their affiliates within an
insurance holding company system, depending on the size and nature of the
transactions. These requirements may include prior regulatory approval or prior
notice for certain material transactions. Currently, the Company and its
insurance subsidiaries are registered as a holding company system pursuant to
such laws and regulations in the domiciliary states of the insurance
subsidiaries. In addition, the Company's insurance subsidiaries routinely report
to other jurisdictions.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the
17
ability of our insurance subsidiaries to pay dividends is subject to state
insurance department regulations and is based on the financial statements of our
insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of, or in a few states, the lesser of:
o statutory net gain from operations or statutory net income for the
prior year; or
o 10 percent of statutory capital and surplus at the end of the
preceding year.
Any dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department.
In accordance with orders from the Florida Office of Insurance Regulation,
Conseco Senior may not distribute funds to any affiliate or shareholder unless
such distributions have been approved by the Florida Office of Insurance
Regulation and Washington National Insurance Company ("Washington National") may
not make similar distributions without prior notice to the Florida Office of
Insurance Regulation. In addition, the risk-based capital and other capital
requirements described below can also limit, in certain circumstances, the
ability of our insurance subsidiaries to pay dividends.
In connection with monitoring the financial condition of insurers, certain
state insurance departments have requested additional information from two of
the Company's insurance subsidiaries, Conseco Senior and Conseco Life Insurance
Company ("Conseco Life"), because such insurance subsidiaries have incurred
statutory losses in a 12 month period in excess of 50 percent of its capital and
surplus. The statutory losses of Conseco Life are primarily attributable to a
tentative litigation settlement. 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 "Commitments and
Contingencies". The statutory losses of Conseco Senior are primarily
attributable to the adverse development of prior period claim reserves and an
increase in initial claims during 2006 related to long-term care policies. Based
on our discussions with state insurance departments, we do not expect the
regulators to take any actions against Conseco Senior or Conseco Life due to the
causes of our statutory losses and the actions being undertaken by the Company.
Conseco Senior has 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 because we believe the existing rates are too low. In many
instances, we are requesting three years of consecutive rate increases. The full
effect of all three years of rate increases will take as long as five years to
be fully realized. It is likely 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 likely that we will not be able to obtain
approval for some of the rate increases currently pending or that 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.
During 2006, the Florida legislature enacted a statute, known as House Bill
947, intended to provide new protections to long-term care insurance
policyholders. Among other requirements, this statute requires: (i) claim
experience of affiliated long-term care insurers to be pooled in determining
justification for rate increases for Florida policyholders; and (ii) insurers
with closed blocks of long-term care insurance to not raise rates above the
comparable new business premium rates offered by affiliated insurers. The manner
in which the requirements of this statute are applied to our long-term care
policies in Florida (including policies subject to the order from the Florida
Office of Insurance Regulation as described in "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations - Other
Business in Run-off") may affect our ability to achieve our anticipated rate
increases on this business.
Most states have also enacted legislation or adopted administrative
regulations that affect the acquisition (or sale) of control of insurance
companies. The nature and extent of such legislation and regulations vary from
state to state. Generally, these regulations require an acquirer of control to
file detailed information and the plan of acquisition, and to obtain
administrative approval prior to the acquisition of control. "Control" is
generally defined as the direct or indirect power to direct or cause the
direction of the management and policies of a person and is rebuttably presumed
to exist if a person or group of affiliated persons directly or indirectly owns
or controls 10 percent or more of the voting securities of another
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person.
Using statutory statements filed with state regulators annually, the NAIC
calculates certain financial ratios to assist state regulators in monitoring the
financial condition of insurance companies. A "usual range" of results for each
ratio is used as a benchmark. In the past, variances in certain ratios of our
insurance subsidiaries have resulted in inquiries from insurance departments, to
which we have responded. These inquiries have not led to any restrictions
affecting our operations.
The NAIC's RBC requirements provide a tool for insurance regulators to
determine the levels of statutory capital and surplus an insurer must maintain
in relation to its insurance and investment risks and the need for possible
regulatory attention. The RBC requirements provide four levels of regulatory
attention, varying with the ratio of the insurance company's total adjusted
capital (defined as the total of its statutory capital and surplus, asset
valuation reserve ("AVR") and certain other adjustments) to its RBC (as measured
on December 31 of each year), as follows:
o if a company's total adjusted capital is less than 100 percent but
greater than or equal to 75 percent of its RBC (the "Company Action
Level"), the company must submit a comprehensive plan to the
regulatory authority proposing corrective actions aimed at improving
its capital position;
o if a company's total adjusted capital is less than 75 percent but
greater than or equal to 50 percent of its RBC (the "Regulatory Action
Level"), the regulatory authority will perform a special examination
of the company and issue an order specifying the corrective actions
that must be taken;
o if a company's total adjusted capital is less than 50 percent but
greater than or equal to 35 percent of its RBC (the "Authorized
Control Level"), the regulatory authority may take any action it deems
necessary, including placing the company under regulatory control; and
o if a company's total adjusted capital is less than 35 percent of its
RBC (the "Mandatory Control Level"), the regulatory authority must
place the company under its control.
In addition, the RBC requirements provide for a trend test if a company's
total adjusted capital is between 100 percent and 125 percent of its RBC at the
end of the year. The trend test calculates the greater of the decrease in the
margin of total adjusted capital over RBC:
o between the current year and the prior year; and
o for the average of the last 3 years.
It assumes that such decrease could occur again in the coming year. Any company
whose trended total adjusted capital is less than 95 percent of its RBC would
trigger a requirement to submit a comprehensive plan as described above for the
Company Action Level. In order to avoid triggering the trend test with respect
to Conseco Senior, we made capital contributions totaling $110.0 million during
2006 to Conseco Senior, including $80.0 million which was accrued at December
31, 2006, and paid in February 2007.
In addition to the RBC requirements, certain states have established
minimum capital requirements for insurance companies licensed to do business in
their state. These additional requirements generally have not had a significant
impact on the Company's insurance subsidiaries, but the capital requirements in
Florida have caused Conseco Health Insurance Company to maintain a higher level
of capital and surplus than it would otherwise maintain and have thus limited
its ability to pay dividends. Refer to the note entitled "Statutory Information"
in our notes to consolidated financial statements for more information on our
RBC ratios.
In addition, we may need to contribute additional capital to strengthen the
surplus of certain insurance subsidiaries and this could affect the ability of
our top tier insurance subsidiary to pay dividends. The ability of our insurance
subsidiaries to pay dividends is also impacted by various criteria established
by rating agencies for higher ratings. During 2006, we made capital
contributions of $75 million to one of our insurance subsidiaries (Conseco Life)
in an effort to meet such criteria.
The NAIC has adopted model long-term care policy language providing
nonforfeiture benefits and has proposed a rate stabilization standard for
long-term care policies. Various bills are introduced from time to time in the
U.S. Congress which propose the implementation of certain minimum consumer
protection standards in all long-term care policies, including guaranteed
renewability, protection against inflation and limitations on waiting periods
for pre-existing conditions. Federal
19
legislation permits premiums paid for qualified long-term care insurance to be
tax-deductible medical expenses and for benefits received on such policies to be
excluded from taxable income.
Our insurance subsidiaries are required, under guaranty fund laws of most
states, to pay assessments up to prescribed limits to fund policyholder losses
or liabilities of insolvent insurance companies. Assessments can be partially
recovered through a reduction in future premium taxes in some states.
Most states mandate minimum benefit standards and benefit ratios for
accident and health insurance policies. We are generally required to maintain,
with respect to our individual long-term care policies, minimum anticipated
benefit ratios over the entire period of coverage of not less than 60 percent.
With respect to our Medicare supplement policies, we are generally required to
attain and maintain an actual benefit ratio, after three years, of not less than
65 percent. We provide to the insurance departments of all states in which we
conduct business annual calculations that demonstrate compliance with required
minimum benefit ratios for both long-term care and Medicare supplement
insurance. These calculations are prepared utilizing statutory lapse and
interest rate assumptions. In the event that we fail to maintain minimum
mandated benefit ratios, our insurance subsidiaries could be required to provide
retrospective refunds and/or prospective rate reductions. We believe that our
insurance subsidiaries currently comply with all applicable mandated minimum
benefit ratios.
The federal government does not directly regulate the insurance business.
However, federal legislation and administrative policies in several areas,
including pension regulation, age and sex discrimination, financial services
regulation, securities regulation, privacy laws and federal taxation, do affect
the insurance business. Legislation has been introduced from time to time in
Congress that could result in the federal government assuming some direct role
in the regulation of insurance.
Numerous proposals to reform the current health care system (including
Medicare) have been introduced in Congress and in various state legislatures.
Proposals have included, among other things, modifications to the existing
employer-based insurance system, a quasi-regulated system of "managed
competition" among health plans, and a single-payer, public program. Changes in
health care policy could significantly affect our business. For example, Federal
comprehensive major medical or long-term care programs, if proposed and
implemented, could partially or fully replace some of Conseco's current
products. Recent federal and state legislation and legislative proposals
relating to healthcare reform contain features that could severely limit or
eliminate our ability to vary our pricing terms or apply medical underwriting
standards, which could have the effect of increasing our benefit ratios and
adversely affecting our financial results. Also, Medicare reform and legislation
concerning prescription drugs could affect our ability to price or sell our
products.
The United States Department of Health and Human Services has issued
regulations under the Health Insurance Portability and Accountability Act
("HIPAA") relating to standardized electronic transaction formats, code sets and
the privacy of member health information. These regulations, and any
corresponding state legislation, affect our administration of health insurance.
A number of states have passed or are considering legislation that limits
the differentials in rates that insurers could charge for health care coverages
between new business and renewal business for similar demographic groups. State
legislation has also been adopted or is being considered that would make health
insurance available to all small groups by requiring coverage of all employees
and their dependents, by limiting the applicability of pre-existing conditions
exclusions, by requiring insurers to offer a basic plan exempt from certain
benefits as well as a standard plan, or by establishing a mechanism to spread
the risk of high risk employees to all small group insurers. Congress and
various state legislators have from time to time proposed changes to the health
care system that could affect the relationship between health insurers and their
customers, including external review. We cannot predict with certainty the
effect of any legislative proposals on our insurance businesses and operation.
The asset management activities of 40|86 Advisors are subject to various
federal and state securities laws and regulations. The SEC and certain state
securities commissions are the principal regulators of our asset management
operations. In addition, Conseco has two subsidiaries that are registered as
broker/dealers. The broker/dealers are regulated by the National Association of
Securities Dealers and by state securities commissioners.
FEDERAL INCOME TAXATION
Our annuity and life insurance products generally provide policyholders
with an income tax advantage, as compared to other savings investments such as
certificates of deposit and bonds, because taxes on the increase in value of the
products are
20
deferred until received by policyholders. With other savings investments, the
increase in value is generally taxed as earned. Annuity benefits and life
insurance benefits, which accrue prior to the death of the policyholder, are
generally not taxable until paid. Life insurance death benefits are generally
exempt from income tax. Also, benefits received on immediate annuities (other
than structured settlements) are recognized as taxable income ratably, as
opposed to the methods used for some other investments which tend to accelerate
taxable income into earlier years. The tax advantage for annuities and life
insurance is provided in the Internal Revenue Code (the "Code"), and is
generally followed in all states and other United States taxing jurisdictions.
In recent years, Congress enacted legislation to lower marginal tax rates,
reduce the federal estate tax gradually over a ten-year period, with total
elimination of the federal estate tax in 2010, and increase contributions that
may be made to individual retirement accounts and 401(k) accounts. While these
tax law changes will sunset at the beginning of 2011 absent future congressional
action, they could in the interim diminish the appeal of our annuity and life
insurance products. Additionally, Congress has considered, from time to time,
other possible changes to the U.S. tax laws, including elimination of the tax
deferral on the accretion of value of certain annuities and life insurance
products. It is possible that further tax legislation will be enacted which
would contain provisions with possible adverse effects on our annuity and life
insurance products.
Our insurance company subsidiaries are taxed under the life insurance
company provisions of the Code. Provisions in the Code require a portion of the
expenses incurred in selling insurance products to be deducted over a period of
years, as opposed to immediate deduction in the year incurred. This provision
increases the tax for statutory accounting purposes, which reduces statutory
earnings and surplus and, accordingly, decreases the amount of cash dividends
that may be paid by the life insurance subsidiaries.
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss carryforwards
("NOLs"). 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 future taxable income during the periods in which our temporary
differences become deductible and before our NOLs expire. In addition, the use
of our NOLs is dependent, in part, on whether the Internal Revenue Service
("IRS") ultimately agrees with the tax position we plan to take in our current
and future tax returns. Accordingly, with respect to our deferred tax assets, we
assess the need for a valuation allowance on an ongoing basis.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance equal to our entire balance of
net deferred income tax assets because, at that time, the realization of such
deferred tax assets in future periods was uncertain. As of December 31, 2006,
2005 and 2004, we determined that a full valuation allowance was no longer
necessary. However, as further discussed in the note to the consolidated
financial statements entitled "Income Taxes", we continue to believe that it is
necessary to have a valuation allowance on a portion of our deferred tax asset.
This determination was made by evaluating each component of the deferred tax
assets and assessing the effects of limitations or issues on the value of such
component to be fully recognized in the future.
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. In addition, please refer to the "Cautionary Statement
Regarding Forward-Looking Statements" included in "Item 7 - Management's
Discussion and Analysis of Consolidated Financial Condition and Results of
Operations".
The limited historical claims experience on our long-term care products
could negatively impact our operations if our estimates prove wrong and we
have not adequately set premium rates.
In setting premium rates, we consider historical claims information and
other factors, but we cannot predict future claims with certainty. This is
particularly applicable to our long-term care insurance products, for which we
have relatively limited historical claims experience. Long-term care products
tend to have fewer claims than other health products such as Medicare
supplement, but when claims are incurred, they tend to be much higher in dollar
amount. Also, long-term care products have a much longer tail, meaning that
claims are incurred much later in the life of the policy than most other
supplemental health products. As a result of these traits, it is difficult to
appropriately price this product. For our long-term care insurance, actual
persistency in later policy durations that is higher than our persistency
assumptions could have a negative impact on profitability. If these policies
remain inforce longer than we assumed, then we could be required to make
21
greater benefit payment than anticipated when the products were priced.
Mortality is a critical factor influencing the length of time a claimant
receives long-term care benefits. Mortality continues to improve for the general
population, and life expectancy has increased. Changes in actual mortality
trends relative to assumptions may adversely affect our profitability.
Our Bankers Life segment has offered long-term care insurance since 1985.
The claims experience on our Bankers Life long-term care blocks has generally
been lower than our pricing expectations. However, the persistency of these
policies has been higher than our pricing expectations and this may result in
higher benefit ratios in the future.
The long-term care insurance businesses included in the Other Business in
Run-off segment were acquired through acquisitions completed in 1996 and 1997.
The majority of such business was written between 1990 and 1997. The experience
on these acquired blocks has generally been worse than the acquired companies'
original pricing expectations. We have received necessary regulatory approvals
for numerous premium rate increases in recent years pertaining to these blocks.
Even with these rate increases, these blocks experienced benefit ratios of 137
percent in 2006, 100 percent in 2005 and 103 percent in 2004. If future claims
experience proves to be worse than anticipated as our long-term care blocks
continue to age, our financial results could be adversely affected. In addition,
such rate increases may cause existing policyholders to allow their policies to
lapse, resulting in reduced profitability.
The results of operations of our insurance business will decline if our
premium rates are not adequate or if we are unable to obtain regulatory
approval to increase rates.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, maintenance costs to
administer the policies and the interest rate earned on our investment of
premiums. In setting premium rates, we consider historical claims information,
industry statistics, the rates of our competitors and other factors, but we
cannot predict with certainty the future actual claims on our products. If our
actual claims experience proves to be less favorable than we assumed and we are
unable to raise our premium rates, our financial results may be adversely
affected.
We review the adequacy of our premium rates regularly and file proposed
rate increases on our products when we believe existing premium rates are too
low. It is possible that we will not be able to obtain approval for premium rate
increases from currently pending requests or from future requests. If we are
unable to raise our premium rates because we fail to obtain approval in one or
more states, our financial results will be adversely affected. Moreover, in some
instances, our ability to exit unprofitable lines of business is limited by the
guaranteed renewal feature of the policy. Due to this feature, we cannot exit
such business without regulatory approval, and accordingly, we may be required
to continue to service those products at a loss for an extended period of time.
Most of our long-term care business is guaranteed renewable, and, if necessary
rate increases were not approved, we would be required to recognize a loss and
establish a premium deficiency reserve. During 2006, the financial statements of
three of our subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities reflected the
establishment of asset adequacy and premium deficiency reserves primarily
related to long-term care policies. Total asset adequacy and premium deficiency
reserves for Conseco Senior, Washington National and Bankers Conseco Life
Insurance Company were $30.0 million, $47.0 million and $16.6 million,
respectively at December 31, 2006. Due to increases to insurance liabilities at
the fresh-start date, we were not required to recognize a similar premium
deficiency reserve in our consolidated financial statements prepared in
accordance with GAAP.
If, however, we are successful in obtaining regulatory approval to raise
premium rates, the increased premium rates may reduce the volume of our new
sales and cause existing policyholders to allow their policies to lapse. This
could result in a significantly higher ratio of claim costs to premiums if
healthier policyholders who get coverage elsewhere allow their policies to
lapse, while policies of less healthy policyholders continue inforce. This would
reduce our premium income and profitability in future periods.
Most of our supplemental health policies allow us to increase premium rates
when warranted by our actual claims experience. These rate increases must be
approved by the applicable state insurance departments, and we are required to
submit actuarial claims data to support the need for such rate increases. The
re-rate application and approval process on supplemental health products is a
normal recurring part of our business operations and reasonable rate increases
are typically approved by the state departments as long as they are supported by
actual claims experience and are not unusually large in either dollar amount or
percentage increase. For policy types on which rate increases are a normal
recurring event, our estimates of insurance liabilities assume we will be able
to raise rates if experience on the blocks warrants such increases in the
future.
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The benefit ratio for our long-term care products included in the Other
Business in Run-off segment has increased in recent periods and was 137 percent
during 2006. We will have to raise rates or take other actions with respect to
some of these policies or our financial results will be adversely affected.
During 2006, 2005 and 2004, we received approvals (excluding rate increases
permitted in accordance with the Florida orders described in the following
paragraph) for rate increases totaling $12 million, $6 million and $48 million,
respectively, relating to this long-term care business, which had approximately
$325 million of collected premiums in 2006.
We are also seeking rate increases on approximately 65 percent of the total
long-term care inforce block in the Bankers Life segment. As a result of higher
persistency in this block and lower interest rates than assumed in the original
pricing, the current premium rates are too low. This process is proceeding
according to plan and, to date, we have already received approval for
approximately 80 percent of the total dollar amount of our requested increases.
However, it is possible that we will not be able to obtain approval for premium
rate increases from currently pending requests or future requests. If we are
unable to obtain these rate increases, the profitability of these policies and
the performance of this block of business could be adversely affected. In
addition, such rate increases may reduce the volume of our new sales and cause
existing policyholders to allow their policies to lapse, resulting in reduced
profitability.
We have implemented and will continue to implement from time to time and
when actuarially justified, premium rate increases in our long-term care
business. In some cases, we offer policyholders the opportunity to reduce their
coverage amounts or accept non-forfeiture benefits as alternatives to increasing
their premium rates. The financial impact of our rate increase actions could be
adversely affected by policyholder anti-selection, meaning that policyholders
who are less likely to incur claims may lapse their policies or reduce their
benefits, while policyholders who are more likely to incur claims may maintain
full coverage and accept their rate increase.
We have identified a material weakness in our internal control over
financial reporting, and our business and stock price may be adversely
affected if we have not adequately addressed the weakness or if we have
other material weaknesses or significant deficiencies in our internal
control over financial reporting.
We did not maintain effective controls over the accounting and disclosure
of insurance policy benefits and the liabilities for insurance products. We
identified a material weakness in internal controls over the actuarial reporting
processes related to the design of controls to ensure the completeness and
accuracy of the inforce policies for a block of single premium immediate
annuities in our Bankers Life segment, controls to ensure that accurate reserves
are established for all policy benefits related to certain supplemental
insurance coverages applicable to a block of specified disease policies in the
Conseco Insurance Group segment, and controls to ensure the accuracy of benefit
reserves on certain long-term care policies with inflation riders, lifetime
benefit features or non-forfeiture provisions in our Other Business in Run-off
segment. These control deficiencies resulted in adjustments to insurance policy
benefits and the liabilities for insurance products in the consolidated
financial statements for the year ended December 31, 2006. Additionally, these
control deficiencies could result in the misstatement of the aforementioned
accounts that would result in a material misstatement in our annual or interim
consolidated financial statements that would not be prevented or detected. If we
cannot produce reliable financial reports, investors could lose confidence in
our reported financial information, the market price of our stock could decline
significantly, we may be unable to obtain additional financing to operate and
expand our business, and our business and financial condition could be harmed.
See Item 9A of this annual report for additional information.
Our reserves for future insurance policy benefits and claims may prove to
be inadequate, requiring us to increase liabilities which results in
reduced net income and shareholders' equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders primarily based on assumptions made by our
actuaries. For our health insurance business, we establish an active life
reserve, a liability for due and unpaid claims, claims in the course of
settlement, and incurred but not reported claims, and a reserve for the present
value of amounts on incurred claims not yet due. We establish reserves based on
assumptions and estimates of factors either established at the fresh-start date
for business inforce then or considered when we set premium rates for business
written after that date.
Many factors can affect these reserves and liabilities, such as economic
and social conditions, inflation, hospital and pharmaceutical costs, changes in
life expectancy, regulatory actions, changes in doctrines of legal liability and
extra-contractual damage awards. Therefore, the reserves and liabilities we
establish are necessarily based on estimates, assumptions and prior years'
statistics. It is possible that actual claims will materially exceed our
reserves and have a material adverse effect on our results of operations and
financial condition. We have incurred significant losses beyond our estimates
23
as a result of actual claim costs and persistency of our long-term care business
included in the Other Business in Run-off segment. During the fourth quarter of
2006, our incurred claims increased by $54.1 million as a result of changes to
these blocks of claim liabilities due to prior period deficiencies. Our
financial performance depends significantly upon the extent to which our actual
claims experience and future expenses are consistent with the assumptions we
used in setting our reserves. If our assumptions with respect to future claims
are incorrect, and our reserves prove to be insufficient to cover our actual
losses and expenses, we would be required to increase our liabilities, and our
financial results could be adversely affected.
We may be required to accelerate the amortization of the cost of policies
produced or the value of policies inforce at the Effective Date.
Cost of policies produced represent the costs that vary with, and are
primarily related to, producing new insurance business. The value of policies
inforce at the Effective Date represents the value assigned to the right to
receive future cash flows from contracts existing at September 10, 2003. The
balances of these accounts are amortized over the expected lives of the
underlying insurance contracts. Management, on an ongoing basis, tests these
accounts recorded on our balance sheet to determine if these amounts are
recoverable under current assumptions. In addition, we regularly review the
estimates and assumptions underlying these accounts for those products for which
we amortize the cost of policies produced or the value of insurance inforce at
the Effective Date in proportion to gross profits or gross margins. If facts and
circumstances change, these tests and reviews could lead to reduction in the
balance of those accounts that could have an adverse effect on the results of
our operations and our financial condition.
Our net income and revenues will suffer if policyholder surrender levels
differ significantly from our assumptions.
Surrenders of our annuities and life insurance products can result in
losses and decreased revenues if surrender levels differ significantly from
assumed levels. At December 31, 2006, approximately 18 percent of our total
insurance liabilities, or approximately $4.7 billion, could be surrendered by
the policyholder without penalty. The surrender charges that are imposed on our
fixed rate annuities typically decline during a penalty period, which ranges
from five to twelve years after the date the policy is issued. Surrenders and
redemptions could require us to dispose of assets earlier than we had planned,
possibly at a loss. Moreover, surrenders and redemptions require faster
amortization of either the acquisition costs or the commissions associated with
the original sale of a product, thus reducing our net income. We believe
policyholders are generally more likely to surrender their policies if they
believe the issuer is having financial difficulties, or if they are able to
reinvest the policy's value at a higher rate of return in an alternative
insurance or investment product.
Our investment portfolio is subject to several risks that may diminish the
value of our invested assets and negatively impact our profitability.
The value of our investment portfolio is subject to numerous factors, which
are difficult to predict, and are often beyond our control. These factors
include, but are not limited to, the following:
o Changes in interest rates can reduce the value of our investments as
further discussed in the risk factor entitled "Changing interest rates
may adversely affect our results of operations".
o Changes in the ability of issuers to make timely repayments on
actively managed fixed maturity investments can reduce the value of
our investments. This risk is significantly greater with respect to
below-investment grade securities, which comprised 6.8 percent of our
actively managed fixed maturity investments as of December 31, 2006.
We have recorded writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which
caused us to conclude a decline in the fair value of the investment
was other than temporary as follows: $22.4 million in 2006; $14.7
million in 2005; and $18.1 million in 2004.
Our structured security investments, which comprised 26 percent of our
actively managed fixed maturity investments at December 31, 2006, are subject to
risks relating to variable prepayment and default on the assets underlying such
securities, such as mortgage loans. When structured securities prepay faster
than expected, investment income may be adversely affected due to the
acceleration of the amortization of purchase premiums or the inability to
reinvest at comparable yields in lower interest rate environments.
In the event of substantial product surrenders or policy claims, we may
choose to maintain highly liquid, and potentially lower-yielding, assets, or to
sell assets at a loss, thereby eroding the performance of our portfolio.
24
Because a substantial portion of our net income is derived from returns on
our investment portfolio, significant losses in the portfolio may have a direct
and materially adverse impact on our results of operations. In addition, losses
on our investment portfolio could reduce the investment returns that we are able
to credit to our customers of certain products, thereby impacting our sales and
eroding our financial performance.
Changing interest rates may adversely affect our results of operations.
Our profitability is affected by fluctuating interest rates. While we
monitor the interest rate environment and have previously employed hedging
strategies to mitigate such impact, our financial results could be adversely
affected by changes in interest rates. Our spread-based insurance and annuity
business is subject to several inherent risks arising from movements in interest
rates, especially if we fail to anticipate or respond to such movements. First,
interest rate changes can cause compression of our net spread between interest
earned on investments and interest credited to customer deposits. Our ability to
adjust for such a compression is limited by the guaranteed minimum rates that we
must credit to policyholders on certain products, as well as the terms on most
of our other products that limit reductions in the crediting rates to
pre-established intervals. As of December 31, 2006, approximately 40 percent of
our insurance liabilities were subject to interest rates that may be reset
annually; 46 percent had a fixed explicit interest rate for the duration of the
contract; 10 percent had credited rates that approximate the income we earn; and
the remainder had no explicit interest rates. Second, if interest rate changes
produce an unanticipated increase in surrenders of our spread-based products, we
may be forced to sell invested assets at a loss in order to fund such
surrenders. Third, the profits from many non-spread-based insurance products,
such as long-term care policies, can be adversely affected when interest rates
decline because we may be unable to reinvest the cash from premiums received at
the interest rates anticipated when we sold the policies. Finally, changes in
interest rates can have significant effects on the performance of our structured
securities portfolio, including collateralized mortgage obligations, as a result
of changes in the prepayment rate of the loans underlying such securities. We
follow asset/liability strategies that are designed to mitigate the effects of
interest rate changes on our profitability but do not currently extensively
employ derivative instruments for this purpose. We may not be successful in
implementing these strategies and achieving adequate investment spreads.
We use computer models to simulate our cash flows expected from existing
business under various interest rate scenarios. These simulations help us
measure the potential gain or loss in fair value of our interest-sensitive
financial instruments. With such estimates, we seek to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, exposure to
interest rate risk is minimized because a change in the value of assets should
be largely offset by a change in the value of liabilities. At December 31, 2006,
the duration of our fixed maturity investments (as modified to reflect
prepayments and potential calls) was approximately 7.0 years, and the duration
of our insurance liabilities was approximately 7.4 years. We estimate that our
fixed maturity securities and short-term investments, net of corresponding
changes in insurance acquisition costs, would decline in fair value by
approximately $515 million if interest rates were to increase by 10 percent from
rates as of December 31, 2006. This compares to a decline in fair value of $685
million based on amounts and rates at December 31, 2005. The calculations
involved in our computer simulations incorporate numerous assumptions, require
significant estimates and assume an immediate change in interest rates without
any management reaction to such change. Consequently, potential changes in the
values of our financial instruments indicated by the simulations will likely be
different from the actual changes experienced under given interest rate
scenarios, and the differences may be material. Because we actively manage our
investments and liabilities, our net exposure to interest rates can vary over
time.
Certain purported class action lawsuits could harm our financial strength
and reduce our profitability.
We are involved in a substantial amount of litigation, including class
action lawsuits. Plaintiffs in class action lawsuits against us may seek very
large or indeterminate amounts, including treble damages. 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 could have a material
adverse effect on our business, financial condition, results of operations and
cash flows.
The Company and certain subsidiaries, including principally Conseco Life,
have been named as defendants in multiple purported class actions and individual
cases alleging, among other things, breach of contract, violation of California
Business and Professions Code Section 17200, fraud and misrepresentation
regarding a change made in 2003 and 2004 in the way cost of insurance charges
and related monthly deductions were calculated for approximately 86,500 life
insurance policies. In April 2005, a nationwide class was certified with respect
to the breach of contract claim and, in California, a statewide class was
certified for injunctive and restitutionary relief pursuant to California
Business and Professions Code Section 17200 and breach of the duty of good faith
and fair dealing. These claims allege that the change to the calculation of cost
of insurance charges allowed us to add $360 million to our balance sheet. They
seek, among other things, an injunction that would require
25
the reinstatement of the prior method for calculating monthly cost of insurance
charges, and a refund of any additional charges that resulted from the change.
The Company has reached a tentative settlement of this lawsuit. See note 8 of
the consolidated financial statements. The ultimate outcome of this lawsuit
cannot be predicted with certainty. In addition, we and our subsidiaries may
become subject to similar litigation in other jurisdictions. In addition, a few
state insurance departments are reviewing the change to the calculation of
monthly deductions.
Litigation and regulatory investigations are inherent in our business and
may harm our financial strength and reduce our profitability.
Insurance companies historically have been subject to substantial
litigation resulting from claims, disputes and other matters. In addition to the
traditional policy claims associated with their businesses, insurance companies
typically face policyholder suits and class action suits. We also face
significant risks related to regulatory investigations and actions. The
litigation and regulatory investigations we are, have been, or may become
subject to include matters related to sales or underwriting practices, payment
of contingent or other sales commissions, claim payments and procedures, product
design, product disclosure, administration, additional premium charges for
premiums paid on a periodic basis, calculation of cost of insurance charges,
changes to certain non-guaranteed policy features, denial or delay of benefits,
charging excessive or impermissible fees on products and recommending unsuitable
products to customers. Certain of the Company's insurance policies allow or
require us to make changes based on experience to certain non-guaranteed
elements such as cost of insurance charges, expense loads, credited interest
rates and policyholder bonuses. The Company intends to make changes to certain
non-guaranteed elements in the future. In some instances in the past, such
action has resulted in litigation and similar litigation may arise in the
future. The Company's exposure, if any, arising from any such action cannot
presently be determined. Our pending legal and regulatory actions include
matters that are specific to us, as well as matters faced by other insurance
companies. State insurance departments focus on sales practices and product
issues in their market conduct examinations. Negotiated settlements of class
action and other lawsuits have had a material adverse effect on the business,
financial condition and results of operations of insurance companies. We are, in
the ordinary course of our business, a plaintiff or defendant in actions arising
out of our insurance business, including class actions and reinsurance disputes,
and, from time to time, we are also involved in various governmental and
administrative proceedings and investigations and inquiries such as information
requests, subpoenas and books and record examinations, from state, federal and
other authorities. The ultimate outcome of these lawsuits and investigations,
however, 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 could have a material adverse effect on
our business, financial condition, results of operations or cash flows. We could
also suffer significant reputational harm as a result of such litigation,
regulatory action or investigation which could have a material adverse effect on
our business, financial condition, results of operations or cash flows.
For a description of current legal proceedings, see note 8 of the
consolidated financial statements.
Our business is subject to extensive regulation, which limits our operating
flexibility and could result in our insurance subsidiaries being placed
under regulatory control or otherwise negatively impact our financial
results.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate. Our insurance subsidiaries are subject
to state insurance laws that establish supervisory agencies. Such agencies have
broad administrative powers including: granting and revoking licenses to
transact business; regulating sales and other practices; approving premium rate
increases; licensing agents; approving policy forms; setting reserve and
solvency requirements; determining the form and content of required statutory
financial statements; limiting dividends; and prescribing the type and amount of
investments insurers can make. The regulations issued by state insurance
agencies can be complex and subject to differing interpretations. If a state
insurance regulatory agency determines that one of our insurance company
subsidiaries is not in compliance with applicable regulations, the subsidiary is
subject to various potential administrative remedies including, without
limitation, monetary penalties, restrictions on the subsidiary's ability to do
business in that state and a return of a portion of policyholder premiums. In
addition, regulatory action or investigations could cause us to suffer
significant reputational harm, which could have an adverse effect on our
business, financial condition and results of operations.
In connection with monitoring the financial condition of insurers, certain
state insurance departments have requested additional information from two of
the Company's insurance subsidiaries, Conseco Senior and Conseco Life, as such
insurance subsidiaries have incurred statutory losses in a 12 month period in
excess of 50 percent of its capital and surplus. The statutory losses of Conseco
Life are primarily attributable to a tentative litigation settlement. 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 "Commitments and Contingencies". The statutory losses of
Conseco Senior are primarily
26
attributable to the adverse development of prior period claim reserves and an
increase in initial claims during 2006 related to long-term care policies. Based
on our discussions with state insurance departments, we do not expect the
regulators to take any actions against Conseco Senior or Conseco Life due to the
causes of our statutory losses and the actions being undertaken by the Company.
Our insurance subsidiaries are also subject to risk-based capital
requirements. These requirements were designed to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks
associated with asset quality, mortality and morbidity, asset and liability
matching and other business factors. The requirements are used by states as an
early warning tool to discover potential weakly-capitalized companies for the
purpose of initiating regulatory action. Generally, if an insurer's risk-based
capital falls below specified levels, the insurer would be subject to different
degrees of regulatory action depending upon the magnitude of the deficiency. The
2006 statutory annual statements filed with the state insurance regulators of
each of our insurance subsidiaries reflected total adjusted capital in excess of
the levels subjecting the subsidiaries to any regulatory action. However, the
risk-based capital ratio of Conseco Senior, which has experienced losses on its
long-term care business in our Other Business in Run-off segment, was near the
level at which it would have been required to submit a comprehensive plan to
insurance regulators proposing corrective actions aimed at improving its capital
position. We contributed $110.0 million to the capital and surplus of Conseco
Senior in 2006, including $80.0 million which was accrued at December 31, 2006,
and paid in February 2007.
Our results of operations may be negatively impacted if we are unable to
achieve the goals of our initiatives to restructure our principal insurance
businesses or if our planned conversions result in valuation differences.
Our Conseco Insurance Group segment has experienced decreases in premium
revenues and new annualized premiums in recent years as well as expense levels
that exceed product pricing expense assumptions. We have implemented several
initiatives to improve operating results, including: (i) focusing sales efforts
on higher margin products; (ii) reducing operating expenses by eliminating or
reducing marketing costs of certain products; (iii) streamlining administrative
procedures and reducing personnel; and (iv) increasing retention rates on our
more profitable blocks of inforce business. Our efforts to stabilize the
profitability of the long-term care block of business in run-off sold through
independent agents include premium rate increases, improved claim adjudication
procedures and other actions. Many of our initiatives address issues resulting
from the substantial number of acquisitions of our predecessor. Between 1982 and
1997, our predecessor completed 19 transactions involving the acquisitions of 44
separate insurance companies. Our efforts involve improvements to our policy
administration procedures and significant systems conversions, such as the
elimination of duplicate processing systems for similar business. These
initiatives may result in unforeseen expenses, complications or delays, and may
be inadequate to address all issues. In addition, changes to our claim
adjudication procedures have resulted in increased complaints from our
policyholders and, in some cases, have resulted in inquiries from state
regulators. Some of these initiatives have only recently begun to be executed,
and may not ultimately be successfully completed. While our future operating
performance depends greatly on the success of these efforts, even if we
successfully implement these measures, they alone may not sufficiently improve
our results of operations.
Conversions to new systems can result in valuation differences between the
prior system and the new system. We have recognized such differences in the
past. During the fourth quarter of 2005, our conversion to a seriatim-based
valuation system to determine reserves for the long-term care block of business
in run-off resulted in decreases to insurance liabilities of approximately $38
million. Our planned conversions could result in such valuation adjustments, and
there can be no assurance that these adjustments will not have a material
adverse effect on future earnings.
A failure to improve the financial strength ratings of our insurance
subsidiaries or a decline from the current ratings could cause us to
experience decreased sales, increased agent attrition and increased
policyholder lapses and redemptions.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. Agents,
insurance brokers and marketing companies who market our products, and
prospective policyholders view ratings as an important factor in evaluating an
insurer's products. This is especially true for annuity, interest-sensitive life
insurance and long-term care products. The current financial strength ratings of
our primary insurance subsidiaries (other than Conseco Senior) from A.M. Best,
S&P and Moody's are "B++ (Very Good)," "BB+" and "Baa3," respectively. The
ratings of Conseco Senior from A.M. Best, S&P and Moody's are "B (Fair)," "CCC"
and "Caa1," respectively. The "B++" rating and the "B" rating from A.M. Best are
the fifth and seventh highest, respectively, of sixteen possible ratings. The
"BB+" rating and the "CCC" rating from S&P are the eleventh and eighteenth
highest, respectively, of twenty-one possible ratings. The "Baa3" rating and the
"Caa1" rating from Moody's are the tenth and seventeenth highest of
27
twenty-one possible ratings. Most of our competitors have higher financial
strength ratings and, to be competitive, we believe it is critical to achieve
improved ratings.
If we fail to achieve and maintain an "A" category rating from A.M. Best or
if our ratings are downgraded, we may experience declining sales of certain of
our insurance products, defections of our independent and career sales force,
and increased policies being redeemed or allowed to lapse. These events would
adversely affect our financial results, which could then lead to ratings
downgrades.
Competition from companies that have greater market share, higher ratings,
greater financial resources and stronger brand recognition, may impair our
ability to retain existing customers and sales representatives, attract new
customers and sales representatives and maintain or improve our financial
results.
The supplemental health insurance, annuity and individual life insurance
markets are highly competitive. Competitors include other life and accident and
health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
Our principal competitors vary by product line. Our main competitors for
agent sold long-term care insurance products include Genworth Financial, John
Hancock Financial Services and MetLife. Our main competitors for agent sold
Medicare supplement insurance products include United HealthCare, Blue Cross and
Blue Shield Plans, Mutual of Omaha and United American.
In some of our product lines, such as life insurance and fixed annuities,
we have a relatively small market share. Even in some of the lines in which we
are one of the top five writers, our market share is relatively small. For
example, while our Bankers Life segment ranked fourth in annualized premiums of
individual long-term care insurance in 2006 with a market share of approximately
7 percent, the top three writers of individual long-term care insurance had
annualized premiums with a combined market share of approximately 57 percent
during the period. In addition, while our Bankers Life segment was ranked fourth
in direct premiums earned for individual Medicare supplement insurance in 2006
with a market share of 3.7 percent, the top writer of individual Medicare
supplement insurance had direct premiums with a market share of 12.1 percent
during the period.
Virtually all of our major competitors have higher financial strength
ratings than we do. Many of our competitors are larger companies that have
greater capital, technological and marketing resources and have access to
capital at a lower cost. Recent industry consolidation, including business
combinations among insurance and other financial services companies, has
resulted in larger competitors with even greater financial resources.
Furthermore, changes in federal law have narrowed the historical separation
between banks and insurance companies, enabling traditional banking institutions
to enter the insurance and annuity markets and further increase competition.
This increased competition may harm our ability to maintain or improve our
profitability.
In addition, because the actual cost of products is unknown when they are
sold, we are subject to competitors who may sell a product at a price that does
not cover its actual cost. Accordingly, if we do not also lower our prices for
similar products, we may lose market share to these competitors. If we lower our
prices to maintain market share, our profitability will decline.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among insurance and financial
services companies for sales representatives. We compete for sales
representatives primarily on the basis of our financial position, financial
strength ratings, support services, compensation and product features. Our
competitiveness for such agents also depends upon the relationships we develop
with these agents. Our Predecessor's bankruptcy continues to be an adverse
factor in developing relationships with certain agents. If we are unable to
attract and retain sufficient numbers of sales representatives to sell our
products, our ability to compete and our revenues and profitability would
suffer.
Volatility in the securities markets, and other economic factors, may
adversely affect our business, particularly our sales of certain life
insurance products and annuities.
Fluctuations in the securities markets and other economic factors may
adversely affect sales and/or policy surrenders of our annuities and life
insurance policies. For example, volatility in the equity markets may deter
potential purchasers from investing in equity-indexed annuities and may cause
current policyholders to surrender their policies for the cash value or to
reduce their investments. In addition, significant or unusual volatility in the
general level of interest rates could negatively impact sales and/or lapse rates
on certain types of insurance products.
28
Our ability to meet our obligations may be constrained by our subsidiaries'
ability to distribute cash to us.
Conseco, Inc. and CDOC, Inc. ("CDOC"), our wholly owned subsidiary and a
guarantor under our $675.0 million secured credit agreement (the "Second Amended
Credit Facility"), are holding companies with no business operations of their
own. As a result, they depend on their operating subsidiaries for cash to make
principal and interest payments on debt and to pay fees for services provided
pursuant to service agreements and income taxes. The cash they receive from
insurance subsidiaries consists of dividends and distributions, principal and
interest payments on surplus debentures, fees for services, tax-sharing
payments, and from our non-insurance subsidiaries, loans and advances. A
deterioration in the financial condition, earnings or cash flow of the
significant subsidiaries of us or CDOC for any reason could limit their ability
to pay cash dividends or other disbursements to us and CDOC. In addition, we may
need to contribute additional capital to improve the risk-based capital ratios
of certain insurance subsidiaries and this could affect the ability of our top
tier insurance subsidiary to pay dividends. Accordingly, this would limit the
ability of CDOC and us to meet debt service requirements and satisfy other
financial obligations.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the ability of our insurance subsidiaries to pay dividends is subject
to state insurance department regulations. Insurance regulations generally
permit dividends to be paid from statutory earned surplus of the insurance
company without regulatory approval 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 statutory 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. All of the dividends we plan to
have our insurance subsidiaries pay in 2007 will require regulatory approval.
In accordance with orders from the Florida Office of Insurance Regulation,
Conseco Senior may not distribute funds to any affiliate or shareholder unless
such distributions have been approved by the Florida Office of Insurance
Regulation and Washington National may not make similar distributions without
prior notice to the Florida Office of Insurance Regulation. In addition, the
risk-based capital and other capital requirements described below can also
limit, in certain circumstances, the ability of our insurance subsidiaries to
pay dividends.
Certain states have established minimum capital requirements for insurance
companies licensed to do business in their state. These additional requirements
generally have not had a significant impact on the Company's insurance
subsidiaries, but the capital requirements in Florida have caused Conseco Health
Insurance Company to maintain a higher level of capital and surplus than it
would otherwise maintain and have thus limited its ability to pay dividends.
In addition, we may need to contribute additional capital to strengthen the
surplus of certain insurance subsidiaries and this could affect the ability of
our top tier insurance subsidiary to pay dividends. The ability of our insurance
subsidiaries to pay dividends is also impacted by various criteria established
by rating agencies for higher ratings. During 2006 and 2005, we made capital
contributions of $75.0 million to Conseco Life and $160.5 million to Bankers
Life and Casualty, respectively, in an effort to meet such criteria.
The following table sets forth the aggregate amount of dividends and
other distributions that our insurance subsidiaries paid to us in each of the
last two fiscal years (dollars in millions):
Years ended December 31,
------------------------
2006 2005
---- ----
Dividends................................................................... $ 72.5 $ -
Surplus debenture interest.................................................. 68.2 54.8
Fees for services provided pursuant to service agreements................... 89.4 90.8
Tax sharing payments........................................................ (5.5) 1.1
------ ------
Total paid................................................................ $224.6 $146.7
====== ======
Federal and state legislation could adversely affect the financial
performance of our insurance operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and pending legislative proposals concerning
healthcare reform contain features that could severely limit, or eliminate, our
ability to vary pricing terms or apply medical underwriting
29
standards to individuals, thereby potentially increasing our benefit ratios and
adversely impacting our financial results. In particular, Medicare reform could
affect our ability to price or sell our products or profitably maintain our
blocks in force. For example, the Medicare Advantage program provides incentives
for health plans to offer managed care plans to seniors. The growth of managed
care plans under this program could decrease sales of the traditional Medicare
supplement products we sell.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards in all long-term care policies, including:
guaranteed premium rates; protection against inflation; limitations on waiting
periods for pre-existing conditions; setting standards for sales practices for
long-term care insurance; and guaranteed consumer access to information about
insurers, including information regarding lapse and replacement rates for
policies and the percentage of claims denied. Enactment of any proposal that
would limit the amount we can charge for our products, such as guaranteed
premium rates, or that would increase the benefits we must pay, such as
limitations on waiting periods, or that would otherwise increase the costs of
our business, could adversely affect our financial results.
Our Second Amended Credit Facility contains various restrictive covenants
and required financial ratios that limit our operating flexibility.
As of December 31, 2006, we had $673.3 million principal amount of debt
outstanding under our Second Amended Credit Facility. The Second Amended Credit
Facility imposes a number of covenants and financial ratios as defined in the
Second Amended Credit Facility that we must meet or maintain, including:
o a debt to total capitalization ratio;
o an interest coverage ratio;
o an aggregate risk-based capital ratio; and
o a combined statutory capital and surplus level.
At December 31, 2006, we were in compliance with all of the Second Amended
Credit Facility's covenants and financial ratios. Although our forecasts
indicate we will meet and/or maintain all of the Second Amended Credit
Facility's covenants and financial ratios, our ability to do so may be affected
by events beyond our control.
Our Second Amended Credit Facility also imposes restrictions that limit our
flexibility to plan for and react to changes in the economy and industry,
thereby increasing our vulnerability to adverse economic and industry
conditions. These restrictions include limitations on our ability to:
o incur additional indebtedness;
o transfer or sell assets;
o enter into mergers or other business combinations;
o pay cash dividends or repurchase stock; and
o make investments and capital expenditures.
S&P has assigned a "BB- (Marginal)" rating on our senior secured debt. In
S&P's view, an obligation rated "BB-" is less vulnerable to nonpayment than
other speculative issues, but faces major ongoing uncertainties or exposure to
adverse business, financial or economic conditions which could lead to the
obligor's inadequate capacity to meet its financial commitment on the
obligation. S&P has a total of twenty-two separate categories rating senior
debt, ranging from "AAA (Extremely Strong)" to "D (Payment Default)." A "BB-"
rating is the thirteenth highest rating. In March 2006, Moody's upgraded our
senior secured debt rating to "Ba3" from "B2" with a positive outlook. In
Moody's view, an obligation rated "Ba" is judged to have speculative elements
and its future can not be considered as being well-assured. The protection of
interest and principal payments may be very moderate, and thereby not
well-safeguarded during both good and bad times over the future. Moody's has a
total of twenty-one separate categories in which to rate senior debt, ranging
from "Aaa (Exceptional)" to "C (Lowest Rated)." A "Ba3" rating is the thirteenth
highest rating. If we were to require additional capital, either to refinance
our existing indebtedness or to help fund future growth, our current senior debt
ratings could restrict our access to such capital. A positive outlook by Moody's
is an opinion regarding the likely direction of a rating over the medium term.
30
Tax law changes could adversely affect our insurance product sales and
profitability.
We sell deferred annuities and some forms of life insurance that are
attractive, in part, because policyholders generally are not subject to United
States Federal income tax on increases in policy values until some form of
distribution is made. Congress has enacted legislation to lower marginal tax
rates, to reduce the federal estate tax gradually over a ten-year period (with
total elimination of the federal estate tax in 2010) and to increase
contributions that may be made to individual retirement accounts and 401(k)
accounts. While these tax law changes will expire at the beginning of 2011
absent future congressional action, they could in the interim diminish the
appeal of our annuity and life insurance products because the benefit of tax
deferral is lessened when tax rates are lower and because fewer people may
purchase these products when they can contribute more to individual retirement
accounts and 401(k) accounts. Additionally, Congress has considered, from time
to time, other possible changes to U.S. tax laws, including elimination of the
tax deferral on the accretion of value within certain annuities and life
insurance products. Such a change would make these products less attractive to
prospective purchasers and therefore would likely cause our sales of these
products to decline.
We face risk with respect to our reinsurance agreements.
We transfer exposure to certain risks to others through reinsurance
arrangements. Under these arrangements, other insurers assume a portion of our
losses and expenses associated with reported and unreported claims in exchange
for a portion of policy premiums. The availability, amount and cost of
reinsurance depend on general market conditions and may vary significantly. As
of December 31, 2006, our reinsurance receivables totaled $850.8 million. Our
ceded life insurance inforce totaled $16.6 billion. Our eight largest reinsurers
accounted for 86 percent of our ceded life insurance inforce. We face credit
risk with respect to reinsurance. When we obtain reinsurance, we are still
liable for those transferred risks if the reinsurer cannot meet its obligations.
Therefore, the inability of our reinsurers to meet their financial obligations
may require us to increase liabilities, thereby reducing our net income and
shareholders' equity.
Our insurance subsidiaries may be required to pay assessments to fund
policyholder losses or liabilities and this may negatively impact our
financial results.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments up to certain
prescribed limits to fund policyholder losses or liabilities of other insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Although past assessments have not been material, if there were a
number of large insolvencies, future assessments could be material and could
have a material adverse effect on our operating results and financial position.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2. PROPERTIES.
Our headquarters and the administrative operations of our Conseco Insurance
Group segment are located on a Company-owned 117-acre corporate campus in
Carmel, Indiana, immediately north of Indianapolis. The six buildings on the
campus contain approximately 626,000 square feet of space and house Conseco's
executive offices and certain administrative operations of its subsidiaries.
Management believes that our remaining office space is adequate for our needs.
Our Bankers Life segment is primarily administered from two facilities in
downtown Chicago, Illinois. Bankers Life has approximately 114,000 square feet
leased under an agreement which expires in 2018 and approximately 222,000 square
feet which expires in 2013. We also lease 213 sales offices in various states
totaling approximately 600,000 square feet. These leases are short-term in
length, with remaining lease terms expiring between 2007 and 2011.
Our Colonial Penn segment is administered from an office building in
Philadelphia, Pennsylvania with approximately 127,000 square feet. We occupy
approximately 60 percent of this space, with the remainder leased to tenants.
ITEM 3. LEGAL PROCEEDINGS.
Information required for Item 3 is incorporated by reference to the
discussion under the heading "Legal Proceedings" in note 8 "Commitments and
Contingencies" to our consolidated financial statements included in Item 8 of
this Form 10-K.
31
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
Executive Officers of the Registrant
Officer Positions with Conseco, Principal
Name and Age (a) Since Occupation and Business Experience (b)
---------------- ----- --------------------------------------
C. James Prieur, 55................................ 2006 Since September 2006, chief executive officer. From April 1999 until
September 2006, president and chief operating officer of Sun Life
Financial, Inc. and chief operating officer of its principal
subsidiary, Sun Life Assurance Company.
Eugene M. Bullis, 61............................... 2000 Since November 2002, executive vice president and chief financial
officer. From 2000 until 2002, Mr. Bullis served as chief financial
officer of Managed Ops.Com, Inc.
Mark E. Alberts, 41................................ 2004 Since January 2007, executive vice president and chief actuary. Mr.
Alberts has served in various actuarial capacities with Conseco since
2004 and also from 1991 to 2001. From 2001 until April 2004, senior
vice president, chief actuary, Standard Life Insurance Company of
Indiana.
Russell M. Bostick, 50............................. 2005 Since 2005, executive president and chief information officer. From
1998 until 2005, chief technology officer of Chase Insurance and its
predecessors.
Michael J. Dubes, 64............................... 2005 Since May 2005, president of Conseco Insurance Group. From 1965 until
its acquisition by ING in 2000, Mr. Dubes held a variety of executive
positions with ReliaStar. He was also an executive of ING Americas
from 2000 until his retirement in 2002. He then formed and was the
principal of Dubes Consulting Group and was affiliated with KNW Group
prior to joining Conseco.
Eric R. Johnson, 46................................ 1997 Since September 2003, president and chief executive officer of 40|86
Advisors, Inc. (formerly Conseco Capital Management, Inc.), Conseco's
wholly-owned registered investment advisor. Mr. Johnson has held
various positions since joining Conseco Capital Management, Inc. in
1997.
John R. Kline, 49.................................. 1990 Since July 2002, senior vice president and chief accounting officer.
Mr. Kline has served in various accounting and finance capacities
with Conseco since 1990.
Susan L. Menzel, 41................................ 2005 Since May 2005, executive vice president, human resources. From 2004
to May 2005, senior vice president, human resources of APAC Customer
Services. From 1997 to 2004, vice president, human resources of Sears
Roebuck.
Christopher J. Nickele, 50......................... 2005 Since October 2005, executive vice president, new product development.
From 2002 until September 2005, vice president - product development
of Lincoln National Corporation.
32
Officer Positions with Conseco, Principal
Name and Age (a) Since Occupation and Business Experience (b)
---------------- ----- --------------------------------------
Scott R. Perry, 44................................. 2001 Since 2006, president of Bankers Life. Employed in various capacities
for Bankers Life since 2001.
Steven M. Stecher, 46.............................. 2004 Since January 2007, executive vice president, operations. From August
2004 until January 2007, executive vice president of Conseco Insurance
Group. From 2003 until May 2004 chief information officer of Orix
Financial Services. From 1997 until 2002, Mr. Stecher held several
executive positions with ING Americas, including chief information
officer, vice president of strategic marketing and head of shared
services.
Daniel G. Walseth, 59.............................. 2006 Since April 2006, executive vice president, general counsel and
secretary. From 2002 to 2003, vice president and senior associate
general counsel for Thrivent Financial for Lutherans.
Messrs. Bullis and Kline served as officers of our Predecessor company,
which filed a bankruptcy petition on December 17, 2002. Mr. Bullis also served
as a director and/or officer of several subsidiaries of our Predecessor that
also filed bankruptcy petitions on December 17, 2002.
- --------------------
(a) The executive officers serve as such at the discretion of the Board of
Directors and are elected annually.
(b) Business experience is given for at least the last five years.
33
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
MARKET INFORMATION
The following table sets forth the ranges of high and low sales prices per
share for our common stock on the New York Stock Exchange for the quarterly
periods beginning January 1, 2005. There have been no dividends paid or declared
on our common stock during this period.
Period Market price
- ------ ------------------
High Low
---- ---
2005:
First Quarter........................................... $20.47 $18.80
Second Quarter.......................................... 22.10 19.15
Third Quarter........................................... 22.75 20.23
Fourth Quarter.......................................... 23.59 19.77
2006:
First Quarter........................................... $25.95 $23.16
Second Quarter.......................................... 25.86 22.00
Third Quarter........................................... 23.46 19.91
Fourth Quarter.......................................... 21.17 19.53
As of February 20, 2007, there were approximately 94,200 holders of the
outstanding shares of common stock, including individual participants in
securities position listings.
DIVIDENDS
The Company does not anticipate declaring or paying cash dividends on its
common stock in the foreseeable future, and is currently limited in doing so
pursuant to our credit agreement. Please refer to "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations -
Liquidity of the Holding Companies" for a further discussion of these
restrictions.
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes information, as of December 31, 2006,
relating to our common stock that may be issued under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan.
Number of securities
remaining available for
Number of securities Weighted-average future issuance under
to be issued upon exercise exercise price of equity compensation
of outstanding options, outstanding options, plans (excluding securities
warrants or rights warrants or rights reflected in first column)
------------------ ------------------ --------------------------
Equity compensation plans
approved by security holders...... 4,216,825 $20.76 4,019,986
Equity compensation plans not
approved by security holders...... - - -
--------- ------ ---------
Total................................. 4,216,825 $20.76 4,019,986
========= ====== =========
34
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
Successor Predecessor
--------------------------------------- ---------------------------
Years Four months Eight months
ended ended ended Year ended
December 31, December 31, August 31, December 31,
------------------------- ------------
2006 2005 2004 2003 2003 2002
---- ---- ---- ---- ---- ----
(Amounts in millions, except per share data)
STATEMENT OF OPERATIONS DATA(a)
Insurance policy income......................... $2,989.0 $2,930.1 $2,949.3 $1,005.8 $2,204.3 $ 3,602.3
Net investment income........................... 1,506.4 1,374.6 1,318.6 474.6 969.0 1,334.3
Net realized investment gains (losses) ......... (47.2) (2.9) 40.6 11.8 (5.4) (556.3)
Total revenues.................................. 4,467.4 4,326.5 4,330.0 1,505.5 3,203.4 4,450.4
Interest expense (contractual interest:
$268.5 for the eight months ended August 31,
2003; and $345.3 for 2002).................... 73.5 58.3 79.5 36.8 202.5 341.9
Total benefits and expenses..................... 4,315.1 3,823.1 3,875.9 1,356.0 1,031.2 6,082.6
Income (loss) before income taxes, minority
interest, discontinued operations and
cumulative effect of accounting change........ 152.3 503.4 454.1 149.5 2,172.2 (1,632.2)
Cumulative effect of accounting change, net
of income tax................................. - - - - - (2,949.2)
Net income (loss)............................... 96.5 324.9 294.8 96.3 2,201.7 (7,835.7)
Preferred stock dividends ...................... 38.0 38.0 65.5 27.8 - 2.1
Net income (loss) applicable to common stock.... 58.5 286.9 229.3 68.5 2,201.7 (7,837.8)
PER SHARE DATA
Net income, basic............................... $ .39 $ 1.90 $ 1.73 $ .68
Net income, diluted............................. .38 1.76 1.63 .67
Book value per common share outstanding......... 26.58 25.42 21.41 19.28
Weighted average shares outstanding for
basic earnings................................ 151.7 151.2 132.3 100.1
Weighted average shares outstanding for
diluted earnings.............................. 152.9 185.0 155.9 143.5
Shares outstanding at period-end................ 152.7 151.5 151.1 100.1
BALANCE SHEET DATA - AT PERIOD END(a)
Total investments............................... $25,736.4 $25,041.2 $24,306.3 $22,796.7 $22,018.3 $21,783.7
Goodwill ...................................... - - - 952.2 99.4 100.0
Total assets.................................... 32,717.3 31,525.3 30,732.6 29,990.4 28,318.1 46,509.0
Corporate notes payable......................... 1,000.8 851.5 768.0 1,300.0 - -
Liabilities subject to compromise............... - - - - 6,951.4 4,873.3
Total liabilities............................... 28,004.2 27,005.5 26,830.4 27,172.8 30,519.5 46,637.9
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts.. - - - - - 1,921.5
Shareholders' equity (deficit).................. 4,713.1 4,519.8 3,902.2 2,817.6 (2,201.4) (2,050.4)
STATUTORY DATA(b) - AT PERIOD END
Statutory capital and surplus................... $1,554.5 $1,603.8 $1,510.0 $1,514.1 $ 1,064.4
Asset valuation reserve ("AVR")................. 179.1 142.7 117.0 40.9 11.6
Total statutory capital and surplus and AVR..... 1,733.6 1,746.5 1,627.0 1,555.0 1,076.0
<FN>
- --------------------
(a) Our financial condition and results of operations have been
significantly affected during the periods presented by the
discontinued finance operations. As part of the Chapter 11
reorganization of our Predecessor company and some of its
non-insurance subsidiaries, we sold the assets of our finance business
and exited this line of business. We accounted for our finance
business as a discontinued operation in 2002 once we formalized our
plans to sell it. The sale of the finance business was completed in
the second quarter of 2003. We did not receive any proceeds from this
sale, nor did any creditors of our Predecessor. As of March 31, 2003,
we ceased to include the assets and liabilities of the finance
business in our Predecessor's consolidated balance sheet.
(b) We have derived the statutory data from statements filed by our
insurance subsidiaries with regulatory authorities which are prepared
in accordance with statutory accounting principles, which vary in
certain respects from GAAP.
</FN>
35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at December 31, 2006, and the consolidated results of operations for the years
ended December 31, 2006, 2005 and 2004 and, where appropriate, factors that may
affect future financial performance. Please read this discussion in conjunction
with the consolidated financial statements and notes included in this Form 10-K.
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" in Item 1A provide 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 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 changes in our assumptions related to the cost of policies produced or
the value of policies inforce at the Effective Date.
o our ability to achieve anticipated expense reductions and levels of
operational efficiencies including improvements in claims adjudication
and continued automation and rationalization of operating systems;
o performance of our investments;
o our ability to identify products and markets in which we can compete
effectively against competitors with greater market share, higher
ratings, greater financial resources and stronger brand recognition;
o the ultimate outcome of lawsuits filed against us and other legal and
regulatory proceedings to which we are subject;
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 our ability to achieve an upgrade of the financial strength ratings of
our insurance company subsidiaries as well as the potential impact of
rating downgrades on our business;
o the risk factors or uncertainties listed from time to time in our
filings with the SEC;
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;
36
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; and
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products.
Other factors and assumptions not identified above are also relevant to the
forward-looking statements, and if they prove incorrect, could also cause actual
results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
We manage our business through the following: three primary operating
segments, Bankers Life, Conseco Insurance Group and Colonial Penn, which are
defined on the basis of product distribution; a fourth segment comprised of
other business in run-off; and corporate operations. These segments reflect the
addition of Colonial Penn as a separate segment resulting from a change in how
management disaggregates the Company's operations for making internal operating
decisions in the fourth quarter of 2006. Colonial Penn's operations were
previously aggregated with the Bankers Life segment. We have restated all prior
period segment disclosures to conform to management's current view of the
Company's operating segments. Our segments are described below:
o Bankers Life, which consists of the business of 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
approximately 4,650 exclusive career agents and sales managers.
Bankers Life and Casualty markets its products under its own brand
name and Medicare Part D products through a marketing agreement with
Coventry.
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 over
500 IMOs that represent over 6,400 producing independent agents. This
segment markets its products under the "Conseco" and "Washington
National" (a wholly-owned insurance subsidiary of Conseco) brand
names.
o Colonial Penn, which consists of the business of Colonial Penn,
markets graded benefit and simplified issue life insurance directly to
customers through television advertising, direct mail, the internet
and telemarketing. Colonial Penn markets its products under its own
brand name.
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.
o Corporate operations, which consists of holding company activities and
certain noninsurance company businesses that are not related to our
operating segments.
For the year ended December 31, 2006, net income after dividends on our
preferred stock totaled $58.5 million, or $.38 per diluted share.
37
Our major goals for 2007 are to continue to strengthen our balance sheet
and improve our execution on the basics of our business by:
o Increasing emphasis on sales and revenue growth.
o Further reducing operating expenses and improving the efficiency of
our operations.
o Continuing to build best practices in governance and compliance.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Management has made estimates in the past
that we believed to be appropriate but were subsequently revised to reflect
actual experience. If our future experience differs materially from these
estimates and assumptions, our results of operations and financial condition
could be affected.
We base our estimates on historical experience and other assumptions that
we believe are reasonable under the circumstances. We continually evaluate the
information used to make these estimates as our business and the economic
environment change. The use of estimates is pervasive throughout our financial
statements. The accounting policies and estimates we consider most critical are
summarized below. Additional information on our accounting policies is included
in the note to our consolidated financial statements entitled "Summary of
Significant Accounting Policies".
Investments
At December 31, 2006, the carrying value of our investment portfolio was
$25.7 billion. The accounting risks associated with investments relate to the
recognition of income, our determination of other-than-temporary impairments and
our estimation of fair values.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments. We consider anticipated prepayments on
structured securities when we estimate yields on such securities. When actual
prepayments differ from our estimates, the adjustment to yield is recognized as
investment income (loss).
We regularly evaluate our investments for possible impairment based on
current economic conditions, credit loss experience and other investee-specific
developments. When we conclude that a decline in a security's net realizable
value is other than temporary, the decline is recognized as a realized loss and
the cost basis of the security is reduced to its estimated fair value. During
the year ended December 31, 2006, we recorded $22.4 million of such writedowns
of investments.
Our evaluation of investments for impairment requires significant
judgments, including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) the assessment
of whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of a realized
investment loss at that time.
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. At December
31, 2006, our net accumulated other comprehensive income (loss) included gross
unrealized losses on fixed maturity securities of $342.3 million, which we
consider to be temporary declines in estimated fair value.
When the cost basis of a security is written down to fair value due to an
other than temporary decline, we review the
38
circumstances of that particular investment in relation to other investments in
our portfolio. If such circumstances exist with respect to other investments,
those investments are also written down to fair value. Future events may occur,
or additional or updated information may become available, which may necessitate
future realized losses of securities in our portfolio. Significant realized
losses on our investments could have a material adverse effect on our earnings
in future periods.
Estimated fair values for our investments are determined by using
nationally recognized pricing services, broker-dealer market makers and
internally developed methods. Our internally developed methods require us to
make judgments about the security's credit quality, liquidity and market spread.
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.
During 2006, we sold $6.4 billion of fixed maturity investments which
resulted in net realized investment losses of $28.4 million. Our fixed maturity
investments are generally purchased in the context of a long-term strategy to
fund insurance liabilities, so we do not generally seek to purchase and sell
such securities to generate gains. In certain circumstances, including those in
which securities are selling at prices which exceed our view of their current
fair value, and it is possible to reinvest the proceeds to better meet our
long-term asset-liability objectives, we may sell certain securities. During
2006, we sold $3.2 billion of fixed maturity investments which resulted in gross
investment losses (before income taxes) of $98.5 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 generally seek to balance the duration and cash flows of our invested
assets with the estimated duration and cash flows of benefit payments arising
from contract liabilities. These efforts may cause us to sell investments before
their maturity date and could result in the realization of net realized
investment gains (losses). When the estimated durations of assets and
liabilities are similar, exposure to interest rate risk is minimized because a
change in the value of assets should be largely offset by a change in the value
of liabilities. In certain circumstances, a mismatch of the durations or related
cash flows of invested assets and insurance liabilities could have a significant
impact on our results of operations and financial position. See "-- Quantitative
and Qualitative Disclosures About Market Risks" for additional discussion of the
duration of our invested assets and insurance liabilities.
For more information on our investment portfolio and our critical
accounting policies related to investments, see the note to our consolidated
financial statements entitled "Investments".
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 contracts
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 same manner as the cost of
policies produced described below. We expect to amortize approximately 13
percent of the December 31, 2006 balance of value of policies inforce in 2007,
11 percent in 2008, 10 percent in 2009, 9 percent in 2010 and 7 percent in 2011.
The cost of policies produced are those costs that vary with, and are
primarily related to, producing new insurance business in the period after
September 10, 2003. For universal life or investment products, we amortize these
costs using the interest rate credited to the underlying policy in relation to
the estimated gross profits. For other products, we amortize these costs using
the projected investment earnings rate in relation to future anticipated premium
revenue. The value of policies inforce and the cost of policies produced are
collectively referred to as "insurance acquisition costs."
39
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.
During the fourth quarter of 2006, we recognized additional amortization
expense of $7.8 million to reflect a change in an actuarial assumption related
to a block of interest-sensitive life insurance policies based on a change in
management's intent on the administration of such policies. The policies
affected by the adjustments described above were issued through a subsidiary
prior to its acquisition by Conseco in 1996.
During the first quarter of 2006, we made certain adjustments to our
assumptions of expected future profits for the annuity and universal life blocks
of business in this segment related to investment returns, lapse rates, the cost
of options underlying our equity-indexed products and other refinements. We
recognized additional amortization expense of $12.4 million in 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.
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 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
increased (decreased) amortization expense for such changes by $(10.1) million,
$(2.8) million and $13.4 million during the years ended December 31, 2006, 2005
and 2004, 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 $32.4 million at December 31, 2006.
At December 31, 2006, the balance of insurance acquisition costs was $3.2
billion. The recoverability of this amount
40
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 revisions to certain assumptions
--------------------------------
(dollars in millions)
Universal life-type products (a):
5% increase to assumed mortality.................................. $(36.4)
5% decrease to assumed mortality.................................. 28.0
15% increase to assumed expenses.................................. (9.0)
15% decrease to assumed expenses.................................. 7.9
10 basis point decrease to assumed spread......................... (7.7)
10 basis point increase to assumed spread......................... 7.2
Investment-type products:
20% increase to assumed surrenders................................ $(8.8)
20% decrease to assumed surrenders................................ 10.5
15% increase to assumed expenses.................................. (2.6)
15% decrease to assumed expenses.................................. 2.5
10 basis point decrease to assumed spread......................... (7.9)
10 basis point increase to assumed spread......................... 7.4
Other than universal life and investment-type products(b):
5% increase to assumed morbidity.................................. (40.4)
<FN>
- --------------------
(a) 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.
(b) We have excluded the effect of reasonably likely changes in mortality,
lapse, surrender, expense and investment spread 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.
</FN>
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 with 50 percent of net premiums and related policy benefits
subject to a risk corridor. The Part D program became effective January 1, 2006.
Pursuant to the Coventry Medicare Part D Plan, the insurance plan covers 75
percent of the policyholder's prescription drug costs
41
up to $2,250; zero percent from $2,251 to $5,100; and 95 percent over $5,100.
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").
The following summarizes the income before income taxes recognized on this
business (primarily in the Bankers Life segment) (dollars in millions):
2006
----
Insurance policy income......................................................................... $74.4 (a)
Fee revenue and other........................................................................... 5.3
-----
Total revenues................................................................................ 79.7
-----
Insurance policy benefits....................................................................... 59.6
Commission expense.............................................................................. 8.7
Other operating expenses........................................................................ 6.5
-----
Total expense................................................................................. 74.8
-----
Income before income tax...................................................................... $ 4.9
=====
<FN>
- -----------
(a) Such amounts include our quota-share of premiums collected by Coventry
summarized as follows (dollars in millions):
</FN>
2006
----
Premiums from the CMS........................................................................... $53.2
CMS risk share premium.......................................................................... (7.5)
Premiums from the policyholders................................................................. 28.7
-----
$74.4
=====
42
Income Taxes
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 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 because we believed that the realization of such
net deferred income tax assets in future periods was uncertain. During 2004,
2005 and 2006, we concluded that it was no longer necessary to hold certain
portions of the previously established valuation allowance. Accordingly, we
reduced our valuation allowance by $947.0 million, $585.8 million and $260.0
million in 2004, 2005 and 2006, respectively. We are required to continue to
hold a valuation allowance of $777.8 million at December 31, 2006 because we
have determined that it is more likely than not that a portion of our deferred
tax assets will not be realized. This determination was made by evaluating each
component of the deferred tax asset and assessing the effects of limitations or
interpretations on the value of such component to be fully recognized in the
future.
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 extent to which losses
realized by a life insurance entity (or entities) may offset income from a
non-life entity (or entities).
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 $142 million per year with any unused amounts
carried forward to the following year. Our Section 382 limitation for 2007 will
be approximately $424 million (including $282 million of unused amounts carried
forward from prior years).
43
Changes in our valuation allowance are summarized as follows (dollars in
millions):
Balance at December 31, 2003............................................. $2,362.1
Realization of deferred income taxes recognized
in 2004 (a)......................................................... (168.6)
Release of tax valuation reserve related to unrealized
gains during 2004 (a)............................................... (65.4)
Recovery of amounts related to our bankruptcy and
state taxes (a)..................................................... (4.1)
Increase in deferred tax assets related to the worthlessness
of CFC.............................................................. 500.1
Release of valuation allowance (a)..................................... (947.0)
Deferred tax assets not realizable..................................... (47.5)
--------
Balance at December 31, 2004............................................. 1,629.6
Release of valuation allowance (b)..................................... (585.8)
--------
Balance at December 31, 2005............................................. 1,043.8
Decrease due to expiration of NOL and capital loss carryforwards....... (6.0)
Release of valuation allowance (b)..................................... (260.0)
--------
Balance at December 31, 2006............................................. $ 777.8
========
<FN>
- --------------------
(a) There is a corresponding increase (decrease) for these items in the
following accounts: (i) goodwill - ($952.2) million; (ii) other
intangible assets - $(171.1) million; and (iii) additional paid-in
capital - $61.8 million.
(b) There is a corresponding increase to additional paid-in capital.
</FN>
As of December 31, 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) Capital loss Total loss Total loss carryforwards
--------------------- ---------------------------------------
Year of expiration Life Non-life carryforwards carryforwards Subject to ss.382 Not subject to ss.382
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
2007....... $ - $ .1 $ 449.1 $ 449.2 $ 449.2 $ -
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....... - 1.6 - 1.6 1.6 -
2016....... 16.9 - - 16.9 16.9 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6 (a) .7 - 2,171.3 44.8 2,126.5
2019....... - .8 - .8 .8 -
2021....... 66.0 - - 66.0 - 66.0
2023....... - 2,070.7 (a) - 2,070.7 60.6 2,010.1
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 29.0 - 29.0 - 29.0
-------- -------- -------- -------- -------- --------
Total...... $2,286.7 $2,228.7 $1,119.0 $5,634.4 $1,194.6 $4,439.8
======== ======== ======== ======== ======== ========
<FN>
- --------------------
(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
</FN>
44
indebtedness income. This matter is described below. 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 following paragraphs describe an open matter related to the
classification of our NOLs.
In July 2006, the Joint Committee of Taxation accepted the audit and the
settlement 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.
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 Statement of Financial Accounting Standards No. 123
(revised 2004) "Share-Based Payment" ("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 $.6 million related to deductions for stock
options and restricted stock will be reflected in additional paid-in capital if
realized.
Liabilities for Insurance Products
At December 31, 2006, the total balance of our liabilities for insurance
products was $26.0 billion. These liabilities are generally payable over an
extended period of time and the profitability of the related products is
dependent on the pricing of the products and other factors. Differences between
our expectations when we sold these products and our actual experience could
result in future losses.
We calculate and maintain reserves for the future payment of claims to our
policyholders based on actuarial assumptions. For all our insurance products, we
establish an active life reserve, a liability for due and unpaid claims, claims
in the course of settlement and incurred but not reported claims. In addition,
for our supplemental health insurance business, we establish a reserve for the
present value of amounts not yet due on claims. Many factors can affect these
reserves and liabilities, such as economic and social conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal liability and
extra-contractual damage awards. Therefore, our reserves and liabilities are
necessarily based on numerous estimates and assumptions as well as historical
experience. Establishing reserves is an uncertain process, and it is possible
that actual claims will materially exceed our reserves and have a material
adverse effect on our results of operations and financial condition. We have
incurred significant losses beyond our estimates as a result of actual claim
costs and persistency of our long-term care business included in the Other
Business in Run-off segment. During the fourth quarter of 2006, our incurred
claims increased by $54.1 million as a result of changes to these blocks of
claims due to prior period deficiencies (including $24.5 million related to
claims with incurral dates in the first three quarters of 2006 and $29.6 million
related to prior years). Our financial results depend significantly upon the
extent to which our actual claims experience is consistent with the assumptions
we used in determining our reserves and pricing our products. If our assumptions
with respect to future claims are incorrect, and our reserves are insufficient
to cover our actual losses and expenses, we would be required to increase our
liabilities, which would negatively affect our operating results.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and standard actuarial tables, of
mortality, morbidity, lapse rates, investment experience and expense levels.
45
Accounting for Long-term Care Premium Rate Increases
Many of our long-term care policies were subject to premium rate increases
in 2006. In some cases, these premium rate increases were reasonably consistent
with the assumptions we used to value the particular block at the fresh-start
date. In other cases, the premium rate increases were materially different from
that assumed at the fresh-start date, leading us to change our best estimates of
future actuarial assumptions. With respect to the 2006 premium rate increases,
some of our policyholders were provided an option to cease paying their premiums
and receive a non-forfeiture option in the form of a paid-up policy with limited
benefits. In addition, our policyholders could choose to reduce their coverage
amounts and premiums in the same proportion, when permitted by our contracts or
as required by regulators. The following describes how we account for these
policyholder options:
o Premium rate increases - If premium rate increases reflect a change in
our previous rate increase assumptions, the new assumptions are
reflected prospectively in our reserves and deferred insurance
acquisition costs (including the cost of policies produced and the
value of policies inforce at the Effective Date) using a method known
as the "pivot" method. The pivot method describes a modification to
the valuation approach whereby our reserves and deferred insurance
acquisition costs are unchanged at the time of the premium rate
increase, but the future pattern of reserve changes is modified to
reflect the relationship of premiums to benefits based on the current
best estimate of future claim cost, morbidity, persistency and
investment returns. If there is no significant change in underlying
premium rate assumptions, a premium rate increase has no effect on
reserves or deferred insurance acquisition costs.
o Benefit reductions - A policyholder may choose reduced coverage with a
proportionate reduction in premium, when permitted by our contracts.
This option does not require additional underwriting. Benefit
reductions are treated as a partial lapse of coverage, and the balance
of our reserves and deferred insurance acquisition costs is reduced in
proportion to the reduced coverage.
o Non-forfeiture benefits offered in conjunction with a rate increase -
In some cases, non-forfeiture benefits are offered to policyholders
who wish to lapse their policies at the time of a significant rate
increase. In these cases, exercise of this option is treated as an
extinguishment of the original contract and issuance of a new
contract. The balance of reserves and deferred insurance acquisition
cost are released, and a reserve for the new contract is established.
o Florida Order - The Florida Office of Insurance Regulation issued an
order to our subsidiaries in the Other Business in Run-off segment
regarding their long-term care business in Florida. The order required
them to offer a choice of three alternatives to holders of home health
care policies in Florida subject to premium rate increases as follows:
o retention of their current policy with a rate increase of 50
percent in the first year and actuarially justified
increases in subsequent years;
o receipt of a replacement policy with reduced benefits and a
rate increase in the first year of 25 percent and no more
than 15 percent in subsequent years; or
o receipt of a paid-up policy, allowing the holder to file
future claims up to 100 percent of the amount of premiums
paid since the inception of the policy.
Reserves for all three groups of policies under the order were
prospectively adjusted using the pivot method described above, as
these alternatives were required by the Florida Office of Insurance
Regulation. There were no deferred insurance acquisition costs
associated with these policies.
Some of our policyholders may receive a non-forfeiture benefit if they cease
paying their premiums pursuant to their original contract (or pursuant to
changes made to their original contract as a result of a litigation settlement
made prior to the fresh-start date or an order issued by the Florida Office of
Insurance Regulation). In these cases, exercise of this option is treated as the
exercise of a policy benefit, and the reserve for premium paying benefits is
reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect
the election of this benefit.
46
Liabilities for Loss Contingencies Related to Lawsuits and Our Guarantees
of Bank Loans and Related Interest Loans
We are involved on an ongoing basis in arbitrations and lawsuits, including
purported class actions. The ultimate outcome of these legal matters cannot be
predicted with certainty. We recognize an estimated loss from these loss
contingencies when we believe it is probable that a loss has been incurred and
the amount of the loss can be reasonably estimated. However, it is difficult to
measure the actual loss that might be incurred related to litigation. The
ultimate outcome of these lawsuits could have a significant impact on our
results of operations and financial position.
In conjunction with our bankruptcy reorganization in 2003, $481.3 million
principal amount of bank loans made to certain former directors and employees to
enable them to purchase common stock of Old Conseco were transferred to the
Company. These loans had been guaranteed by Old Conseco. We received all rights
to collect the balances due pursuant to the original terms of these loans. In
addition, we hold loans to participants for interest on the 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 December 31, 2006, we have estimated that
approximately $22.9 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 connection with our bankruptcy
reorganization in 2003, the former holders of TOPrS (issued by Old Conseco's
subsidiary trusts and eliminated in our reorganization) who did not opt out of
the bankruptcy settlement will be entitled to receive 45 percent of any proceeds
from the collection of certain D&O loans in an aggregate amount not to exceed
$30 million. As of December 31, 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.
47
RESULTS OF OPERATIONS:
We manage our business through the following: three primary operating
segments, Bankers Life, Conseco Insurance Group and Colonial Penn which are
defined on the basis of product distribution; a fourth segment comprised of
other business in run-off; and corporate operations, which consists of holding
company activities and certain noninsurance businesses.
Please read this discussion in conjunction with the consolidated financial
statements and notes included in this Form 10-K.
The following tables and narratives summarize the operating results of our
segments (dollars in millions):
2006 2005 2004
---- ---- ----
Income (loss) before net realized investment gains (losses), net of
related amortization and income taxes (a non-GAAP measure) (a):
Bankers Life ...................................................... $258.4 $234.4 $ 210.9
Conseco Insurance Group............................................ 32.0 256.7 257.7
Colonial Penn...................................................... 21.6 20.0 18.0
Other Business in Run-off.......................................... (41.9) 77.2 65.8
Corporate operations............................................... (80.7) (84.8) (125.5)
------ ------ -------
189.4 503.5 426.9
------ ------ -------
Net realized investment gains (losses), net of related amortization:
Bankers Life ...................................................... (16.3) (3.2) 10.6
Conseco Insurance Group............................................ (12.6) 3.4 12.8
Colonial Penn...................................................... .2 .6 2.1
Other Business in Run-off.......................................... (8.0) .5 4.5
Corporate operations............................................... (.4) (1.4) (2.8)
------ ------ -------
(37.1) (.1) 27.2
------ ------ -------
Income (loss) before income taxes:
Bankers Life ...................................................... 242.1 231.2 221.5
Conseco Insurance Group............................................ 19.4 260.1 270.5
Colonial Penn...................................................... 21.8 20.6 20.1
Other Business in Run-off.......................................... (49.9) 77.7 70.3
Corporate operations............................................... (81.1) (86.2) (128.3)
------ ------ -------
Income before income taxes........................................ $152.3 $503.4 $ 454.1
====== ====== =======
<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, through our Conseco Insurance
Group segment, which utilizes professional independent producers, and through
our Colonial Penn segment, which utilizes direct response marketing. 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-
48
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 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 2006. Refer to the analysis which follows for
more information.
Bankers Life (dollars in millions)
2006 2005 2004
---- ---- ----
Premium collections:
Annuities........................................................... $ 997.5 $ 951.1 $ 950.5
Supplemental health................................................. 1,308.3 1,213.7 1,172.9
Life................................................................ 184.2 152.1 101.2
-------- -------- --------
Total collections................................................. $2,490.0 $2,316.9 $2,224.6
======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based................................................. $ 277.6 $ 268.0 $ 261.3
Equity-indexed.................................................. 500.2 324.9 276.5
Deposit based................................................... 4,435.4 4,087.6 3,504.8
Health.............................................................. 3,300.6 3,032.2 2,771.6
Life:
Interest sensitive.............................................. 348.2 324.8 307.8
Non-interest sensitive.......................................... 246.7 196.5 184.0
-------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded.......................... $9,108.7 $8,234.0 $7,306.0
======== ======== ========
Revenues:
Insurance policy income............................................. $1,545.5 $1,405.7 $1,307.5
Net investment income:
General account invested assets................................... 513.3 450.6 384.3
Equity-indexed products based on the change in value of options... 12.3 (2.6) 2.6
Fee revenue and other income........................................ 6.0 1.1 1.5
-------- -------- --------
Total revenues.................................................. 2,077.1 1,854.8 1,695.9
-------- -------- --------
Expenses:
Insurance policy benefits........................................... 1,242.6 1,128.7 1,015.2
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than equity-indexed products..................... 173.6 163.8 148.2
Equity-indexed products........................................... 20.8 1.7 8.6
Amortization related to operations.................................. 223.8 184.7 166.4
Interest expense on investment borrowings........................... .1 1.3 2.3
Other operating costs and expenses.................................. 157.8 140.2 144.3
-------- -------- --------
Total expenses.................................................. 1,818.7 1,620.4 1,485.0
-------- -------- --------
Income before net realized investment gains (losses),
net of related amortization and income taxes........................ 258.4 234.4 210.9
-------- -------- --------
Net realized investment gains (losses)............................ (19.5) (4.2) 15.3
Amortization related to net realized investment gains (losses).... 3.2 1.0 (4.7)
-------- -------- --------
Net realized investment gains (losses),
net of related amortization................................ (16.3) (3.2) 10.6
-------- -------- --------
Income before income taxes............................................... $ 242.1 $ 231.2 $ 221.5
======== ======== ========
(continued)
49
(continued from previous page)
2006 2005 2004
---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits.......................................... $1,088.4 $992.7 $919.0
Benefit ratio (a).................................................. 82.1% 81.7% 78.2%
Medicare supplement:
Insurance policy benefits.......................................... $431.0 $459.9 $434.1
Benefit ratio (a).................................................. 66.8% 71.7% 69.1%
Long-term care:
Insurance policy benefits.......................................... $592.2 $526.2 $477.5
Benefit ratio (a).................................................. 99.5% 93.6% 89.3%
Interest-adjusted benefit ratio (b)................................ 69.9% 65.1% 62.3%
Other:
Insurance policy benefits.......................................... $65.2 $6.6 $7.4
Benefit ratio (a).................................................. 77.0% 62.1% 64.8%
<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 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 benefits 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
$175.9 million, $160.3 million and $144.2 million in 2006, 2005 and
2004, respectively.
</FN>
Total premium collections were $2,490.0 million in 2006, up 7.5 percent
from 2005, and $2,316.9 million in 2005, up 4.1 percent from 2004. Premium
collections in 2006 include $76.7 million of premiums collected pursuant to the
quota-share agreement with Coventry described above under "Accounting for the
marketing and quota-share agreement with Coventry". See "Premium Collections"
for further analysis of Bankers Life's premium collections.
Average liabilities for insurance products, net of reinsurance ceded were
$9.1 billion in 2006, up 11 percent from 2005, and $8.2 billion in 2005, up 13
percent from 2004. The increase in such liabilities was primarily due to
increases in annuity reserves resulting from new sales of these products.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. Insurance policy income in 2006 includes $74.4 million of
premium income from the quota-share agreement with Coventry described above
under "Accounting for the marketing and quota-share agreement with Coventry".
Net investment income on general account invested assets (which excludes
income on policyholder accounts) increased by 14 percent, to $513.3 million, in
2006 and by 17 percent, to $450.6 million, in 2005. The average balance of
general account invested assets increased by 12 percent in 2006, to $9.2
billion, and by 14 percent in 2005, to $8.2 billion. The yield on these assets
was 5.59 percent in 2006, 5.49 percent in 2005 and 5.31 percent in 2004. The
increase in general account invested assets is primarily due to sales of our
annuity products in recent periods. The yield was impacted by income related to
prepayments of securities (including prepayment penalties on mortgages, call
premiums on fixed maturities and acceleration of discount amortization, net of
premium amortization) and income received on securities in default of $2.5
million in 2006, $2.9 million in 2005 and $3.7 million in 2004.
50
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 $12.3 million, $(2.6) million and $2.6 million in
2006, 2005 and 2004, respectively. Such amounts are generally offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products based on the change in value of the indices. Such
income and related charges fluctuate based on the value of options embedded in
the segment's equity-indexed annuity policyholder account balances subject to
this benefit and to the performance of the index to which the returns on such
products are linked.
Fee revenue and other income increased to $6.0 million in 2006, compared to
$1.1 million in 2005 and $1.5 million in 2004. During 2006, we recognized fee
income of $5.3 million pursuant to the agreements described above under
"Accounting for the marketing and quota-share agreement with Coventry".
Insurance policy benefits were reduced by a $7.4 million pre-tax adjustment
during the fourth quarter of 2006. We determined that we had been carrying
insurance liabilities for certain single premium annuities that were no longer
in force over several years. Approximately $1.8 million of the adjustment was
determined to relate to the first three quarters of 2006, $1.1 million to 2005,
$.6 million to 2004 and $3.9 million to periods prior to 2004.
Insurance policy benefits also 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. Government 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. Since the
insurance product liabilities we establish for Medicare supplement business are
subject to significant estimates, the ultimate claim liability we incur for a
particular period is likely to be different than our initial estimate. Our
insurance policy benefits reflected reserve redundancies (deficiencies) from
prior years of $9.8 million, $(2.0) million and $1.5 million in 2006, 2005 and
2004, respectively. Excluding the effects of prior year claim reserve
redundancies (deficiencies), our benefit ratios would have been 68.3 percent,
71.4 percent, and 69.3 percent in 2006, 2005 and 2004, respectively. Such ratios
are consistent with our expectations considering 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 benefits is partially offset by
investment income earned on the accumulated assets. The benefit ratio on this
business has increased over the last year, consistent with the aging of this
block. In addition, the older policies have not lapsed at the rate we assumed in
our pricing. In the first quarter of 2005, we began introducing several new
long-term care products to replace our previous 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 99.5 percent, 93.6 percent and 89.3
percent in 2006, 2005 and 2004, 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 69.9 percent, 65.1 percent
and 62.3 percent in 2006, 2005 and 2004, respectively. Since the insurance
product liabilities we establish for long-term care business are subject to
significant estimates, the ultimate claim liability we incur for a particular
period is likely to be different than our initial estimate. Our insurance policy
benefits reflected reserve deficiencies from prior years of $.5 million, $4.3
million and $1.0 million in 2006, 2005 and 2004, respectively. Excluding the
effects of prior year claim reserve deficiencies, our benefit ratios would have
been 99.4 percent, 92.8 percent, and 89.1 percent in 2006, 2005 and 2004,
respectively. We experienced an increase in the number of incurred claims in
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. As an
alternative to the rate increase, policyholders were offered the option: (i) to
reduce their benefits to maintain their previous premium rates; or (ii) to
choose a nonforfeiture benefit equal
51
to the sum of accumulated premiums paid less claims received. 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 86 percent of
the impacted inforce block through December 31, 2006. We expect the execution of
our premium rate increases will continue for the next two quarters given the
timing of the implementation as a result of the regulatory approvals.
During 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 insurance policy benefits in the other health products line include
claims incurred on the Medicare Part D business we began assuming through our
marketing and quota-share agreements with Coventry on January 1, 2006. These
agreements are described above under "Accounting for marketing and quota-share
agreements with Coventry". During 2006, we recognized insurance policy income of
$74.4 million and insurance policy benefits of $59.6 million related to the Part
D program. The benefit ratio on this business was 80.1 percent in 2006.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $173.6 million, $163.8 million and $148.2
million in 2006, 2005 and 2004, respectively. The increases were primarily due
to increases in annuity reserves (resulting from higher sales of these products)
partially offset by lower average crediting rates. The weighted average
crediting rates for these products were 3.6 percent, 3.7 percent and 3.9 percent
in 2006, 2005 and 2004, 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 generally 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 $223.8 million,
$184.7 million and $166.4 million in 2006, 2005 and 2004, respectively. Such
amounts were generally consistent with the related premium revenue and gross
profits for such periods and the assumptions we made when we established the
value of policies inforce as of the Effective Date. However, during the first
half 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 half of 2006. The lapses of our Medicare supplement
products in the first half 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 second half 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 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.
52
Other operating costs and expenses in our Bankers Life segment were $157.8
million in 2006, up 13 percent from 2005 and were $140.2 million in 2005, down
2.8 percent from 2004. The increase in expenses in 2006 reflects the expenses we
incurred related to the marketing and quota-share agreements with Coventry and
increased non-deferrable commission expense. Other operating costs and expenses
include the following (dollars in millions):
2006 2005 2004
---- ---- ----
Expenses related to the marketing and quota-share
agreements with Coventry............................................ $ 15.2 $ - $ -
Commission expense..................................................... 20.7 18.9 14.7
Other operating expenses............................................... 121.9 121.3 129.6
------ ------ ------
Total............................................................... $157.8 $140.2 $144.3
====== ====== ======
Net realized investment gains (losses) fluctuated each period. During 2006,
net realized investment gains (losses) in this segment included $15.1 million of
net losses from the sales of investments (primarily fixed maturities), and $4.4
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary. During 2005, net realized investment
gains (losses) in this segment included $1.5 million of net losses from the
sales of investments (primarily fixed maturities), and $2.7 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During 2004, net realized investment gains
in this segment included $19.4 million of net gains from the sales of
investments (primarily fixed maturities), net of $4.1 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 which
back our universal life and investment-type products at a gain (loss) and
reinvest the proceeds at a different yield, we increase (reduce) the
amortization of insurance acquisition costs in order to reflect the change in
future expected yields. Sales of fixed maturity investments resulted in an
increase (decrease) in the amortization of insurance acquisition costs of $(3.2)
million, $(1.0) million and $4.7 million in 2006, 2005 and 2004, respectively.
53
Conseco Insurance Group (dollars in millions)
2006 2005 2004
---- ---- ----
Premium collections:
Annuities........................................................... $ 433.3 $ 161.7 $ 63.7
Supplemental health................................................. 611.6 661.5 729.6
Life................................................................ 314.6 335.0 372.3
--------- --------- ---------
Total collections................................................. $ 1,359.5 $ 1,158.2 $ 1,165.6
========= ========= =========
Average liabilities for insurance products:
Annuities:
Mortality based..................................................... $ 241.2 $ 269.8 $ 245.2
Equity-indexed.................................................... 1,376.4 1,349.0 1,485.5
Deposit based..................................................... 3,150.2 3,470.2 3,790.4
Separate accounts and investment trust liabilities................ 29.3 30.6 33.9
Health.............................................................. 2,381.9 2,375.1 2,331.6
Life:
Interest sensitive................................................ 3,056.1 3,121.0 3,249.1
Non-interest sensitive............................................ 1,416.8 1,431.0 1,446.2
--------- --------- ---------
Total average liabilities for insurance products,
net of reinsurance ceded...................................... $11,651.9 $12,046.7 $12,581.9
========= ========= =========
Revenues:
Insurance policy income............................................. $ 994.8 $ 1,064.0 $ 1,148.4
Net investment income:
General account invested assets................................... 699.6 718.6 702.3
Equity-indexed products........................................... 26.0 (16.3) 17.5
Trading account income related to policyholder and
reinsurer accounts.............................................. 5.5 (3.3) 5.2
Change in value of embedded derivatives related to
modified coinsurance agreements................................. 2.2 3.0 (1.2)
Fee revenue and other income........................................ 1.0 1.9 4.8
--------- --------- ---------
Total revenues.................................................... 1,729.1 1,767.9 1,877.0
--------- --------- ---------
Expenses:
Insurance policy benefits........................................... 770.0 798.5 844.5
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products.............................. 251.9 254.5 260.9
Equity-indexed products........................................... 55.8 12.6 45.7
Amortization related to operations.................................. 174.5 168.6 156.7
Interest expense on investment borrowings........................... .8 4.9 5.2
Costs related to the tentative litigation settlement................ 165.8 9.2 4.9
Other operating costs and expenses.................................. 278.3 262.9 301.4
--------- --------- ---------
Total expenses.................................................... 1,697.1 1,511.2 1,619.3
--------- --------- ---------
Income before net realized investment gains (losses),
net of related amortization and income taxes........................ 32.0 256.7 257.7
--------- --------- ---------
Net realized investment gains (losses)............................ (19.5) 1.6 21.5
Amortization related to net realized investment
(gains) losses.................................................. 6.9 1.8 (8.7)
--------- --------- ---------
Net realized investment gains (losses),
net of related amortization................................... (12.6) 3.4 12.8
--------- --------- ---------
Income before income taxes............................................... $ 19.4 $ 260.1 $ 270.5
========= ========= =========
(continued)
54
(continued from previous page)
2006 2005 2004
---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits.......................................... $450.9 $462.0 $492.9
Benefit ratio (a).................................................. 72.1% 68.7% 67.0%
Medicare supplement:
Insurance policy benefits.......................................... $158.9 $178.5 $225.5
Benefit ratio (a).................................................. 61.9% 59.4% 63.2%
Specified disease:
Insurance policy benefits.......................................... $282.8 $273.6 $256.9
Benefit ratio (a).................................................. 79.0% 76.2% 71.0%
Interest-adjusted benefit ratio (b)................................ 47.0% 45.1% 40.9%
Other:
Insurance policy benefits.......................................... $9.2 $9.9 $10.5
Benefit ratio (a).................................................. 84.2% 75.9% 64.6%
<FN>
- --------------------
(a) We calculate benefit ratios by dividing the related product's
insurance policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for Conseco Insurance Group's specified disease products by dividing
such product's insurance policy benefits less interest income on the
accumulated assets backing the insurance liabilities by policy income.
Interest income is an important factor in measuring the performance of
this product, since approximately three-fourths of these policies have
return of premium or cash value riders. 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 benefits
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 $114.7 million, $111.7 million and $108.8 million in
2006, 2005 and 2004 respectively.
</FN>
Total premium collections were $1,359.5 million in 2006, up 17 percent from
2005, and $1,158.2 million in 2005, down .6 percent from 2004. Such fluctuations
are primarily due to higher premium collections from our equity-indexed
products, partially offset by lower premium collections from Medicare supplement
and life insurance products. See "Premium Collections" for further analysis of
fluctuations in premiums collected by product.
Average liabilities for insurance products, net of reinsurance ceded were
$11.7 billion in 2006, down 3.3 percent from 2005, and $12.0 billion in 2005,
down 4.3 percent from 2004. The decrease in such liabilities was due primarily
to policyholder redemptions and lapses exceeding new sales.
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 in insurance policy
income is primarily due to lower income from Medicare supplement products due to
higher lapses following premium rate increases. See "Premium Collections" for
further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) decreased by 2.6 percent, to
$699.6 million, in 2006 and increased by 2.3 percent, to $718.6 million, in
2005. The average balance of general account invested assets decreased by 3.1
percent in 2006, to $12.2 billion, and by 3.9 percent in 2005, to $12.6 billion.
The average yield on these assets was 5.74 percent in 2006, 5.71 percent in 2005
and 5.37 percent in 2004. This segment's investment income included income
related to prepayments of securities (including prepayment penalties on
mortgages, call premiums on fixed maturities and acceleration of discount
amortization, net of premium amortization) of $8.2 million, $22.8 million and
$5.0 million in 2006, 2005 and 2004, respectively. This additional investment
income was partially offset by approximately $4.0 million, $9.4 million and nil
of additional amortization expense in 2006, 2005 and 2004, respectively, to
reflect the higher resulting gross profits for universal life and
investment-
55
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
$28.1 million, $(12.0) million and $11.1 million in 2006, 2005 and 2004,
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 income (loss) was $(2.1) million, $(4.3) million
and $6.4 million in 2006, 2005 and 2004, respectively. Such amounts were
partially offset by the corresponding charge (credit) to amounts added to
policyholder account balances for equity-indexed products. 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) amounts included in insurance policy
benefits related to the aforementioned annuity products.
Change in value of embedded derivatives related to modified coinsurance
agreements is described in the note to our consolidated financial statements
entitled "Summary of Significant Accounting Policies - 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 were affected by a number of unusual adjustments
during 2006. During the fourth quarter of 2006, we increased our insurance
product liabilities by $8.0 million to reflect management's intent to enhance
certain benefits related to a block of life policies. The policies affected by
the adjustments described above were issued through a subsidiary prior to its
acquisition by Conseco in 1997. During the first quarter of 2006, we reduced
insurance benefits by $3.0 million for a change in an actuarial assumption
related to a block of interest-sensitive life insurance policies based on a
change in management's intent on the administration of such policies. Such
decreases were more than offset by a $4.7 million increase in amortization of
insurance acquisition costs related to the assumption changes. Also during the
first quarter of 2006, we 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.
Insurance policy benefits also fluctuated as a result of the factors
summarized below for benefit ratios. Benefit ratios are calculated by dividing
the related insurance product's insurance policy benefits by insurance policy
income.
The benefit ratios on Conseco Insurance Group's Medicare supplement
products have been impacted by an increase in policyholder lapses in each of the
last three years, following our premium rate increase actions and competition
from companies offering Medicare Advantage products. We establish active life
reserves for these policies, which are in addition to amounts required for
incurred claims. When policies lapse, active life reserves for such lapsed
policies are released, resulting in decreased insurance policy benefits
(although such decrease is substantially offset by additional amortization
expense). In addition, the insurance product liabilities we establish for our
Medicare supplement business are subject to significant estimates and the
ultimate claim liability we incur for a particular period is likely to be
different than our initial estimate. Our insurance policy benefits reflected
claim reserve redundancies from prior years of $5.4 million, $6.5 million and
$12.4 million in 2006, 2005 and 2004, respectively. Excluding the effects of
prior year claim reserve redundancies, our benefit ratios for the Medicare
supplement block would have been 64.1 percent, 61.5 percent and 66.6 percent in
2006, 2005 and 2004, respectively. 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.
56
Conseco Insurance Group's specified disease products generally provide
fixed or limited benefits. For example, payments under cancer insurance policies
are generally made directly to, or at the direction of, the policyholder
following diagnosis of, or treatment for, a covered type of cancer.
Approximately three-fourths of our specified disease policies inforce (based on
policy count) are sold with return of premium or cash value riders. The return
of premium rider generally provides that after a policy has been inforce for a
specified number of years or upon the policyholder reaching a specified age, we
will pay to the policyholder, or a beneficiary under the policy, the aggregate
amount of all premiums paid under the policy, without interest, less the
aggregate amount of all claims incurred under the policy. The cash value rider
is similar to the return of premium rider, but also provides for payment of a
graded portion of the return of premium benefit if the policy terminates before
the return of premium benefit is earned. Accordingly, the net cash flows from
these products generally result in the accumulation of amounts in the early
years of a policy (accounted for as reserve increases) which will be paid out as
benefits in later policy years (accounted for as reserve decreases). As the
policies age, the benefit ratio will typically increase, but the increase in
benefits will be partially offset by investment income earned on the accumulated
assets.
During the fourth quarter of 2006, we recorded a pre-tax adjustment that
increased insurance policy benefits by $13.3 million. We determined that we had
not been establishing insurance product liabilities for certain insurance
benefits for several years. In addition, we determined that certain factors used
to calculate the liability for the base policies were incorrect. This adjustment
was offset by a $1.6 million reduction in the amortization of insurance
intangibles. Approximately $2.1 million of the adjustment was determined to
relate to the first three quarters of 2006, $7.7 million to 2005, $4.1 million
to 2004 and $(2.2) million to periods prior to 2004.
The benefit ratio in this block of business is affected by the number of
policies which lapse in a period. In addition, when policies lapse before
reaching the specified age at which the return of premium benefit is payable,
the reserve established for such benefit through the lapse date is released,
resulting in lower insurance policy benefits for the period. In the third
quarter of 2004, we changed the criteria pursuant to which we consider a
specified disease policy to have lapsed. Although our specified disease policies
generally may be lapsed for non-payment of premiums after being delinquent for
90 days, policyholders are permitted to reinstate their coverage by paying past
due premiums prior to our final lapse notice. In addition, timing differences
and delays in billing, receipt and processing of premiums can affect whether a
policy has, in fact, lapsed. We revised our previous methodology of determining
which policies have lapsed to consider the fact that many policyholders whose
payments are delinquent past their grace periods may, in fact, reinstate their
coverage through payment of past due premiums. These changes resulted in an
increase to reserves of approximately $6 million in 2004.
Excluding the effects of the fourth quarter 2006 adjustment and the
methodology change in 2004, our benefit ratios for the specified disease block
would have been 75.3 percent, 76.2 percent and 69.3 percent in 2006, 2005 and
2004, respectively. The decrease in the benefit ratio in 2006 reflects improved
claim experience during the year, while the increase in the benefit ratio in
2005 reflects higher paid claims on base policies. 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. We no
longer actively market these products.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $251.9 million, $254.5 million and $260.9
million in 2006, 2005 and 2004, respectively. The fluctuations are primarily due
to a smaller block of annuity business inforce, partially offset by higher
crediting rates. The weighted average crediting rates for these products were
4.1 percent, 4.0 percent and 3.8 percent in 2006, 2005 and 2004, respectively.
Amounts added to equity-indexed products generally fluctuate with the
corresponding related investment income accounts described above. In addition,
in the first quarter of 2006, we reduced such amounts by $8.5 million to reflect
a change in the assumptions for the cost of options underlying our
equity-indexed products as described below under amortization related to
operations. Such decreases were partially offset by a $4.7 million increase in
amortization of insurance acquisition costs related to the assumption changes.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs are generally 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
57
expectation of future profits. For other products, we amortize insurance
acquisition costs in relation to actual and expected premium revenue, and
amortization is only adjusted if expected premium revenue changes or if we
determine the balance of these costs is not recoverable from future profits. The
assumptions we use to estimate our future gross profits and premiums involve
significant judgment. A revision to our current assumptions could result in
increases or decreases to amortization expense in future periods.
During the fourth quarter of 2006, we recognized additional amortization
expense of $7.8 million to reflect a change in an actuarial assumption related
to a block of interest-sensitive life insurance policies based on a change in
management's intent on the administration of such policies. The policies
affected by the adjustments described above were issued through a subsidiary
prior to its acquisition by Conseco in 1996.
During the first quarter of 2006, we made certain adjustments to our
assumptions of expected future profits for the annuity and universal life blocks
of business in this segment related to investment returns, lapse rates, the cost
of options underlying our equity-indexed products and other refinements. We
recognized additional amortization expense of $12.4 million in 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. Also, during 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 2004, we evaluated certain amortization assumptions used to estimate
gross profits for universal life products and investment-type products by
comparing them to our actual experience. We made refinements to the previous
assumptions related to investment income to match the actual experience and our
estimates for future assumptions. The changes we made did not affect our
expectations for the total estimated profits to be earned on this business, but
did affect how we expect the profits to emerge over time. These new assumptions
resulted in a reduction to the amortization of insurance acquisition costs of
$7.7 million in the second quarter of 2004.
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 "Commitments and Contingencies". Legal and other
costs of $8.9 million for this litigation were incurred by the Corporate
Operations segment in 2006 related to the non-insurance company allegations made
in such lawsuits.
Other operating costs and expenses were $278.3 million, $262.9 million and
$301.4 million in 2006, 2005 and 2004, respectively. Other operating costs and
expenses include commission expense. Operating expenses in 2005 and 2004
reflected expense recoveries associated with the Predecessor's bankruptcy.
Operating expenses in 2005 and 2004 also reflected gains related to the
termination of a postretirement health plan. Other operating costs and expenses
include the follow (dollars in millions):
2006 2005 2004
---- ---- ----
Commission expenses...................................... $ 87.1 $ 94.2 $111.9
Other operating expense.................................. 191.2 185.1 208.7
Expense recoveries related to bankruptcy................. - (7.6) (11.3)
Amounts related to postretirement plan................... - (8.8) (7.9)
------ ------ ------
$278.3 $262.9 $301.4
====== ====== ======
Net realized investment gains (losses) fluctuate each period. During 2006,
net realized investment losses included $10.5 million of net losses from the
sales of investments (primarily fixed maturities), and $9.0 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During 2005, net realized investment gains
included $6.0 million of net gains from the sales of investments (primarily
fixed maturities), net of $4.4 million of writedowns of investments resulting
from declines in fair values that we concluded were other than temporary. During
2004, net realized investment gains in this segment included $32.1 million of
net gains from the sales of investments
58
(primarily fixed maturities), net of $10.6 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 which
back our universal life and investment-type products 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 an increase (decrease) in the amortization of insurance acquisition costs of
$(6.9) million, $(1.8) million and $8.7 million in 2006, 2005 and 2004,
respectively.
59
Colonial Penn (dollars in millions)
2006 2005 2004
---- ---- ----
Premium collections:
Life................................................................. $ 97.2 $ 85.1 $ 79.7
Supplemental health.................................................. 12.0 13.8 15.6
------ ------ ------
Total collections.................................................. $109.2 $ 98.9 $ 95.3
====== ====== ======
Average liabilities for insurance products:
Annuities:
Mortality based.................................................. $ 86.9 $ 89.5 $ 95.2
Deposit based.................................................... 3.9 4.2 1.9
Health............................................................... 25.6 29.0 31.5
Life:
Interest sensitive............................................... 27.6 29.0 27.6
Non-interest sensitive........................................... 553.6 555.7 565.3
------ ------ ------
Total average liabilities for insurance
products, net of reinsurance ceded........................... $697.6 $707.4 $721.5
====== ====== ======
Revenues:
Insurance policy income.............................................. $112.1 $101.3 $ 97.6
Net investment income:
General account invested assets.................................... 38.2 38.2 38.3
Trading account income related to reinsurer accounts............... (4.3) (6.1) 3.7
Change in value of embedded derivatives related
to modified coinsurance agreements............................... 4.3 6.1 (3.7)
Fee revenue and other income......................................... .6 .7 .4
------ ------ ------
Total revenues................................................... 150.9 140.2 136.3
------ ------ ------
Expenses:
Insurance policy benefits............................................ 95.1 88.1 84.7
Amounts added to annuity and interest-sensitive life product
account balances................................................. 1.3 1.6 1.3
Amortization related to operations................................... 17.3 15.1 16.2
Interest expense on investment borrowings............................ - .4 .3
Other operating costs and expenses................................... 15.6 15.0 15.8
------ ------ ------
Total expenses................................................... 129.3 120.2 118.3
------ ------ ------
Income before net realized investment gains and
income taxes......................................................... 21.6 20.0 18.0
Net realized investment gains...................................... .2 .6 2.1
------ ------ ------
Income before income taxes................................................ $ 21.8 $ 20.6 $ 20.1
====== ====== ======
Total premium collections were $109.2 million in 2006, up 10 percent from
2005, and $98.9 million in 2005, up 3.8 percent from 2004. See "Premium
Collections" for further analysis of Colonial Penn's premium collections.
Average liabilities for insurance products, net of reinsurance ceded, were
$697.6 million in 2006, down 1.4 percent from 2005, and $707.4 million in 2005,
down 2.0 percent from 2004.
60
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) did not fluctuate significantly
during the three years ended December 31, 2006. The decrease in average invested
assets was offset by higher investment yields. The average balance of general
account invested assets decreased by 5.3 percent in 2006, to $688.5 million, and
by 3.2 percent in 2005, to $726.9 million. The yield on these assets was 5.55
percent in 2006, 5.26 percent in 2005 and 5.10 percent in 2004.
Trading account income related to 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 "Summary of Significant Accounting Policies - Accounting for
Derivatives." We have transferred the specific block of investments related to
these agreements to our trading account, which we carry at estimated fair value
with changes in such value recognized as trading account income. We expect the
change in the value of the embedded derivatives to be largely offset by the
change in value of the trading securities.
Insurance policy benefits fluctuated as a result of the growth in this
segment in recent periods.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs in the Colonial Penn segment are
amortized 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. 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. 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 Colonial Penn segment did not
fluctuate significantly during the three years ended December 31, 2006.
Net realized investment gains fluctuated each period. During 2006, net
realized investment gains in this segment included $.4 million of net gains from
the sales of investments (primarily fixed maturities), net of $.2 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During 2005, net realized investment gains
in this segment included $.6 million of net gains from the sales of investments
(primarily fixed maturities). During 2004, net realized investment gains in this
segment included $2.1 million of net gains from the sales of investments
(primarily fixed maturities). There were no writedowns in the Colonial Penn
segment in 2005 or 2004.
61
Other Business in Run-off (dollars in millions)
2006 2005 2004
---- ---- ----
Premium collections:
Long-term care....................................................... $ 323.0 $ 349.1 $ 380.1
Major medical........................................................ 4.8 2.8 15.8
-------- -------- --------
Total collections............................................... $ 327.8 $ 351.9 $ 395.9
======== ======== ========
Average liabilities for insurance products:
Long-term care....................................................... $3,229.8 $3,288.4 $3,281.8
Major medical........................................................ 29.2 41.5 73.4
-------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded..................................... $3,259.0 $3,329.9 $3,355.2
======== ======== ========
Revenues:
Insurance policy income.............................................. $ 336.6 $ 359.1 $ 395.8
Net investment income on general account
invested assets.................................................... 179.5 177.6 167.5
Fee revenue and other income......................................... .4 .5 .8
-------- -------- --------
Total revenues................................................... 516.5 537.2 564.1
-------- -------- --------
Expenses:
Insurance policy benefits............................................ 457.3 351.1 386.1
Amortization related to operations................................... 17.9 22.8 18.5
Interest expense on investment borrowings............................ - - .2
Other operating costs and expenses................................... 83.2 86.1 93.5
-------- -------- --------
Total expenses................................................... 558.4 460.0 498.3
-------- -------- --------
Income (loss) before net realized investment
gains (losses) and income taxes........................................ (41.9) 77.2 65.8
Net realized investment gains (losses)............................... (8.0) .5 4.5
-------- -------- --------
Income (loss) before income taxes......................................... $ (49.9) $ 77.7 $ 70.3
======== ======== ========
Health benefit ratios:
Insurance policy benefits.......................................... $457.3 $351.1 $386.1
Benefit ratio (a).................................................. 135.9% 97.8% 97.5%
Interest-adjusted benefit ratio (b)................................ 83.2% 49.2% 56.2%
<FN>
- --------------------
(a) We calculate benefit ratios by dividing the related product's
insurance policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for long-term care products by dividing such product's insurance
policy benefits less interest income on the accumulated assets backing
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 benefits 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 long-term
care reserves in our Other Business in Run-off segment was $177.2
million, $174.5 million and $163.5 million in 2006, 2005 and 2004,
respectively.
</FN>
62
Total premium collections were $327.8 million in 2006, down 6.8 percent
from 2005 and $351.9 million in 2005, down 11 percent from 2004. 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. Premium collections are also
affected by non-forfeiture elections selected by policyholders subject to the
Florida Order discussed below. See "Premium Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
approximately $3.3 billion in 2006, 2005 and 2004.
Insurance policy income is comprised of premiums earned on the segment's
long-term care and major medical policies. See "Premium Collections" for further
analysis.
Net investment income on general account invested assets increased by 1.1
percent, to $179.5 million, in 2006 and by 6.0 percent, to $177.6 million, in
2005. The average balance of general account invested assets was $3.0 billion in
2006, 2005 and 2004. The average yield on these assets was 5.89 percent, 5.95
percent and 5.62 percent in 2006, 2005 and 2004, respectively. The increase in
yield in 2005 was primarily due to: (i) lengthening the duration of this
portfolio to better match the duration of the related insurance liabilities; and
(ii) income of $2.3 million related to prepayments of securities (including
prepayment penalties on mortgages, call premiums on fixed maturities, and
acceleration of discount amortization, net of premium amortization). There was
no significant prepayment income in 2006 or 2004.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below.
The benefit ratio on our Other Business in Run-off segment was 135.9
percent, 97.8 percent and 97.5 percent in 2006, 2005 and 2004, respectively.
Benefit ratios are calculated by dividing the product's insurance policy
benefits by insurance policy income. Since the insurance product liabilities we
establish for long-term care business are subject to significant estimates, the
ultimate claim liability we incur for a particular period is likely to be
different than our initial estimate. Our insurance policy benefits reflected
reserve deficiencies from prior years of $77.2 million, $59.9 million and $44.5
million in 2006, 2005 and 2004, respectively. Excluding the effects of prior
year claim reserve deficiencies, our benefit ratios would have been 112.9
percent, 81.1 percent and 86.3 percent in 2006, 2005 and 2004, respectively.
These ratios reflect the significantly higher level of incurred claims
experienced in 2006 resulting in increases in reserves for future benefits as
discussed below, adverse development on claims incurred in prior periods as
discussed below, and decreases in policy income. The prior period deficiencies
have resulted from the impact of paid claim experience being different than
prior estimates, changes in actuarial assumptions and refinements to claimant
data used to determine claim reserves.
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 benefits 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. The interest-adjusted benefit ratio on this business was 83.2 percent,
49.2 percent and 56.2 percent in 2006, 2005 and 2004, respectively.
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. In addition, there has been an increase in the
incidence and duration of claims in recent periods. This adverse experience is
reflected in the higher insurance policy benefits experienced in 2006.
In addition, we experienced increases in our reserves for future benefits
due primarily to higher than expected persistency in this block of business in
2006. A small variance in persistency can have a significant impact on our
earnings 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
63
amount. The average persistency rate, excluding policies subject to the Florida
Order was 92.4 percent in 2006 and 91.8 percent in 2005 with persistency rates
trending upward throughout 2006. In addition, our assumed persistency rate in
2006 was lower than the assumed persistency rate in 2005 by approximately 1.0 to
1.5 percent due to aging of the inforce. If actual persistency rates continue to
be higher than our assumed rates, this will have an adverse effect on income in
this segment. As further discussed below, valuation system conversions and other
reserve refinements resulted in reserve decreases of $23.4 million in 2006 and
$38 million in 2005.
During the fourth quarter of 2006, we recorded a pre-tax adjustment that
increased insurance policy benefits for our long-term care run-off block by $61
million. Two primary factors caused this action.
First, incurred claims increased by $54.1 million as a result of changes in
estimate to this block's claim liabilities due to prior period deficiencies.
These deficiencies resulted from paid claims being higher than expected and
changes in actuarial assumptions. Approximately $24.5 million of the claim
reserve increases were determined to relate to claims with initial incurral
dates in the first three quarters of 2006 and approximately $29.6 million
relates to prior years.
Second, incurred claims increased by $7.1 million as a result of the net
effect of several changes we made to our reserve estimation process.
Approximately $(.1) million of the changes were determined to relate to the
first three quarters of 2006, $2.3 million relate to 2005, $.2 million relate to
2004, and $4.7 million relate to periods prior to 2004. These changes included
the following:
o In the process of reviewing our claim estimates, we discovered that
some claim liabilities related to policies with inflation riders had
previously been estimated excluding inflation benefits. We changed our
estimates to properly reflect the inflation benefits.
o We also discovered that some claim liabilities related to policies
providing lifetime benefits had been estimated based on the assumption
the benefit period was limited. We changed our estimates to properly
reflect the benefit periods.
o Certain claims in this segment are being paid pursuant to
non-forfeiture benefits, which are provided in certain cases when the
policyholder elects this option and ceases paying premiums.
Liabilities for these claims are provided for as they are incurred,
until an aggregate maximum (or "pool of money") is exhausted. During
the fourth quarter of 2006, we discovered that some claim liabilities
for non-forfeiture benefits had been estimated based on the original
pool of money benefit, rather than pool amounts reduced by benefits
previously paid. We changed our estimates to properly reflect the
benefits available for these policies.
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 2006.
During the fourth quarter of 2005, we utilized a new seriatim-based
valuation system to determine reserves for the long-term care block of business
in run-off. We had previously used a model-based valuation system since the
fresh-start date. Such conversion to the seriatim-based valuation system
resulted in decreases to our insurance liabilities of approximately $38 million
in the fourth quarter of 2005. In addition, we completed a new claims cost study
and developed new continuance tables based on our recent experience which were
used to estimate claim reserves resulting in an increase to insurance
liabilities of $40 million in the fourth quarter of 2005.
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
64
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 and implemented
rate increases equivalent to approximately 37 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 12 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 likely 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.
On April 20, 2004, the Florida Office of Insurance Regulation issued an
Order to our subsidiary, 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, 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 was 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 such actions being justified based on the
experience of the business 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.
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 were $83.2 million in 2006, down 3.4
percent from 2005 and $86.1 million in 2005, down 7.9 percent from 2004. Other
operating costs and expenses, excluding commission expenses, for this segment
were $47.0 million in 2006, up 1.5 percent from 2005 and $46.3 million in 2005,
down 8.0 percent from 2004. The decrease in 2005 resulted from our initiatives
to reduce operating expenses and improve the efficiency of our operations.
Net realized investment gains (losses) fluctuated each period. During 2006,
net realized investment gains included $.8 million of net gains from the sales
of investments (primarily fixed maturities), net of $8.8 million of writedowns
of investments resulting from declines in fair values that we concluded were
other than temporary. During 2005, net realized investment gains included $6.8
million of net gains from the sales of investments (primarily fixed maturities),
net of $6.3
65
million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary. During 2004, net realized
investment gains in this segment included $5.1 million of net gains from the
sales of investments (primarily fixed maturities), net of $.6 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary.
Corporate Operations (dollars in millions)
2006 2005 2004
---- ---- ----
Corporate operations:
Interest expense on corporate debt..................................... $(52.9) $(48.1) $ (71.5)
Investment income ..................................................... 4.6 5.4 2.1
Fee revenue and other income........................................... 10.9 20.2 14.0
Net operating results of variable interest entity...................... 4.9 .1 -
Costs related to the tentative litigation settlement................... (8.9) (9.1) (4.9)
Other operating costs and expenses..................................... (38.6) (49.6) (68.0)
Gain (loss) on extinguishment of debt.................................. (.7) (3.7) 2.8
------ ------ -------
Income (loss) before net realized investment losses
and income taxes.................................................. (80.7) (84.8) (125.5)
Net realized investment losses......................................... (.4) (1.4) (2.8)
------ ------ -------
Income (loss) before income taxes.................................... $(81.1) $(86.2) $(128.3)
====== ====== =======
Interest expense on corporate debt has been impacted by: (i) the repayment
or amendment of the Company's credit facilities during each of the last three
years; and (ii) the issuance of the Debentures in 2005. These transactions are
further discussed in the note to the consolidated financial statements entitled
"Notes Payable - Direct Corporate Obligations". Our average corporate debt
outstanding was $864.3 million, $773.4 million and $975.3 million in 2006, 2005
and 2004, respectively. The average interest rate on our debt was 5.7 percent,
5.9 percent and 6.8 percent in 2006, 2005 and 2004, respectively. Interest
expense on corporate debt in 2004 included a credit agreement charge of $3.8
million.
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. In 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 has 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 represent 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. 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
"Commitments and Contingencies" for further information related to this case.
66
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 2006 and
2005, other operating costs and expenses are net of recoveries of $3.0 million
and $3.2 million, respectively, related to our evaluation of the collectibility
of the D&O loans. In 2004, we incurred expenses of $13.2 million related to our
executive transition. General corporate expenses included other severance
expense of $1.8 million, $2.4 million and $8.3 million in 2006, 2005 and 2004,
respectively.
In December 2004, the FASB issued SFAS 123R, which revised SFAS 123 and
superseded Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" and related interpretations. 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 2006, we
recognized compensation expense related to stock options totaling $6.5 million.
Refer to the note to our consolidated financial statements entitled
"Shareholders' Equity" for further discussion of our share-based payments.
Gain (loss) on extinguishment of debt of $(.7) million in 2006 resulted
from the write-off of certain issuance costs and other costs incurred related to
the Second Amended Credit Facility. The loss of $3.7 million in 2005 resulted
from the write-off of certain debt issuance costs related to the reduction of
the principal amount borrowed under the $447.0 million secured credit agreement
(the "Amended Credit Facility"). The gain on extinguishment of debt of $2.8
million in 2004 resulted from the repayment of our $1.3 billion credit agreement
(the "Previous Credit Facility") as further described in the notes to the
consolidated financial statements entitled "Note Payable - Direct Corporate
Obligations". The gain resulted from the release of a $6.3 million accrual for a
fee that would have been required to be paid under the Previous Credit Facility,
partially offset by the write-off of unamortized amendment fees.
Net realized investment losses often fluctuate each period. During 2006,
net realized investment losses in this segment included $.4 million from the
sale of investments. During 2005, net realized investment losses in this segment
included $.1 million of net losses from the sale of investments (primarily fixed
maturities), and $1.3 million of writedowns due to other-than-temporary declines
in value on certain securities. During 2004, we recognized writedowns of $2.9
million due to other-than-temporary declines in value on certain securities.
67
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 (our Bankers Life segment), independent producers (our
Conseco Insurance Group segment) and direct marketing (our Colonial Penn
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. 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. Our direct marketing distribution channel in the
Colonial Penn segment is engaged primarily in the sale of "graded benefit life"
and simplified issue life insurance policies which are sold directly to the
policyholder.
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. 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
"Management's Discussion and Analysis of Consolidated Financial Condition and
Results of Operations -- 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 likely 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.
68
Total premiums and accumulation product collections were as follows:
Bankers Life (dollars in millions)
2006 2005 2004
---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year).......................................... $ 276.5 $ 130.3 $ 47.5
-------- -------- --------
Other fixed (first-year)............................................. 718.1 818.0 901.2
Other fixed (renewal)................................................ 2.9 2.8 1.8
-------- -------- --------
Subtotal - other fixed annuities................................... 721.0 820.8 903.0
-------- -------- --------
Total annuities.................................................... 997.5 951.1 950.5
-------- -------- --------
Supplemental health:
Medicare supplement (first-year)..................................... 97.8 74.1 69.7
Medicare supplement (renewal)........................................ 531.3 564.7 556.2
-------- -------- --------
Subtotal - Medicare supplement..................................... 629.1 638.8 625.9
-------- -------- --------
Long-term care (first-year).......................................... 51.2 65.4 69.1
Long-term care (renewal)............................................. 541.2 498.8 467.2
-------- -------- --------
Subtotal - long-term care.......................................... 592.4 564.2 536.3
-------- -------- --------
Other health (first-year)............................................ 77.7 1.1 .9
Other health (renewal)............................................... 9.1 9.6 9.8
-------- -------- --------
Subtotal - other health............................................ 86.8 10.7 10.7
-------- -------- --------
Total supplemental health.......................................... 1,308.3 1,213.7 1,172.9
-------- -------- --------
Life insurance:
First-year........................................................... 90.3 74.1 32.3
Renewal.............................................................. 93.9 78.0 68.9
-------- -------- --------
Total life insurance............................................... 184.2 152.1 101.2
-------- -------- --------
Collections on insurance products:
Total first-year premium collections on insurance
products.......................................................... 1,311.6 1,163.0 1,120.7
Total renewal premium collections on insurance
products........................................................... 1,178.4 1,153.9 1,103.9
-------- -------- --------
Total collections on insurance products............................ $2,490.0 $2,316.9 $2,224.6
======== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections in this
segment increased by 4.9 percent, to $997.5 million, in 2006 as compared to
2005. Total annuity collections in 2005 were comparable to 2004. Premium
collections from our equity-indexed products were favorably impacted in 2006 and
2005 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. The increase in short-term interest
rates in recent periods resulted in lower first-year fixed annuity sales as
certain other competing products, such as certificates of deposits, have become
attractive.
Supplemental health products include Medicare supplement, long-term care
and other insurance products distributed through our career agents. Our profits
on supplemental health policies depend on the overall level of sales, the length
of time the business remains inforce, investment yields, claims experience and
expense management.
Collected premiums on Medicare supplement policies in the Bankers Life
segment decreased by 1.5 percent, to $629.1 million, in 2006 and increased by
2.1 percent, to $638.8 million, in 2005. During the first half of 2006, we
experienced
69
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.
Premiums collected on Bankers Life's long-term care policies increased by
5.0 percent, to $592.4 million, in 2006 and by 5.2 percent, to $564.2 million,
in 2005. The increase in premium collections of our long-term care products in
2006 is primarily due to higher premiums associated with the policies that were
impacted by the rate increases which became effective in 2006. The increase in
premiums collections for these products also reflects higher persistency than we
expected.
Other health products in 2006 include $76.7 million of first-year premiums
collected pursuant to the quota-share reinsurance agreement with Coventry
described in Critical Accounting Policies under the caption "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. Life premiums collected in this segment increased by
21 percent, to $184.2 million, in 2006 and by 50 percent, to $152.1 million, in
2005. Collected premiums have been impacted by an increased focus on life
products, including the introduction in the first quarter of 2005 of a new
single premium whole life product. During 2006 and 2005, the new single premium
whole life products accounted for $42.9 million and $32.2 million, respectively,
of our collected premiums.
70
Conseco Insurance Group (dollars in millions)
2006 2005 2004
---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)......................................... $ 369.4 $ 94.4 $ 31.8
Equity-indexed (renewal)............................................ 9.1 10.0 12.5
-------- -------- --------
Subtotal - equity-indexed annuities............................... 378.5 104.4 44.3
-------- -------- --------
Other fixed (first-year)............................................ 46.1 47.5 7.2
Other fixed (renewal)............................................... 8.7 9.8 12.2
-------- -------- --------
Subtotal - other fixed annuities.................................. 54.8 57.3 19.4
-------- -------- --------
Total annuities................................................... 433.3 161.7 63.7
-------- -------- --------
Supplemental health:
Medicare supplement (first-year).................................... 30.6 15.8 21.9
Medicare supplement (renewal)....................................... 213.6 273.0 329.8
-------- -------- --------
Subtotal - Medicare supplement.................................... 244.2 288.8 351.7
-------- -------- --------
Specified disease (first-year)...................................... 28.1 30.6 32.9
Specified disease (renewal)......................................... 329.6 328.9 328.8
-------- -------- --------
Subtotal - specified disease...................................... 357.7 359.5 361.7
-------- -------- --------
Other health (first-year)........................................... - - .1
Other health (renewal).............................................. 9.7 13.2 16.1
-------- -------- --------
Subtotal - other health........................................... 9.7 13.2 16.2
-------- -------- --------
Total supplemental health......................................... 611.6 661.5 729.6
-------- -------- --------
Life insurance:
First-year.......................................................... 6.7 8.2 18.4
Renewal............................................................. 307.9 326.8 353.9
-------- -------- --------
Total life insurance.............................................. 314.6 335.0 372.3
-------- -------- --------
Collections on insurance products:
Total first-year premium collections on
insurance products............................................... 480.9 196.5 112.3
Total renewal premium collections on
insurance products................................................ 878.6 961.7 1,053.3
-------- -------- --------
Total collections on insurance products........................... $1,359.5 $1,158.2 $1,165.6
======== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity collected
premiums in this segment increased by 168 percent, to $433.3 million, in 2006
and by 154 percent, to $161.7 million, in 2005. Total annuity premiums collected
in 2006 and 2005 increased 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. In 2004, we took
actions to reduce our marketing of these products and focus instead on selling
products that were less ratings sensitive (such as specified disease and
Medicare supplement products).
Our equity-indexed annuities have guaranteed minimum cash surrender values,
but have 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
by 263 percent, to $378.5 million, in 2006 and by 136 percent, to $104.4
million, in 2005. Collected premiums for these products increased in 2006 and
2005 due to the introduction of several new products. In addition, these
products have become relatively attractive due to general stock market
conditions in recent periods.
71
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 by 4.4 percent, to
$54.8 million, in 2006 and increased by 195 percent, to $57.3 million, in 2005.
Sales of these products in 2006 and 2005 reflected increased sales efforts.
During the last six months of 2005, collected premiums for these products were
impacted by attractive crediting rates on certain products.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers. Our profits on supplemental health
policies depend on the overall level of sales, the length of time the business
remains inforce, investment yields, claim experience and expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment decreased by 15 percent, to $244.2 million, in 2006 and by 18
percent, to $288.8 million, in 2005. We have experienced higher lapses of these
products in 2006 and 2005 due to premium rate increases implemented in recent
periods and, in 2006, competition from companies offering Medicare Advantage
products.
Premiums collected on specified disease products have been comparable from
period to period.
Premiums collected from other health products decreased by 27 percent, to
$9.7 million, in 2006 and by 19 percent, to $13.2 million, in 2005. Premiums
have decreased from period to period as 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 by 6.1
percent, to $314.6 million, in 2006 and by 10 percent, to $335.0 million, in
2005.
72
Colonial Penn (dollars in millions)
2006 2005 2004
---- ---- ----
Premiums collected by product:
Life insurance:
First-year........................................................... $ 22.9 $19.4 $17.8
Renewal.............................................................. 74.3 65.7 61.9
------ ----- -----
Total life insurance............................................... 97.2 85.1 79.7
------ ----- -----
Supplemental health:
Medicare supplement (renewal)........................................ 10.9 12.4 14.1
Other health (renewal)............................................... 1.1 1.4 1.5
------ ----- -----
Total supplemental health.......................................... 12.0 13.8 15.6
------ ----- -----
Collections on insurance products:
Total first-year premium collections on insurance
products........................................................... 22.9 19.4 17.8
Total renewal premium collections on insurance
products........................................................... 86.3 79.5 77.5
------ ----- -----
Total collections on insurance products............................ $109.2 $98.9 $95.3
====== ===== =====
Life products in this segment are sold primarily to the senior market. Life
premiums collected in this segment increased by 14 percent, to $97.2 million, in
2006 and by 6.8 percent, to $85.1 million, in 2005. Collected premiums have been
impacted by increased advertising. Graded benefit life products sold through our
direct response marketing channel accounted for $92.3 million, $81.2 million and
$72.3 million of collected premiums in 2006, 2005 and 2004, respectively.
Supplemental health products include Medicare supplement and other
insurance products. Our profits on supplemental health policies depend on the
overall level of sales, the length of time the business remains inforce,
investment yields, claims experience and expense management. Premiums collected
on these products have decreased from year to year as we no longer actively
market these products through this segment.
73
Other Business in Run-Off (dollars in millions)
2006 2005 2004
---- ---- ----
Premiums collected by product:
Long-term care:
First-year............................................................ $ - $ - $ .3
Renewal............................................................... 323.0 349.1 379.8
------ ------ ------
Total long-term care................................................ 323.0 349.1 380.1
------ ------ ------
Major medical:
Group (renewal)....................................................... 1.9 .2 12.6
Individual (renewal).................................................. 2.9 2.6 3.2
------ ------ ------
Total major medical................................................. 4.8 2.8 15.8
------ ------ ------
Collections on insurance products:
Total first-year premium collections on
insurance products.................................................. - - .3
Total renewal premium collections on
insurance products.................................................. 327.8 351.9 395.6
------ ------ ------
Total collections on insurance products............................. $327.8 $351.9 $395.9
====== ====== ======
As described elsewhere, 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 by 7.5 percent,
to $323.0 million, in 2006 and by 8.2 percent, to $349.1 million, 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 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.
INVESTMENTS
Our investment strategy is to: (i) maintain a predominately
investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet
our cash obligations to policyholders and others; and (iii) generate stable and
predictable investment income through active investment management. Consistent
with this strategy, investments in fixed maturity securities, mortgage loans and
policy loans made up 97 percent of our $25.7 billion investment portfolio at
December 31, 2006. The remainder of the invested assets were trading securities,
equity securities and other invested assets.
74
The following table summarizes the composition of our investment
portfolio as of December 31, 2006 (dollars in millions):
Carrying Percent of
value total investments
----- -----------------
Actively managed fixed maturities............................................... $22,802.9 89%
Equity securities............................................................... 24.8 -
Mortgage loans.................................................................. 1,642.2 6
Policy loans.................................................................... 412.5 2
Trading securities.............................................................. 675.2 3
Partnership investments......................................................... 55.0 -
Other invested assets........................................................... 123.8 -
--------- ---
Total investments............................................................ $25,736.4 100%
========= ===
Insurance statutes regulate the types of investments that our insurance
subsidiaries are permitted to make and limit the amount of funds that may be
used for any one type of investment. In light of these statutes and regulations
and our business and investment strategy, we generally seek to invest in United
States government and government-agency securities and corporate securities
rated investment grade by established nationally recognized rating organizations
or in securities of comparable investment quality, if not rated.
The following table summarizes the carrying values of our fixed maturity
securities by category as of December 31, 2006 (dollars in millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 5,934.2 26.0%
Manufacturing........................................................................ 2,906.6 12.7
Bank and finance..................................................................... 2,229.7 9.8
Services............................................................................. 1,808.9 7.9
Utilities............................................................................ 1,630.8 7.2
U.S. Government...................................................................... 1,422.1 6.2
Holding and other investment offices................................................. 1,110.7 4.9
Communications....................................................................... 1,092.0 4.8
Agriculture, forestry and mining..................................................... 843.4 3.7
Retail and wholesale................................................................. 733.3 3.2
Transportation....................................................................... 695.2 3.1
States and political subdivisions.................................................... 669.5 2.9
Asset-backed securities.............................................................. 564.9 2.5
Other................................................................................ 1,161.6 5.1
--------- -----
Total actively managed fixed maturities........................................... $22,802.9 100.0%
========= =====
Our fixed maturity securities consist predominantly of publicly traded
securities. We classify securities issued in the Rule 144A market as publicly
traded. Privately traded securities comprise less than seven percent of our
total fixed maturity securities portfolio.
The following table sets forth fixed maturity investments at December 31,
2006, classified by rating categories. The category assigned is the highest
rating by a nationally recognized statistical rating organization or, as to
$985.8 million fair value of fixed maturities not rated by such firms, the
rating assigned by the NAIC. For purposes of the table, NAIC Class 1 is included
in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and
below" (dollars in millions):
75
Estimated fair value
--------------------------
Percent of
Amortized fixed
Investment rating cost Amount maturities
- ----------------- ---- ------ ----------
AAA...................................................................... $ 7,612.6 $ 7,533.0 33%
AA....................................................................... 1,524.0 1,505.5 6
A........................................................................ 5,634.2 5,613.7 25
BBB+..................................................................... 2,498.4 2,495.2 11
BBB...................................................................... 2,852.2 2,843.0 12
BBB-..................................................................... 1,264.1 1,257.6 6
--------- --------- ---
Investment grade..................................................... 21,385.5 21,248.0 93
--------- --------- ---
BB+ ..................................................................... 265.8 268.8 1
BB ..................................................................... 317.6 317.1 2
BB- ..................................................................... 518.5 509.3 2
B+ and below............................................................. 459.5 459.7 2
--------- --------- ---
Below-investment grade (a)........................................... 1,561.4 1,554.9 7
--------- --------- ---
Total fixed maturity securities................................... $22,946.9 $22,802.9 100%
========= ========= ===
<FN>
- ---------
(a) Below-investment grade fixed maturity securities with an amortized
cost of $448.6 million and an estimated fair value of $446.5 million
are securities held by a variable interest entity that we are required
to consolidate. These fixed maturity securities are legally isolated
and are not available to the Company. The liabilities of such variable
interest entity will be satisfied from the cash flows generated by
these securities. At December 31, 2006, our total investment in the
variable interest entity was $48.8 million, and $47.0 million of such
investment was rated BBB.
</FN>
The following table summarizes investment yields earned over the past three
years on the general account invested assets of our insurance subsidiaries.
General account investments exclude the value of options (dollars in millions).
2006 2005 2004
---- ---- ----
Weighted average general account invested assets as defined:
As reported ....................................................... $24,738.6 $25,000.3 $24,499.7
Excluding unrealized appreciation
(depreciation) (a)............................................... 25,112.2 24,491.6 24,049.8
Net investment income on general account
invested assets........................................................ 1,430.6 1,385.0 1,292.4
Yields earned:
As reported........................................................ 5.78% 5.54% 5.28%
Excluding unrealized appreciation
(depreciation) (a)............................................... 5.70% 5.66% 5.37%
<FN>
- --------------------
(a) Excludes the effect of reporting fixed maturities at fair value as
described in the note to our consolidated financial statements
entitled "Investments".
</FN>
Although investment income is a significant component of total revenues,
the profitability of certain of our insurance products is determined primarily
by the spreads between the interest rates we earn and the rates we credit or
accrue to our insurance liabilities. At December 31, 2006 and 2005, the average
yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 5.7 percent and 5.6 percent, respectively, and the average
interest rate credited or accruing to our total insurance liabilities (excluding
interest rate bonuses for the first policy year only and excluding the effect of
credited rates attributable to variable or equity-indexed products) was 4.6
percent and 4.6 percent, respectively.
76
Actively Managed Fixed Maturities
Our actively managed fixed maturity portfolio at December 31, 2006,
included primarily debt securities of the United States government, public
utilities and other corporations, and structured securities. Structured
securities included mortgage-backed securities, collateralized mortgage
obligations ("CMOs"), asset-backed securities and commercial mortgage-backed
securities.
At December 31, 2006, our fixed maturity portfolio had $198.3 million of
unrealized gains and $342.3 million of unrealized losses, for a net unrealized
loss of $144.0 million. Estimated fair values of fixed maturity investments were
determined based on estimates from: (i) nationally recognized pricing services
(91 percent of the portfolio); (ii) broker-dealer market makers (3 percent of
the portfolio); and (iii) internally developed methods (6 percent of the
portfolio).
At December 31, 2006, approximately 6.0 percent of our invested assets (6.8
percent of fixed maturity investments) were fixed maturities rated
below-investment grade by nationally recognized statistical rating organizations
(or, if not rated by such firms, with ratings below Class 2 assigned by the
NAIC). We currently plan to maintain our present level of investments in
below-investment-grade fixed maturities, although this plan could change if
market conditions change. Below-investment grade securities have different
characteristics than investment grade corporate debt securities. The 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, than investment grade issuers.
The Company attempts to reduce the overall risk related to its investment in
below-investment grade securities, as in all investments, through careful credit
analysis, strict investment policy guidelines, and diversification by issuer
and/or guarantor and by industry. At December 31, 2006, our
below-investment-grade fixed maturity investments had an amortized cost of
$1,561.4 million and an estimated fair value of $1,554.9 million.
We continually evaluate the creditworthiness of each issuer whose
securities we hold. We pay special attention to those securities whose market
values have declined materially for reasons other than changes in interest rates
or other general market conditions. We evaluate the realizable value of the
investment, the specific condition of the issuer and the issuer's ability to
comply with the material terms of the security. We review the recent operational
results and financial position of the issuer, information about its industry,
information about factors affecting the issuer's performance and other
information. 40|86 Advisors employs a staff of experienced securities analysts
in a variety of specialty areas who compile and review such data. If evidence
does not exist to support a realizable value equal to or greater than the
carrying value of the investment, and such decline in market value is determined
to be other than temporary, we reduce the carrying amount to its fair value,
which becomes the new cost basis. We report the amount of the reduction as a
realized loss. We recognize any recovery of such reductions as investment income
over the remaining life of the investment (but only to the extent our current
valuations indicate such amounts will ultimately be collected), or upon the
repayment of the investment. We recorded writedowns of fixed maturity
investments, equity securities and other invested assets totaling $22.4 million
in 2006. Our investment portfolio is subject to the risks of further declines in
realizable value. However, we attempt to mitigate this risk through the
diversification and active management of our portfolio.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we have both the ability and intent to hold securities with
unrealized losses until they mature or recover in value, we may sell securities
at a loss in the future because of actual or expected changes in our view of the
particular investment, its industry, its type or the general investment
environment.
As of December 31, 2006, our investments in substantive default (i.e., in
default due to nonpayment of interest or principal) or technical default (i.e.,
in default, but not as to the payment of interest or principal) had an amortized
cost of $7.0 million and a carrying value of $7.2 million. 40|86 Advisors
employs experienced professionals to manage non-performing and impaired
investments. There were no other fixed maturity investments about which we had
serious doubts as to the ability of the issuer to comply with the material terms
of the instrument on a timely basis.
When a security defaults, our policy is to discontinue the accrual of
interest and eliminate all previous interest accruals, if we determine that such
amounts will not be ultimately realized in full. Investment income forgone due
to
77
defaulted securities was nil, $.8 million and $3.5 million for the years ended
December 31, 2006, 2005 and 2004, respectively.
At December 31, 2006, fixed maturity investments included $5.9 billion of
structured securities (or 26 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations and commercial mortgage-backed securities. CMOs are backed
by pools of mortgages that are segregated into sections or "tranches" that
prioritize principal retirement. Pass-through securities receive principal and
interest payments through their regular pro rata share of the payments on the
underlying mortgages backing the 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 may occur more frequently, often monthly. In
addition, mortgage-backed securities are often subject to a higher degree of
risk associated with variable prepayments of principal. For example, prepayment
rates are influenced by a number of factors that cannot be predicted with
certainty, including: the relative sensitivity of the underlying mortgages
backing the assets to changes in interest rates; a variety of economic,
geographic and other factors; and various security-specific structural
considerations (for example, the repayment priority of a given security in a
securitization structure).
In general, the rate of prepayments on structured securities increases when
prevailing interest rates decline significantly in absolute terms and also
relative to the interest rates on the underlying loans. The yields 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 December 31, 2006 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent.......................................................... $ 201.1 $ 201.0 $ 197.6
4 percent - 5 percent.................................................... 1,132.7 1,087.6 1,075.3
5 percent - 6 percent.................................................... 3,880.6 3,829.3 3,778.1
6 percent - 7 percent.................................................... 729.1 739.1 736.8
7 percent - 8 percent.................................................... 115.4 118.9 118.6
8 percent and above...................................................... 26.4 27.0 27.8
-------- -------- --------
Total structured securities (a)................................... $6,085.3 $6,002.9 $5,934.2
======== ======== ========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an
amortized cost and estimated fair value of $18.2 million and $18.4
million, respectively.
</FN>
The amortized cost and estimated fair value of structured securities at
December 31, 2006, summarized by type of security, were as follows (dollars in
millions):
Estimated Fair Value
------------------------
Percent of
Amortized fixed
Type Cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs and sequential and targeted amortization classes.......... $3,709.4 $3,662.4 16%
Planned amortization classes and accretion-directed bonds............... 894.1 882.5 4
Commercial mortgage-backed securities................................... 1,383.1 1,373.0 6
Other................................................................... 16.3 16.3 -
-------- -------- --
Total structured securities (a).................................. $6,002.9 $5,934.2 26%
======== ======== ==
78
- --------------------
(a) Includes below-investment grade structured securities with an
amortized cost and estimated fair value of $18.2 million and $18.4
million, respectively.
Pass-through securities and sequential and targeted amortization class
securities typically 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.
During 2006, we sold $3.2 billion of fixed maturity investments which
resulted in gross investment losses (before income taxes) of $98.5 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; or (v) our analysis
indicates there is a high probability that the security is
other-than-temporarily impaired. As discussed in the notes to our consolidated
financial statements, the realization of gains and losses affects the timing of
the amortization of insurance acquisition costs related to universal life and
investment products.
Other Investments
At December 31, 2006, we held mortgage loan investments with a carrying
value of $1,642.2 million (or 6.4 percent of total invested assets) and a fair
value of $1,684.7 million. The mortgage loan balance was primarily comprised of
commercial loans. Noncurrent mortgage loans were insignificant at December 31,
2006. Realized losses on mortgage loans were not significant in any of the past
three years. Our allowance for loss on mortgage loans was $2.4 million at both
December 31, 2006 and 2005. Approximately 8 percent, 7 percent, 6 percent and 6
percent of the mortgage loan balance were on properties located in Minnesota,
Ohio, New York and California, respectively. No other state comprised greater
than 6 percent of the mortgage loan balance.
The following table shows the distribution of our mortgage loan portfolio
by property type as of December 31, 2006 (dollars in millions):
Number of Carrying
loans value
----- -----
Retail.......................................................................... 362 $ 881.6
Office building................................................................. 147 575.3
Industrial...................................................................... 49 131.3
Multi-family.................................................................... 36 41.6
Other........................................................................... 4 12.4
--- --------
Total mortgage loans......................................................... 598 $1,642.2
=== ========
79
The following table shows our mortgage loan portfolio by loan size (dollars
in millions):
Number Principal
of loans balance
-------- -------
Under $5 million................................................................ 518 $ 967.6
$5 million but less than $10 million............................................ 66 457.0
$10 million but less than $20 million........................................... 11 146.9
Over $20 million................................................................ 3 74.9
--- --------
Total mortgage loans......................................................... 598 $1,646.4
=== ========
The following table summarizes the distribution of maturities of our
mortgage loans (dollars in millions):
Number Principal
of loans balance
-------- -------
2007............................................................................ 12 $ 1.4
2008............................................................................ 12 13.7
2009............................................................................ 31 97.6
2010............................................................................ 8 2.5
2011............................................................................ 22 82.5
after 2011...................................................................... 513 1,448.7
--- --------
Total mortgage loans......................................................... 598 $1,646.4
=== ========
At December 31, 2006, we held $675.2 million of trading securities. We
carry trading securities at estimated fair value; changes in fair value are
reflected in the statement of operations. 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 to the
consolidated financial statements entitled "Summary of Significant Accounting
Policies - 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.
Other invested assets also include options backing our equity-indexed
products, futures, credit default swaps, forward contracts and certain
nontraditional investments, including investments in limited partnerships,
promissory notes and real estate investments held for sale.
From time-to-time, as part of our investment strategy, we enter into
reverse repurchase agreements and dollar-roll transactions to increase our
return on investments and improve our liquidity. Reverse repurchase agreements
involve a sale of securities and an agreement to repurchase the same securities
at a later date at an agreed-upon price. Dollar rolls are similar to reverse
repurchase agreements except that the repurchase involves securities that are
only substantially the same as the securities sold. We enhance our investment
yield by investing the proceeds from the sales in short-term securities pending
the contractual repurchase of the securities at discounted prices in the forward
market. In many cases, such transactions arise from the market demand for
mortgage-backed securities to form CMOs. During the third quarter of 2005, the
market spread on these transactions declined to a level at which our continued
participation in these transactions was not profitable. As a result, these
transactions were terminated. Investment borrowings related to repurchase and
dollar-roll transactions averaged approximately $234.2 million and $522.6
million during the years ended December 31, 2005 and 2004, respectively, and
were collateralized by investment securities with fair values approximately
equal to the loan values. The weighted average interest rates on such borrowings
were 2.9 percent and 1.5 percent during the years ended December 31, 2005 and
2004, respectively. The primary risk associated with short-term collateralized
borrowings is that the counterparty might be unable to perform under the terms
of the contract. Our exposure is limited to the excess of the net replacement
cost of the securities over the value of the short-term investments.
80
Investment borrowings as of December 31, 2006 and 2005, consisted of the
following (dollars in millions):
2006 2005
------ ------
Securities issued by variable
interest entity........................ $406.8 $302.2
Other..................................... 11.5 12.9
------ ------
Total.................................. $418.3 $315.1
====== ======
Securities issued by the variable interest entity are the liabilities of a
collateralized loan trust which is consolidated with the Company. Repayment of
the securities is primarily dependent on cash flows generated by the invested
assets of the trust.
CONSOLIDATED FINANCIAL CONDITION
Changes in the Consolidated Balance Sheet
Changes in our consolidated balance sheet between December 31, 2006 and
December 31, 2005, primarily reflect: (i) our net income for 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 December 31, 2006, we decreased the
carrying value of such investments by $136.3 million as a result of this fair
value adjustment.
Our capital structure as of December 31, 2006 and 2005, was as follows
(dollars in millions):
2006 2005
---- ----
Total capital:
Corporate notes payable ...................................... $1,000.8 $ 851.5
Shareholders' equity:
Preferred stock ........................................... 667.8 667.8
Common stock............................................... 1.5 1.5
Additional paid-in capital................................. 3,473.2 3,194.1
Accumulated other comprehensive income (loss).............. (72.6) 71.7
Retained earnings.......................................... 643.2 584.7
-------- --------
Total shareholders' equity............................. 4,713.1 4,519.8
-------- --------
Total capital.......................................... $5,713.9 $5,371.3
======== ========
81
The following table summarizes certain financial ratios as of and for the
years ended December 31, 2006 and 2005:
2006 2005
---- ----
Book value per common share................................................................... $26.58 $25.42
Book value per common share, excluding accumulated other comprehensive income (a)............. 27.06 24.95
Ratio of earnings to fixed charges............................................................ 1.30x 2.03x
Ratio of earnings to fixed charges and preferred dividends.................................... 1.16x 1.81x
Debt to total capital ratios:
Corporate debt to total capital.......................................................... 18% 16%
Corporate debt to total capital, excluding accumulated other comprehensive income (a).... 17% 16%
Corporate debt and preferred stock to total capital...................................... 29% 28%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (a)............................................................... 29% 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>
Contractual Obligations
The Company's significant contractual obligations as of December 31, 2006,
were as follows (dollars in millions):
Payment due in
-------------------------------------------------------
Total 2007 2008-2009 2010-2011 Thereafter
----- ---- --------- --------- ----------
Insurance liabilities (a)............ $56,726.6 $4,047.0 $7,322.8 $6,629.1 $38,727.7
Notes payable (b).................... 1,378.1 68.7 135.8 449.4 724.2
Investment borrowings (c)............ 683.9 26.3 54.9 51.0 551.7
Postretirement plans (d)............. 158.7 3.6 7.3 8.0 139.8
Operating leases and certain other
contractual commitments (e)...... 211.9 35.1 55.4 39.2 82.2
--------- -------- -------- -------- ---------
Total............................ $59,159.2 $4,180.7 $7,576.2 $7,176.7 $40,225.6
========= ======== ======== ======== =========
<FN>
- --------------------
(a) These cash flows represent our estimates of the payments we expect to
make to our policyholders, without consideration of future premiums or
reinsurance recoveries. These estimates are based on numerous
assumptions (depending on the product type) related to mortality,
morbidity, lapses, withdrawals, future premiums, future deposits,
interest rates on investments, credited rates, expenses and other
factors which affect our future payments. The cash flows presented are
undiscounted for interest. As a result, total outflows for all years
exceed the corresponding liabilities of $26.0 billion included in our
consolidated balance sheet as of December 31, 2006. As such payments
are based on numerous assumptions, the actual payments may vary
significantly from the amounts shown.
In estimating the payments we expect to make to our policyholders, we
considered the following:
o For products such as immediate annuities and structured
settlement annuities without life contingencies, the payment
obligation is fixed and determinable based on the terms of
the policy.
o For products such as universal life, ordinary life,
long-term care, specified disease and fixed rate annuities,
the
</FN>
82
future payments are not due until the occurrence of an
insurable event (such as death or disability) or a
triggering event (such as a surrender or partial
withdrawal). We estimated these payments using actuarial
models based on historical experience and our expectation of
the future payment patterns.
o For short-term insurance products such as Medicare
supplement insurance, the future payments relate only to
amounts necessary to settle all outstanding claims,
including those that have been incurred but not reported as
of the balance sheet date. We estimated these payments based
on our historical experience and our expectation of future
payment patterns.
o The average interest rate we assumed would be credited to
our total insurance liabilities (excluding interest rate
bonuses for the first policy year only and excluding the
effect of credited rates attributable to variable or
equity-indexed products) over the term of the contracts was
4.6 percent.
(b) Includes projected interest payments based on market rates, as
applicable, as of December 31, 2006. Refer to the notes to the
consolidated financial statements entitled "Notes Payable - Direct
Corporate Obligations" for additional information on notes payable.
(c) These borrowings primarily represent the securities issued by a
variable interest entity and include projected interest payments based
on market rates, as applicable, as of December 31, 2006.
(d) Includes benefits expected to be paid pursuant to our deferred
compensation plan and postretirement plans based on numerous actuarial
assumptions and interest credited at 5.75 percent.
(e) Refer to the notes to the consolidated financial statements entitled
"Commitments and Contingencies" for additional information on
operating leases and certain other contractual commitments.
It is possible that the ultimate outcomes of various uncertainties could
affect our liquidity in future periods. For example, the following events could
have a material adverse effect on our cash flows:
o An adverse decision in pending or future litigation.
o An inability to obtain rate increases on certain of our insurance
products.
o Worse than anticipated claims experience.
o Lower than expected dividends and/or surplus debenture interest
payments from our insurance subsidiaries (resulting from inadequate
earnings or capital or regulatory requirements).
o An inability to meet and/or maintain the covenants in our Second
Amended Credit Facility.
o A significant increase in policy surrender levels.
o A significant increase in investment defaults.
o An inability of our reinsurers to meet their financial obligations.
While we seek to balance the duration and cash flows of our invested assets
with the estimated duration and cash flows of benefit payments arising from
contract liabilities, there could be significant variations in the timing of
such cash flows. The claim experience on our long-term care business in the
Other Business in Run-off segment has been worse than our original pricing
expectations. Although we believe our current estimates properly project future
claim experience, if these estimates prove to be wrong, and our experience
worsens (as it did in some prior periods), our future liquidity could be
adversely affected.
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
83
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
"Commitments and Contingencies".
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 Other 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 loss for this segment
was $41.9 million for the year ended December 31, 2006 and we
contributed capital of $110 million to Conseco Senior in 2006,
including $80 million which was accrued at December 31, 2006 and paid
in February 2007).
- 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 $189.0 million for the year ended December 31,
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 Other 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
loss for this segment was $41.9 million for the year ended December
31, 2006 and we contributed capital of $110 million to Conseco Senior
in 2006, including $80 million which was accrued at December 31, 2006
and paid in February 2007).
- 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 $258.4 million for the year ended December 31, 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 $189.0 million for the
year ended December 31, 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 was 6 percent in 2006).
- Maintain financial leverage below 25 percent with EBIT interest
coverage of at least five times. (We are exceeding these requirements
at December 31, 2006).
84
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.
The current financial strength ratings of our primary insurance
subsidiaries (except Conseco Senior) from S&P are "BB+" and Conseco Senior's
rating is "CCC". On February 23, 2007, S&P affirmed the financial strength
ratings of our core insurance subsidiaries and Conseco Senior and revised its
outlook on our primary insurance subsidiaries to stable from positive, except
Conseco Senior, for which the outlook was revised to negative from stable. 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. 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.
We have adopted several initiatives designed to reduce the expense levels
that exceed product pricing in our Conseco Insurance Group segment. These
initiatives include system conversions in our Other Business in Run-off segment
which will eliminate duplicate processing systems, improve work flow and
automate manually-intensive systems. We expect to spend over $26 million on
capital expenditures in 2007 (including amounts related to these initiatives).
We believe we have adequate cash flows from operations to fund these
initiatives.
State laws generally give state insurance regulatory agencies broad
authority to protect policyholders in their jurisdictions. Regulators have used
this authority in the past to restrict the ability of our insurance subsidiaries
to pay any dividends or other amounts to any non-insurance company parent
without prior approval. We cannot be assured that the regulators will not seek
to assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs.
In connection with monitoring the financial condition of insurers, certain
state insurance departments have requested additional information from two of
the Company's insurance subsidiaries, Conseco Senior and Conseco Life, as such
insurance subsidiaries have incurred statutory losses in a 12 month period in
excess of 50 percent of its capital and surplus. The statutory losses of Conseco
Life are primarily attributable to a tentative litigation settlement. 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 "Commitments and Contingencies". The statutory losses of
Conseco Senior are primarily attributable to the adverse development of prior
period claim reserves and an increase in initial claims during 2006 related to
long-term care policies. Based on our discussions with state insurance
departments, we do not expect the regulators to take any actions against Conseco
Senior or Conseco Life due to the causes of our statutory losses and the actions
being undertaken by the Company.
Conseco Senior has 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. The full effect of
all three years of rate increases will take as long as five years to be fully
realized. It is possible
85
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.
During 2006, the financial statements of three of our subsidiaries prepared
in accordance with statutory accounting practices prescribed or permitted by
regulatory authorities reflected the establishment of asset adequacy and premium
deficiency reserves primarily related to long-term care policies. Total asset
adequacy and premium deficiency reserves for Conseco Senior, Washington National
and Bankers Conseco Life Insurance Company were $30.0 million, $47.0 million and
$16.6 million, respectively at December 31, 2006. Due to increases to insurance
liabilities at the fresh-start date, we were not required to recognize a similar
premium deficiency reserve in our consolidated financial statements prepared in
accordance with GAAP.
Liquidity of the Holding Companies
In October 2006, we entered into the Second Amended Credit Facility. 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 is 200 basis points over LIBOR, an increase of 25 basis points over the
Amended Credit Facility. Approximately $195 million of the proceeds were used to
strengthen the capital of our insurance subsidiaries. During 2006, we made
scheduled principal payments totaling $1.3 million on our Amended Credit
Facility, as well as a mandatory prepayment of $45.0 million based on the
Company's excess cash flows at December 31, 2005, as defined in the Amended
Credit Facility. Under the terms of the Second Amended Credit Facility, we are
required to make quarterly principal payments of .25 percent (approximately $1.7
million) of the initial principal amount through September 30, 2013. The
remaining principal balance is due on October 10, 2013. At December 31, 2006,
the interest rate on our Second Amended Credit Facility was 7.4 percent.
In August 2005, we entered into the Amended Credit Facility with a balance
of $447.0 million. The proceeds of the Amended Credit Facility were used to
repay the remaining principal amount of the $800.0 million secured credit
facility (the "Credit Facility"). The Amended Credit Facility provided for a
one-time increase in the facility or the addition of a new facility of up to
$325.0 million. In December 2005, we borrowed an additional $80.0 million
pursuant to this provision. The proceeds from the additional borrowing were used
to increase the capital and surplus of our insurance subsidiaries. During 2005,
we made principal payments totaling $2.4 million on our Amended Credit Facility.
The Second Amended Credit Facility includes an $80.0 million revolving
credit facility that can be used for general corporate purposes and that would
mature on June 22, 2009. There were no amounts outstanding under the revolving
credit facility at December 31, 2006. The Company pays a commitment fee equal to
..50 percent of the unused portion of the revolving credit facility on an
annualized basis.
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). As further discussed in the note to
the consolidated financial statements entitled "Shareholders Equity", we
repurchased 1.2 million shares of our common stock for $25.0 million in January
2007.
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
86
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.
The Amended Credit Facility and Second Amended Credit Facility are
discussed in further detail in the note to the consolidated financial statements
entitled "Notes Payable - Direct Corporate Obligations".
At December 31, 2006, Conseco Inc. and CDOC held unrestricted cash of $95.9
million. Conseco Inc. and CDOC are holding companies with no business operations
of their own; they depend on their operating subsidiaries for cash to make
principal and interest payments on debt, and to pay administrative expenses and
income taxes. Conseco and CDOC receive cash from insurance subsidiaries,
consisting of dividends and distributions, principal and interest payments on
surplus debentures and tax-sharing payments, as well as cash from non-insurance
subsidiaries consisting of dividends, distributions, loans and advances. The
principal non-insurance subsidiaries that provide cash to Conseco and CDOC are
40|86 Advisors, which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives fees from the
insurance subsidiaries for providing administrative services. A deterioration in
the financial condition, earnings or cash flow of the material subsidiaries of
Conseco or CDOC for any reason could hinder such subsidiaries' ability to pay
cash dividends or other disbursements to Conseco and/or CDOC, which, in turn,
would limit Conseco's and/or CDOC's ability to meet debt service requirements
and satisfy other financial obligations. In addition, we may need to contribute
additional capital to certain insurance subsidiaries to strengthen their surplus
and this could affect the ability of our top tier insurance subsidiary to pay
dividends. We made capital contributions totaling $127.0 million to our top tier
insurance subsidiary in 2006 including $50.0 million of capital contributions
which were accrued at December 31, 2006, and paid in February 2007.
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 2006, our top tier
insurance subsidiary paid dividends of $72.5 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.
MARKET-SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Our spread-based insurance business is subject to several inherent risks
arising from movements in interest rates, especially if we fail to anticipate or
respond to such movements. First, interest rate changes can cause compression of
our net spread between interest earned on investments and interest credited on
customer deposits, thereby adversely affecting our results. Second, if interest
rate changes produce an unanticipated increase in surrenders of our spread-based
products, we may be forced to sell investment assets at a loss in order to fund
such surrenders. Many of our products include surrender charges, market interest
rate adjustments or other features to encourage persistency; however at December
31, 2006, approximately 18 percent of our total insurance liabilities, or
approximately $4.7 billion, could be surrendered by the policyholder without
penalty. Finally, changes in interest rates can have significant effects on the
performance of our structured securities portfolio as a result of changes in the
prepayment rate of the loans underlying such securities. We follow
asset/liability strategies that are designed to mitigate the effect of interest
rate changes on our profitability. However, there can be no assurance that
management will be successful in implementing such strategies and achieving
adequate investment spreads.
87
We seek to invest our available funds in a manner that will fund future
obligations to policyholders, subject to appropriate risk considerations. We
seek to meet this objective through investments that: (i) have similar cash flow
characteristics with the liabilities they support; (ii) are diversified among
industries, issuers and geographic locations; and (iii) are predominantly
investment-grade fixed maturity securities.
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, our entire portfolio of fixed
maturity securities is available to be sold in response to: (i) changes in
market interest rates; (ii) changes in relative values of individual securities
and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit
quality outlook for certain securities; (v) liquidity needs; and (vi) other
factors. From time to time, we invest in securities for trading purposes,
although such investments are a relatively small portion of our total portfolio.
The profitability of many of our products depends on the spread between the
interest earned on investments and the rates credited on our insurance
liabilities. In addition, changes in competition and other factors, including
the level of surrenders and withdrawals, may limit our ability to adjust or to
maintain crediting rates at levels necessary to avoid narrowing of spreads under
certain market conditions. As of December 31, 2006, approximately 40 percent of
our insurance liabilities had interest rates that may be reset annually; 46
percent had a fixed explicit interest rate for the duration of the contract; 10
percent had credited rates which approximate the income earned by the Company;
and the remainder had no explicit interest rates. At December 31, 2006, the
average yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 5.7 percent, and the average interest rate credited or accruing
to our total insurance liabilities (excluding interest rate bonuses for the
first policy year only and excluding the effect of credited rates attributable
to variable or equity-indexed products) was 4.6 percent.
We use computer models to simulate the cash flows expected from our
existing insurance business under various interest rate scenarios. These
simulations help us to measure the potential gain or loss in fair value of our
interest rate-sensitive financial instruments and to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, exposure to
interest rate risk is minimized because a change in the value of assets should
be largely offset by a change in the value of liabilities. At December 31, 2006,
the adjusted modified duration of our fixed maturity investments (as modified to
reflect payments and potential calls) was approximately 7.0 years and the
duration of our insurance liabilities was approximately 7.4 years. We estimate
that our fixed maturity securities and short-term investments (net of
corresponding changes in insurance acquisition costs) would decline in fair
value by approximately $515 million if interest rates were to increase by 10
percent from their levels at December 31, 2006. This compares to a decline in
fair value of $685 million based on amounts and rates at December 31, 2005. Our
computer simulated calculations include numerous assumptions, require
significant estimates and assume an immediate change in interest rates without
any management of the investment portfolio in reaction to such change.
Consequently, potential changes in value of our financial instruments indicated
by the simulations will likely be different from the actual changes experienced
under given interest rate scenarios, and the differences may be material.
Because we actively manage our investments and liabilities, our net exposure to
interest rates can vary over time.
We are subject to the risk that our investments will decline in value. This
has occurred in the past and may occur again. During 2006, we recognized net
realized investment losses of $47.2 million, which were comprised of $24.8
million of net losses from the sales of investments (primarily fixed maturities)
with proceeds of $6.4 billion, and $22.4 million of writedowns of investments
resulting from a decline in the fair value of an investment that we concluded
was other than temporary. During 2005, we recognized net realized investment
losses of $2.9 million, which were comprised of $11.8 million of net gains from
the sales of investments (primarily fixed maturities) with proceeds of $11.5
billion, net of $14.7 million of writedowns of investments resulting from a
decline in the fair value of an investment that we concluded was other than
temporary. During 2004, we recognized net realized investment gains of $40.6
million, which were comprised of $58.7 million of net gains from the sales of
investments (primarily fixed maturities) with proceeds of $12.7 billion, net of
$18.1 million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary.
The operations of the Company are subject to risk resulting from
fluctuations in market prices of our equity securities. In general, these
investments have more year-to-year price variability than our fixed maturity
investments. However, returns over longer time frames have been consistently
higher. We manage this risk by limiting our equity securities to a relatively
small portion of our total investments.
Our investment in options backing our equity-linked products is closely
matched with our obligation to equity-indexed annuity holders. Market value
changes associated with that investment are substantially offset by an increase
or decrease in the amounts added to policyholder account balances for
equity-indexed products.
88
Inflation
Inflation rates may impact the financial statements and operating results
in several areas. Inflation influences interest rates, which in turn impact the
market value of the investment portfolio and yields on new investments.
Inflation also impacts a portion of our insurance policy benefits affected by
increased medical coverage costs. Operating expenses, including payrolls, are
impacted to a certain degree by the inflation rate.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information included under the caption "Market-Sensitive Instruments
and Risk Management" in Item 7. "Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations" is incorporated
herein by reference.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Index to Consolidated Financial Statements
Page
----
Report of Independent Registered Public Accounting Firm............................................................... 90
Consolidated Balance Sheet at December 31, 2006 and 2005.............................................................. 92
Consolidated Statement of Operations for the years ended December 31, 2006, 2005 and 2004............................. 94
Consolidated Statement of Shareholders' Equity for the years ended December 31, 2006, 2005 and 2004................... 95
Consolidated Statement of Cash Flows for the years ended December 31, 2006, 2005 and 2004............................. 97
Notes to Consolidated Financial Statements............................................................................ 98
89
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors Conseco, Inc.:
We have completed integrated audits of Conseco, Inc.'s consolidated financial
statements and of its internal control over financial reporting as of December
31, 2006, in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Our opinions, based on our audits, are
presented below.
Consolidated financial statements
- ---------------------------------
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of
Conseco, Inc. and its subsidiaries (Company) at December 31, 2006 and 2005, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 2006 in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit of
financial statements includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
Internal control over financial reporting
- -----------------------------------------
Also, we have audited management's assessment, included in Management's Report
on Internal Control Over Financial Reporting appearing under Item 9A, that
Conseco, Inc. did not maintain effective internal control over financial
reporting as of December 31, 2006, because of the effect of the material
weakness relating to controls over the actuarial reporting process, based on
criteria established in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express opinions on
management's assessment and on the effectiveness of the Company's internal
control over financial reporting based on our audit.
We conducted our audit of internal control over financial reporting in
accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. An audit of
internal control over financial reporting includes obtaining an understanding of
internal control over financial reporting, evaluating management's assessment,
testing and evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we consider necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company;
(ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
90
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. The following material weakness has been identified and included in
management's assessment.
As of December 31, 2006, Conseco, Inc. did not maintain effective controls over
the accounting and disclosure of insurance policy benefits and the liabilities
for insurance products. Specifically, Conseco, Inc. did not maintain effective
controls over the actuarial reporting processes related to the design of
controls to ensure the completeness and accuracy of the inforce policies for a
block of single premium immediate annuities in the Bankers Life segment,
controls to ensure that accurate reserves are established for all policy
benefits related to certain supplemental insurance coverages applicable to a
block of specified disease policies in the Conseco Insurance Group segment, and
controls to ensure the accuracy of benefit reserves on certain long-term care
policies with inflation riders, lifetime benefit features or non-forfeiture
provisions in the Other Business in Run-off segment. These control deficiencies
resulted in adjustments to insurance policy benefits and the liabilities for
insurance products in the consolidated financial statements for the year ended
December 31, 2006. Additionally, these control deficiencies could result in the
misstatement of the aforementioned accounts that would result in a material
misstatement in the annual or interim Conseco, Inc. consolidated financial
statements that would not be prevented or detected. Accordingly, Conseco, Inc.
management has concluded that these control deficiencies constitute a material
weakness.
This material weakness was considered in determining the nature, timing, and
extent of audit tests applied in our audit of the December 31, 2006 consolidated
financial statements, and our opinion regarding the effectiveness of the
Company's internal control over financial reporting does not affect our opinion
on those consolidated financial statements.
In our opinion, management's assessment that Conseco, Inc. did not maintain
effective internal control over financial reporting as of December 31, 2006, is
fairly stated, in all material respects, based on criteria established in
Internal Control - Integrated Framework issued by the COSO. Also, in our
opinion, because of the effect of the material weakness described above on the
achievement of the objectives of the control criteria, Conseco, Inc. has not
maintained effective internal control over financial reporting as of December
31, 2006, based on criteria established in Internal Control - Integrated
Framework issued by the COSO.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
Indianapolis, Indiana
March 9, 2007
91
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
December 31, 2006 and 2005
(Dollars in millions)
ASSETS
2006 2005
---- ----
Investments:
Actively managed fixed maturities at fair value (amortized cost:
2006 - $22,946.9; 2005 - $22,380.2)............................................... $22,802.9 $22,494.2
Equity securities at fair value (cost: 2006 - $23.9; 2005 - $25.6).................. 24.8 27.1
Mortgage loans...................................................................... 1,642.2 1,264.2
Policy loans........................................................................ 412.5 429.8
Trading securities.................................................................. 675.2 716.3
Other invested assets .............................................................. 178.8 109.6
--------- ---------
Total investments................................................................. 25,736.4 25,041.2
Cash and cash equivalents:
Unrestricted........................................................................ 385.9 237.8
Restricted.......................................................................... 24.0 35.2
Accrued investment income................................................................ 344.5 315.4
Value of policies inforce at the Effective Date.......................................... 2,137.2 2,382.0
Cost of policies produced................................................................ 1,106.7 758.8
Reinsurance receivables.................................................................. 850.8 887.5
Income tax assets, net................................................................... 1,786.9 1,496.6
Assets held in separate accounts......................................................... 28.9 29.8
Other assets............................................................................. 316.0 341.0
--------- ---------
Total assets...................................................................... $32,717.3 $31,525.3
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
92
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (Continued)
December 31, 2006 and 2005
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
2006 2005
---- ----
Liabilities:
Liabilities for insurance products:
Interest-sensitive products........................................................ $13,018.0 $12,686.8
Traditional products............................................................... 12,094.1 11,840.2
Claims payable and other policyholder funds........................................ 832.3 842.1
Liabilities related to separate accounts........................................... 28.9 29.8
Other liabilities.................................................................... 611.8 440.0
Investment borrowings................................................................ 418.3 315.1
Notes payable - direct corporate obligations......................................... 1,000.8 851.5
--------- ---------
Total liabilities................................................................ 28,004.2 27,005.5
--------- ---------
Commitments and Contingencies (Note 8)
Shareholders' equity:
Preferred stock...................................................................... 667.8 667.8
Common stock ($0.01 par value, 8,000,000,000 shares authorized,
shares issued and outstanding: 2006 - 152,165,108; 2005 - 151,513,434)............ 1.5 1.5
Additional paid-in capital........................................................... 3,473.2 3,194.1
Accumulated other comprehensive income (loss)........................................ (72.6) 71.7
Retained earnings.................................................................... 643.2 584.7
--------- ---------
Total shareholders' equity....................................................... 4,713.1 4,519.8
--------- ---------
Total liabilities and shareholders' equity....................................... $32,717.3 $31,525.3
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
93
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
for the years ended December 31, 2006, 2005 and 2004
(Dollars in millions, except per share data)
2006 2005 2004
---- ---- ----
Revenues:
Insurance policy income.............................................. $2,989.0 $2,930.1 $2,949.3
Net investment income (loss):
General account assets............................................ 1,435.2 1,390.4 1,294.5
Policyholder and reinsurer accounts............................... 71.2 (15.8) 24.1
Net realized investment gains (losses) .............................. (47.2) (2.9) 40.6
Fee revenue and other income......................................... 19.2 24.7 21.5
-------- -------- --------
Total revenues.................................................... 4,467.4 4,326.5 4,330.0
-------- -------- --------
Benefits and expenses:
Insurance policy benefits............................................ 3,068.4 2,800.6 2,795.2
Interest expense..................................................... 73.5 58.3 79.5
Amortization......................................................... 423.4 388.4 371.2
(Gain) loss on extinguishment of debt................................ .7 3.7 (2.8)
Costs related to the tentative litigation settlement................. 174.7 18.3 9.8
Other operating costs and expenses................................... 574.4 553.8 623.0
-------- -------- --------
Total benefits and expenses....................................... 4,315.1 3,823.1 3,875.9
-------- -------- --------
Income before income taxes........................................ 152.3 503.4 454.1
Income tax expense on period income...................................... 55.8 178.5 159.3
-------- -------- --------
Net income........................................................ 96.5 324.9 294.8
Preferred stock dividends................................................ 38.0 38.0 65.5
-------- -------- --------
Net income applicable to common stock............................. $ 58.5 $ 286.9 $ 229.3
======== ======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding............................. 151,690,000 151,160,000 132,280,000
=========== =========== ===========
Net income...................................................... $.39 $1.90 $1.73
==== ===== =====
Diluted:
Weighted average shares outstanding............................. 152,509,000 185,040,000 155,930,000
=========== =========== ===========
Net income...................................................... $.38 $1.76 $1.63
==== ===== =====
The accompanying notes are an integral part
of the consolidated financial statements.
94
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income earnings
----- ----- --------------- ------ --------
Balance, December 31, 2003........................... $2,817.6 $887.5 $1,642.9 $218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 294.8 - - - 294.8
Change in unrealized appreciation of
investments (net of applicable income tax
expense of $65.4)............................. 118.6 - - 118.6 -
--------
Total comprehensive income.................. 413.4
Issuance of shares for stock options and
for employee benefit plans, net................. 12.4 - 12.4 - -
Issuance of mandatorily convertible
preferred stock, net............................ 667.8 667.8 - - -
Redemption of cumulative convertible
exchangeable preferred stock.................... (928.9) (928.9) - - -
Issuance of common stock, net..................... 882.2 - 882.2 - -
Reduction of deferred income tax valuation
allowance....................................... 61.8 - 61.8 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................... 41.4 41.4 - - -
Dividends on preferred stock...................... (65.5) - - - (65.5)
-------- ------ -------- ------ ------
Balance, December 31, 2004........................... 3,902.2 667.8 2,599.3 337.3 297.8
Comprehensive income, net of tax:
Net income...................................... 324.9 - - - 324.9
Change in unrealized appreciation of
investments (net of applicable income tax
benefit of $148.7)............................ (265.6) - - (265.6) -
--------
Total comprehensive income.................. 59.3
Reduction of deferred income tax valuation
allowance....................................... 585.8 - 585.8 - -
Stock option and restricted stock plans........... 9.1 - 9.1 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date............................................ 1.4 - 1.4 - -
Dividends on preferred stock...................... (38.0) - - - (38.0)
-------- ------ -------- ------ ------
Balance, December 31, 2005........................... $4,519.8 $ 667.8 $3,195.6 $ 71.7 $584.7
(continued on following page)
The accompanying notes are an integral part
of the consolidated financial statements.
95
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Continued)
(Dollars in millions)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income (loss) earnings
----- ----- --------------- ------------- --------
Balance, December 31, 2005 (carried forward from
prior page)....................................... $4,519.8 $667.8 $3,195.6 $ 71.7 $584.7
Comprehensive loss, net of tax:
Net income...................................... 96.5 - - - 96.5
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $77.4)............................. (137.9) - - (137.9) -
--------
Total comprehensive loss.................... (41.4)
Adjustment to initially apply SFAS No. 158
related to the unrecognized net loss related
to deferred compensation plan (net of
applicable income tax benefit of $3.5).......... (6.4) - - (6.4) -
Reduction of deferred income tax valuation
allowance....................................... 260.0 - 260.0 - -
Stock option and restricted stock plans........... 12.4 - 12.4 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date............................................ 6.7 - 6.7 - -
Dividends on preferred stock...................... (38.0) - - - (38.0)
-------- ------ -------- ------ ------
Balance, December 31, 2006........................... $4,713.1 $667.8 $3,474.7 $(72.6) $643.2
======== ====== ======== ====== ======
The accompanying notes are an integral part
of the consolidated financial statements.
96
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
for the years ended December 31, 2006, 2005 and 2004
(Dollars in millions)
2006 2005 2004
---- ---- ----
Cash flows from operating activities:
Insurance policy income............................................... $ 2,633.4 $ 2,565.3 $ 2,567.5
Net investment income................................................. 1,500.5 1,461.0 1,494.9
Fee revenue and other income.......................................... 19.3 24.7 21.5
Net sales of trading securities....................................... 36.0 165.8 21.1
Insurance policy benefits............................................. (2,184.2) (2,044.8) (2,058.9)
Interest expense...................................................... (66.9) (40.6) (72.2)
Policy acquisition costs.............................................. (484.7) (400.9) (364.4)
Other operating costs................................................. (523.7) (596.8) (579.5)
Taxes................................................................. 1.5 28.4 17.6
--------- --------- ---------
Net cash provided by operating activities......................... 931.2 1,162.1 1,047.6
--------- --------- ---------
Cash flows from investing activities:
Sales of investments.................................................. 6,412.1 11,479.9 12,707.9
Maturities and redemptions of investments............................. 2,038.0 1,455.3 1,882.3
Purchases of investments.............................................. (9,490.8) (14,438.0) (16,000.9)
Change in restricted cash............................................. 11.2 (16.3) 13.0
Other................................................................. (21.7) (31.6) (57.6)
--------- --------- ---------
Net cash used by investing activities............................. (1,051.2) (1,550.7) (1,455.3)
--------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net........................................ 196.7 853.7 790.2
Issuance of preferred stock, net...................................... - - 667.8
Issuance of common stock, net......................................... 1.0 .5 882.2
Payments on notes payable............................................. (48.0) (770.4) (1,332.0)
Redemption of preferred stock......................................... - - (928.9)
Amounts received for deposit products................................. 2,067.7 1,709.8 1,648.3
Withdrawals from deposit products..................................... (2,014.5) (1,787.0) (1,795.7)
Investment borrowings................................................. 103.2 (118.8) 46.6
Dividends paid on preferred stock..................................... (38.0) (38.0) (19.3)
Other................................................................. - - (3.6)
--------- --------- ---------
Net cash provided (used) by financing activities.................. 268.1 (150.2) (44.4)
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents.............. 148.1 (538.8) (452.1)
Cash and cash equivalents, beginning of year............................. 237.8 776.6 1,228.7
--------- --------- ---------
Cash and cash equivalents, end of year................................... $ 385.9 $ 237.8 $ 776.6
========= ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
97
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
1. DESCRIPTION OF BUSINESS
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 in 2003. 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.
We manage our business through the following: three primary operating
segments, Bankers Life, Conseco Insurance Group and Colonial Penn, which are
defined on the basis of product distribution; a fourth segment comprised of
other business in run-off; and corporate operations. These segments reflect the
addition of Colonial Penn as a separate segment resulting from a change in how
management disaggregates the Company's operations for making internal operating
decisions beginning in the fourth quarter of 2006. Colonial Penn's operations
were previously aggregated with the Bankers Life segment. We have restated all
prior period segment disclosures to conform to management's current view of the
Company's operating segments. The primary operating segments are defined on the
basis of product distribution. Our segments are described below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company ("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 approximately 4,650
exclusive career agents and sales managers. Bankers Life and Casualty
markets its products under its own brand name and Medicare Part D
products through a marketing agreement with Coventry Health Care
("Coventry").
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 over
500 independent marketing organizations that represent over 6,400
producing independent agents. This segment markets its products under
the "Conseco" and "Washington National" (a wholly-owned insurance
subsidiary of Conseco) brand names.
o Colonial Penn, which consists of the business of Colonial Penn Life
Insurance Company ("Colonial Penn"), markets graded benefit and
simplified issue life insurance directly to consumers through
television advertising, direct mail, the internet and telemarketing.
Colonial Penn markets its products under its own brand name.
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.
o Corporate operations, which consists of holding company activities and
certain noninsurance company businesses that are unrelated to our
operating segments.
2. BASIS OF PRESENTATION
We prepare our financial statements in accordance with accounting
principles generally accepted in the United States of America ("GAAP"). We
follow the accounting standards established by the Financial Accounting
Standards Board ("FASB"), the American Institute of Certified Public Accountants
and the Securities and Exchange Commission (the "SEC").
The accompanying financial statements include the accounts of the Company
and its subsidiaries. Our consolidated financial statements exclude the results
of material transactions between us and our consolidated affiliates, or among
our consolidated affiliates. We have reclassified certain amounts in our 2005
and 2004 consolidated financial statements and notes to conform with the 2006
presentation. These reclassifications have no effect on net income or
shareholders' equity.
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
98
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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.
On December 17, 2002, Old Conseco and certain of its non-insurance company
subsidiaries filed voluntary petitions for relief under Chapter 11 of Title 11
of the United States Bankruptcy Code in the United States Bankruptcy Court for
the Northern District of Illinois, Eastern Division (the "Bankruptcy Court"). We
emerged from bankruptcy protection under the Sixth Amended Joint Plan of
Reorganization (the "Plan"), which was confirmed pursuant to an order of the
Bankruptcy Court on September 9, 2003, and became effective on September 10,
2003 (the "Effective Date"). Upon confirmation of the Plan, we implemented fresh
start accounting in accordance with Statement of Position 90-7 "Financial
Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7").
References in these consolidated financial statements to "Predecessor" refer to
Old Conseco prior to August 31, 2003. References to "Successor" refer to the
Company on and after August 31, 2003, after the effects of fresh start
reporting.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following summary explains the significant accounting policies we use
to prepare our financial statements.
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); or (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.
Equity securities include investments in common stock and non-redeemable
preferred stock. We carry these investments at estimated fair value. We record
any unrealized gain or loss, net of tax and related adjustments, as a component
of shareholders' equity. When declines in value considered to be other than
temporary occur, we reduce the amortized cost to estimated fair value and
recognize a loss in the statement of operations.
Mortgage loans held in our investment portfolio are carried at amortized
unpaid balances, net of provisions for estimated losses.
Policy loans are stated at current unpaid principal balances.
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 section of this note entitled "Accounting for
Derivatives" for further discussion regarding 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 $675.2 million and $716.3 million at
December 31, 2006 and 2005, respectively.
Other invested assets include: (i) certain call options purchased in an
effort to hedge the effects of certain policyholder benefits related to our
equity-indexed annuity and life insurance products; and (ii) certain
non-traditional investments. We carry the call options at estimated fair value
as further described in the section of this note entitled "Accounting for
Derivatives". Non-traditional investments include investments in certain limited
partnerships, which are accounted for using the equity method, and promissory
notes, which are accounted for using the cost method.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments. We consider anticipated prepayments on
mortgage-backed securities in determining estimated future yields on such
securities.
When we sell a security (other than trading securities), we report the
difference between the sale proceeds and amortized
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
cost (determined based on specific identification) as a realized investment gain
or loss.
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.
Cash and Cash Equivalents
Cash and cash equivalents include commercial paper, invested cash and other
investments purchased with original maturities of less than three months. We
carry them at amortized cost, which approximates estimated fair value.
Cost of Policies Produced
Upon the implementation of fresh start accounting, we eliminated the
historical balance of Old Conseco's cost of policies produced as of September
10, 2003 (the effective date of the reorganization of our Predecessor), and
replaced it with the value of policies inforce at the Effective Date.
The costs that vary with, and are primarily related to, producing new
insurance business subsequent to September 10, 2003 are referred to as cost of
policies produced. For universal life or investment products, we amortize these
costs in relation to the estimated gross profits using the interest rate
credited to the underlying policies. For other products, we amortize these costs
in relation to future anticipated premium revenue using the projected investment
earnings rate.
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 cost of policies
produced for the change in amortization that would have been recorded if
actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income within
shareholders' equity.
When we replace an existing insurance contract with another insurance
contract with substantially different terms, all unamortized cost of policies
produced for such replaced contract is immediately expensed. When we replace an
existing insurance contract with another insurance contract with substantially
similar terms, we continue to defer the cost of policies produced associated
with the replaced contract. Such costs which continue to be deferred related to
replaced contracts were nil in 2006, 2005 and 2004.
We regularly evaluate the recoverability of the unamortized balance of the
cost of policies produced. We consider estimated future gross profits or future
premiums, expected mortality or morbidity, interest earned and credited rates,
persistency and expenses in determining whether the balance is recoverable. If
we determine a portion of the unamortized balance is not recoverable, it is
charged to amortization expense.
Value of Policies Inforce at the Effective Date
Upon 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 August 31, 2003, 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 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. The
balance of this account is amortized, evaluated for recovery, and adjusted for
the impact of unrealized gains (losses) in the same manner as described above
for the cost of policies produced.
The discount rate we used to determine the value of the value of policies
inforce at the Effective Date was 12 percent.
The Company expects to amortize the balance of the value of policies
inforce at the Effective Date as of December 31, 2006 as follows: 13 percent in
2007, 11 percent in 2008, 10 percent in 2009, 9 percent in 2010 and 7 percent in
2011.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Assets Held in Separate Accounts
Separate accounts are funds on which investment income and gains or losses
accrue directly to certain policyholders. The assets of these accounts are
legally segregated. They are not subject to the claims that may arise out of any
other business of Conseco. We report separate account assets at market value;
the underlying investment risks are assumed by the contractholders. We record
the related liabilities at amounts equal to the separate account assets. We
record the fees earned for administrative and contractholder services performed
for the separate accounts in insurance policy income.
Recognition of Insurance Policy Income and Related Benefits and Expenses on
Insurance Contracts
For universal life and investment contracts that do not involve significant
mortality or morbidity risk, the amounts collected from policyholders are
considered deposits and are not included in revenue. Revenues for these
contracts consist of charges for policy administration, cost of insurance
charges and surrender charges assessed against policyholders' account balances.
Such revenues are recognized when the service or coverage is provided, or when
the policy is surrendered.
We establish liabilities for investment and universal life products equal
to the accumulated policy account values, which include an accumulation of
deposit payments plus credited interest, less withdrawals and the amounts
assessed against the policyholder through the end of the period. Sales
inducements provided to the policyholders of these products are recognized as
liabilities over the period that the contract must remain in force to qualify
for the inducement. The options attributed to the policyholder related to our
equity-indexed annuity products are accounted for as embedded derivatives as
described in the section of this note entitled "Accounting for Derivatives".
Traditional life and the majority of our accident and health products
(including long-term care, Medicare supplement and specified disease products)
are long duration insurance contracts. Premiums on these products are recognized
as revenues when due from the policyholders.
We also have a small block of short duration accident and health products.
Premiums on these products are recognized as revenue over the premium paying
period.
We establish liabilities for traditional life, accident and health
insurance, and life contingent payment annuity products using mortality tables
in general use in the United States, which are modified to reflect the Company's
actual experience when appropriate. We establish liabilities for accident and
health insurance products using morbidity tables based on the Company's actual
or expected experience. These reserves are computed at amounts that, with
additions from estimated future premiums received and with interest on such
reserves at estimated future rates, are expected to be sufficient to meet our
obligations under the terms of the policy. Liabilities for future policy
benefits are computed on a net-level premium method based upon assumptions as to
investment yields, mortality, morbidity, withdrawals, policy dividends and
maintenance expenses determined when the policies were issued (or with respect
to policies inforce at August 31, 2003, the Company's best estimate of such
assumptions on the fresh-start date). Once established, assumptions on these
products are generally not changed. We make an additional provision to allow for
potential adverse deviation for some of our assumptions.
We establish claim reserves based on our estimate of the loss to be
incurred on reported claims plus estimates of incurred but unreported claims
based on our past experience.
Accounting for Long-term Care Premium Rate Increases
Many of our long-term care policies were subject to premium rate increases
in 2006. In some cases, these premium rate increases were reasonably consistent
with the assumptions we used to value the particular block at the fresh-start
date. In other cases, the premium rate increases were materially different from
that assumed at the fresh-start date, leading us to change our best estimates of
future actuarial assumptions. With respect to the 2006 premium rate increases,
some of our policyholders were provided an option to cease paying their premiums
and receive a non-forfeiture option in the form of a paid-up policy with limited
benefits. In addition, our policyholders could choose to reduce their coverage
amounts and premiums in the same proportion, when permitted by our contracts or
as required by regulators. The following describes how we account for these
policyholder options:
o Premium rate increases - If premium rate increases reflect a change in
our previous rate increase assumptions, the new assumptions are
reflected prospectively in our reserves and deferred insurance
acquisition costs (including the cost of policies produced and the
value of policies inforce at the Effective Date) using a method known
as the "pivot" method. The pivot method describes a modification to
the valuation approach whereby our reserves and deferred insurance
acquisition costs are unchanged at the time of the premium rate
increase, but the future pattern of reserve changes is modified to
reflect the relationship of premiums to benefits based on the current
best estimate of future claim cost, morbidity, persistency and
investment returns. If there is no significant change in underlying
premium rate assumptions, a premium rate increase has no effect on
reserves or deferred insurance acquisition costs.
o Benefit reductions - A policyholder may choose reduced coverage with a
proportionate reduction in premium, when permitted by our contracts.
This option does not require additional underwriting. Benefit
reductions are treated as a partial lapse of coverage, and the balance
of our reserves and deferred insurance acquisition costs is reduced in
proportion to the reduced coverage.
o Non-forfeiture benefits offered in conjunction with a rate increase -
In some cases, non-forfeiture benefits are offered to policyholders
who wish to lapse their policies at the time of a significant rate
increase. In these cases, exercise of this option is treated as an
extinguishment of the original contract and issuance of a new
contract. The balance of reserves and deferred insurance acquisition
cost are released, and a reserve for the new contract is established.
o Florida Order - The Florida Office of Insurance Regulation issued an
order to our subsidiaries in the Other Business in Run-off segment
regarding their long-term care business in Florida. The order required
them to offer a choice of three alternatives to holders of home health
care policies in Florida subject to premium rate increases as follows:
o retention of their current policy with a rate increase of 50
percent in the first year and actuarially justified
increases in subsequent years;
o receipt of a replacement policy with reduced benefits and a
rate increase in the first year of 25 percent and no more
than 15 percent in subsequent years; or
o receipt of a paid-up policy, allowing the holder to file
future claims up to 100 percent of the amount of premiums
paid since the inception of the policy.
Reserves for all three groups of policies under the order were
prospectively adjusted using the pivot method described above, as
these alternatives were required by the Florida Office of Insurance
Regulation. There were no deferred insurance acquisition costs
associated with these policies.
Some of our policyholders may receive a non-forfeiture benefit if they cease
paying their premiums pursuant to their original contract (or pursuant to
changes made to their original contract as a result of a litigation settlement
made prior to the fresh-start date or an order issued by the Florida Office of
Insurance Regulation). In these cases, exercise of this option is treated as the
exercise of a policy benefit, and the reserve for premium paying benefits is
reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect
the election of this benefit.
Accounting for marketing and quota-share agreements with Coventry Health
Care
The Medicare Prescription Drug, Improvement and Modernization Act of 2003
(the "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 investing 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 with 50
percent of net premiums and related policy benefits subject to a risk corridor.
The Part D program was effective January 1, 2006. 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.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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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.
Reinsurance
In the normal course of business, we seek to limit our loss exposure on any
single insured or to certain groups of policies by ceding reinsurance to other
insurance enterprises. We currently retain no more than $.8 million of mortality
risk on any one policy. We diversify the risk of reinsurance loss by using a
number of reinsurers that have strong claims-paying ratings. In each case, the
ceding Conseco subsidiary is directly liable for claims reinsured if the
assuming company is unable to pay. The likelihood of a material loss being
incurred as a result of the failure of one of our reinsurers is considered
remote. The cost of reinsurance is recognized over the life of the reinsured
policies using assumptions consistent with those used to account for the
underlying policy. The cost of reinsurance ceded totaled $213.3 million, $232.2
million and $255.2 million in 2006, 2005 and 2004, respectively. We deduct this
cost from insurance policy income. Reinsurance recoveries netted against
insurance policy benefits totaled $231.0 million, $231.6 million and $281.8
million in 2006, 2005 and 2004, respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced described above.
Reinsurance premiums assumed totaled $130.3 million, $60.1 million and $70.2
million in 2006, 2005 and 2004, respectively.
See the section of this note entitled "Accounting for Derivatives" for a
discussion of the derivative embedded in the payable related to certain modified
coinsurance agreements.
Income Taxes
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss carryforwards
("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 Internal Revenue Service (the "IRS") 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,
which is further described in the note entitled "Income Taxes".
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets as we believed that the realization of such net
deferred income tax assets in future periods was uncertain. During 2004, 2005
and 2006 we concluded that it was no longer necessary to hold certain portions
of the previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $947.0 million, $585.8 million and $260.0 million in
2004, 2005 and 2006, respectively. However, we are required to continue to hold
a valuation allowance of $777.8 million at December 31, 2006 because we have
determined that it is more likely than not that a portion of our deferred tax
assets will not be realized. This determination was made by evaluating each
component of the deferred tax asset and assessing the effects of limitations or
interpretations on the value of such component to be fully recognized in the
future.
Investment Borrowings
As part of our investment strategy, we may enter into repurchase agreements
and dollar-roll transactions to increase our investment return or to improve our
liquidity. We account for these transactions as collateralized borrowings, where
the amount borrowed is equal to the sales price of the underlying securities.
Repurchase agreements involve a sale of securities and an agreement to
repurchase the same securities at a later date at an agreed-upon price. Dollar
rolls are similar to repurchase agreements except that, with dollar rolls, the
repurchase involves securities that are substantially the same as the securities
sold (rather than being the same security). Such borrowings averaged $234.2
million during 2005. These borrowings were collateralized by investment
securities with fair values approximately equal to the loan value. The weighted
average interest rates on such borrowings were 2.9 percent during 2005. The
primary risk associated with short-term collateralized borrowings is that a
counterparty will be unable to perform under the terms of the contract. Exposure
is limited to the excess of the net replacement cost of the securities over the
value of the short-term investments. During the third quarter of 2005, the
market spread on these transactions declined to a level at which our continued
participation in these transactions was not profitable. As a result, these
transactions were terminated.
At December 31, 2006 and 2005, investment borrowings also include the
securities issued to other entities by a variable interest entity which is
consolidated in our financial statements. Refer to the note entitled "Investment
in a Variable Interest Entity" for further discussion.
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
$40.4 million, $(14.6) million and $13.7 million during 2006, 2005 and 2004,
respectively. These amounts were substantially offset by the corresponding
charge to insurance policy benefits. The estimated fair value of these options
was $93.7 million and $44.5 million at December 31, 2006 and 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 $275.3 million and $210.7
million at December 31, 2006 and 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.
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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 December 31, 2006, all of our counterparties were rated "A" or
higher by Standard & Poor's Corporation ("S&P").
Certain of our reinsurance payable balances contain embedded derivatives as
defined in SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives:
Modified Coinsurance Arrangements and Debt Instruments that Incorporate Credit
Risk Exposures that are Unrelated or Only Partially Related to the
Creditworthiness of the Obligor of Those Instruments". Such derivatives had an
estimated fair value of $9.6 million and $17.4 million at December 31, 2006 and
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.
Multibucket Annuity Product
The Company's multibucket annuity is a fixed annuity product that credits
interest based on the experience of a particular market strategy. Policyholders
allocate their annuity premium payments to several different market strategies
based on different asset classes within the Company's investment portfolio.
Interest is credited to this product based on the market return of the given
strategy, less management fees, and funds may be moved between different
strategies. The Company guarantees a minimum return of premium plus
approximately 3 percent per annum over the life of the contract. The investments
backing the market strategies of these products are designated by the Company as
trading securities. The change in the fair value of these securities is
recognized currently in investment income (classified as income from
policyholder and reinsurer accounts), which is substantially offset by the
change in insurance policy benefits for these products. As of December 31, 2006,
we hold insurance liabilities of $118.5 million related to multibucket annuity
products.
Stock Based Compensation
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 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 2006, we did not capitalize any stock-based compensation
expense as cost of policies produced or any other asset category.
Fair Values of Financial Instruments
We use the following methods and assumptions to determine the estimated
fair values of financial instruments:
Investment securities. For fixed maturity securities (including redeemable
preferred stocks) and for equity and trading securities, we use quotes from
independent pricing services, where available. For investment securities
for which such
104
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
quotes are not available, we use values obtained from broker-dealer market
makers or by discounting expected future cash flows using a current market
rate appropriate for the yield, credit quality, and, for fixed maturity
securities, the maturity of the investment being priced.
Cash and cash equivalents. The carrying amount for these instruments
approximates their estimated fair value.
Mortgage loans and policy loans. We discount future expected cash flows for
loans included in our investment portfolio based on interest rates
currently being offered for similar loans to borrowers with similar credit
ratings. We aggregate loans with similar characteristics in our
calculations. The market value of policy loans approximates their carrying
value.
Other invested assets. We use quoted market prices, where available. When
quotes are not available, we estimate the fair value based on discounted
future expected cash flows or independent transactions which establish a
value for our investment. When we are unable to estimate a fair value, we
assume a market value equal to carrying value.
Insurance liabilities for interest-sensitive products. We discount future
expected cash flows based on interest rates currently being offered for
similar contracts with similar maturities.
Investment borrowings and notes payable. For publicly traded debt, we use
current market values. For other notes, we use discounted cash flow
analyses based on our current incremental borrowing rates for similar types
of borrowing arrangements.
The estimated fair values of our financial instruments at December 31, 2006
and 2005, were as follows (dollars in millions):
2006 2005
--------------------- ---------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
Financial assets:
Actively managed fixed maturities............................... $22,802.9 $22,802.9 $22,494.2 $22,494.2
Equity securities .............................................. 24.8 24.8 27.1 27.1
Mortgage loans.................................................. 1,642.2 1,684.7 1,264.2 1,297.6
Policy loans.................................................... 412.5 412.5 429.8 429.8
Trading securities.............................................. 675.2 675.2 716.3 716.3
Other invested assets........................................... 178.8 178.8 109.6 109.6
Cash and cash equivalents....................................... 409.9 409.9 273.0 273.0
Financial liabilities:
Insurance liabilities for interest-sensitive
products (a).................................................. $13,018.0 $13,018.0 $12,686.8 $12,686.8
Investment borrowings........................................... 418.3 418.3 315.1 315.1
Notes payable - direct corporate obligations.................... 1,000.8 999.8 851.5 876.8
<FN>
- --------------------
(a) The estimated fair value of insurance liabilities for
interest-sensitive products was approximately equal to its carrying
value at December 31, 2006 and 2005. This was because interest rates
credited on the vast majority of account balances approximate current
rates paid on similar products and because these rates are not
generally guaranteed beyond one year.
</FN>
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 $64.0 million, $62.8 million and $14.3 million in
2006, 2005 and 2004, respectively. Amounts amortized totaled $19.1 million, $8.5
million and $2.9 million in 2006, 2005 and 2004, respectively. The unamortized
balance of deferred sales inducements was $115.0 million and $70.1 million at
December 31, 2006 and 2005, respectively. The balance of insurance liabilities
for
105
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
persistency bonus benefits was $296.3 million and $320.7 million at December 31,
2006 and 2005, respectively.
Recently Issued Accounting Standards
Pending Accounting Standards
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 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 have substantially completed our assessment of the impact of the adoption of
FIN 48 and expect that the financial impact of the initial adoption, if any,
will be immaterial to our financial position or results of operations.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140"
("SFAS 155"). SFAS 155 amends SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), and SFAS 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities"
and resolves issues addressed in SFAS 133 Implementation Issue No. D1,
"Application of Statement 133 to Beneficial Interest in Securitized Financial
Assets". SFAS 155: (a) permits fair value remeasurement for any hybrid financial
instrument that contains an embedded derivative that otherwise would require
bifurcation; (b) clarifies which interest-only strips and principal-only strips
are not subject to the requirements of SFAS 133; (c) establishes a requirement
to evaluate beneficial interests in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain an embedded derivative requiring bifurcation; (d)
clarifies that concentrations of credit risk in the form of subordination are
not embedded derivatives; and, (e) eliminates restrictions on a qualifying
special-purpose entity's ability to hold passive derivative financial
instruments that pertain to beneficial interests that are or contain a
derivative financial instrument. The standard also requires presentation within
the financial statements that identifies those hybrid financial instruments for
which the fair value election has been applied and information on the income
statement impact of the changes in fair value of those instruments. SFAS 155 is
effective for all financial instruments acquired or issued in a fiscal year that
begins after September 15, 2006. The adoption of SFAS 155 will not have a
material effect on our financial position or results of operations.
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 beginning January 1, 2007. 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. In addition, our
insurance companies do not sell group health and life products that are subject
to premium rate or benefit adjustment based on a review of the actual experience
of the contractholder. (These products could be subject to a shorter insurance
intangible amortization period under the new guidance).
Adopted 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
106
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 impact of the adoption of SFAS 158 on our consolidated balance sheet at
December 31, 2006, is as follows (dollars in millions):
Balance before Balance after
adoption of adoption of
SFAS 158 Adjustments SFAS 158
-------- ----------- --------
Income tax assets, net.................... $1,783.4 $ 3.5 $1,786.9
Other liabilities......................... 601.9 9.9 611.8
Accumulated other comprehensive loss...... (66.2) (6.4) (72.6)
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 were applied to the annual
financial statements of the Company for the year ended December 31, 2006. Our
adoption of SAB 108 had no effect on our results of operations or financial
position because we currently use an approach consistent with the new
requirement.
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 recognized compensation expense
related to stock options totaling $6.5 million in 2006. 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.
The FASB issued FASB Staff Position ("FSP") FAS 106-2, "Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement
and Modernization Act of 2003" ("FSP FAS 106-2") in May 2004. FSP FAS 106-2
provides guidance on accounting for the effects of the Modernization Act. The
Modernization Act provides, among other things, a federal subsidy to plan
sponsors who maintain postretirement health care plans that provide prescription
drug benefits and meet certain equivalency criteria. FSP FAS 106-2 superseded
FSP FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare
Prescription Drug, Improvement and Modernization Act of 2003". The adoption of
FSP FAS 106-2 did not have a significant impact on our consolidated financial
statements.
107
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
4. INVESTMENTS
At December 31, 2006, the amortized cost and estimated fair value of
actively managed fixed maturities and equity securities were as follows (dollars
in millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities.......................................... $13,179.2 $142.0 $(201.3) $13,119.9
United States Treasury securities and obligations of
United States government corporations and agencies.......... 1,428.6 16.8 (23.3) 1,422.1
States and political subdivisions............................. 675.7 5.2 (11.4) 669.5
Debt securities issued by foreign governments................. 117.3 3.6 (.2) 120.7
Structured securities ........................................ 5,984.7 7.7 (76.6) 5,915.8
Below-investment grade (primarily corporate securities).......... 1,561.4 23.0 (29.5) 1,554.9
--------- ------ ------- ---------
Total actively managed fixed maturities..................... $22,946.9 $198.3 $(342.3) $22,802.9
========= ====== ======= =========
Equity securities................................................ $23.9 $1.2 $(.3) $24.8
===== ==== ==== =====
At December 31, 2005, the amortized cost and estimated fair value of
actively managed fixed maturities and equity securities were as follows (dollars
in millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities.......................................... $12,509.3 $276.3 $(120.5) $12,665.1
United States Treasury securities and obligations of
United States government corporations and agencies.......... 1,570.4 3.7 (17.7) 1,556.4
States and political subdivisions............................. 868.4 18.9 (6.6) 880.7
Debt securities issued by foreign governments................. 162.1 8.3 (.2) 170.2
Structured securities ........................................ 6,283.1 20.7 (76.4) 6,227.4
Below-investment grade (primarily corporate securities).......... 986.9 24.0 (16.5) 994.4
--------- ------ ------- ---------
Total actively managed fixed maturities..................... $22,380.2 $351.9 $(237.9) $22,494.2
========= ====== ======= =========
Equity securities................................................ $25.6 $1.8 $(.3) $27.1
===== ==== ==== =====
Accumulated other comprehensive income (loss) is primarily comprised of the
net effect of unrealized appreciation (depreciation) on our investments. These
amounts, included in shareholders' equity as of December 31, 2006 and 2005, were
as follows (dollars in millions):
2006 2005
---- ----
Net unrealized appreciation (depreciation) on investments................................. $(136.3) $120.9
Adjustment to value of policies inforce at the Effective Date............................. 20.1 (9.2)
Adjustment to cost of policies produced................................................... 12.3 (.3)
Adjustment to initially apply SFAS No. 158 related to the unrecognized net loss related to
deferred compensation plan............................................................ (9.9) -
Deferred income tax liability............................................................. 41.2 (39.7)
------- ------
Accumulated other comprehensive income (loss)...................................... $ (72.6) $ 71.7
======= ======
108
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 December 31, 2006 (dollars in
millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 5,934.2 26.0%
Manufacturing........................................................................ 2,906.6 12.7
Bank and finance..................................................................... 2,229.7 9.8
Services............................................................................. 1,808.9 7.9
Utilities............................................................................ 1,630.8 7.2
U.S. Government...................................................................... 1,422.1 6.2
Holding and other investment offices................................................. 1,110.7 4.9
Communications....................................................................... 1,092.0 4.8
Agriculture, forestry and mining..................................................... 843.4 3.7
Retail and wholesale................................................................. 733.3 3.2
Transportation....................................................................... 695.2 3.1
States and political subdivisions.................................................... 669.5 2.9
Asset-backed securities.............................................................. 564.9 2.5
Other................................................................................ 1,161.6 5.1
--------- -----
Total actively managed fixed maturities........................................... $22,802.9 100.0%
========= =====
Below-Investment Grade Securities
At December 31, 2006, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,561.4 million, or 6.8 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,554.9 million, or 100 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$448.6 million and an estimated fair value of $446.5 million are securities held
by a variable interest entity that we are required to consolidate. These fixed
maturity securities are legally isolated and are not available to the Company.
The liabilities of such variable interest entity will be satisfied from the cash
flows generated by these securities. At December 31, 2006, our total investment
in the variable interest entity was $48.8 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.
109
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Contractual Maturity
The following table sets forth the amortized cost and estimated fair value
of actively managed fixed maturities at December 31, 2006, by contractual
maturity. Actual maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties. Most of the structured securities shown below provide
for periodic payments throughout their lives (dollars in millions):
Estimated
Amortized fair
cost value
---- -----
Due in one year or less...................................................................... $ 404.3 $ 402.9
Due after one year through five years........................................................ 2,371.0 2,351.2
Due after five years through ten years....................................................... 6,084.8 6,054.6
Due after ten years.......................................................................... 8,083.9 8,060.0
--------- ---------
Subtotal................................................................................. 16,944.0 16,868.7
Structured securities (a).................................................................... 6,002.9 5,934.2
--------- ---------
Total actively managed fixed maturities ............................................. $22,946.9 $22,802.9
========= =========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an
amortized cost and estimated fair value of $18.2 million and $18.4
million, respectively.
</FN>
Net Investment Income
Net investment income consisted of the following (dollars in millions):
2006 2005 2004
---- ---- ----
Fixed maturities..................................................... $1,293.6 $1,266.1 $1,176.9
Trading income related to policyholder and
reinsurer accounts................................................ 32.9 3.1 4.0
Equity securities.................................................... 1.8 .5 3.9
Mortgage loans....................................................... 101.9 92.4 90.2
Policy loans......................................................... 25.0 26.3 27.7
Change in value of options
related to equity-indexed products................................ 38.3 (18.9) 20.1
Other invested assets................................................ 13.8 9.6 9.0
Cash and cash equivalents............................................ 19.1 18.2 13.8
-------- -------- --------
Gross investment income........................................... 1,526.4 1,397.3 1,345.6
Less investment expenses............................................. 20.0 22.7 27.0
-------- -------- --------
Net investment income............................................. $1,506.4 $1,374.6 $1,318.6
======== ======== ========
The carrying value of fixed maturity investments and mortgage loans not
accruing investment income totaled nil and $12.7 million at December 31, 2006
and 2005, respectively.
110
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Net Realized Investment Gains (Losses)
Net realized investment gains (losses) were included in revenue as follows
(dollars in millions):
2006 2005 2004
---- ---- ----
Fixed maturities:
Gross gains.......................................................... $ 70.1 $ 86.5 $102.4
Gross losses......................................................... (98.5) (82.3) (45.8)
Other-than-temporary declines in fair value.......................... (12.0) (4.5) (6.2)
------ ------ ------
Net realized investment gains (losses) from
fixed maturities.............................................. (40.4) (.3) 50.4
Equity securities........................................................ .2 1.6 (3.5)
Mortgages................................................................ - 3.2 2.0
Other-than-temporary declines in fair value of
equity securities and other invested assets.......................... (10.4) (10.2) (11.9)
Other ................................................................... 3.4 2.8 3.6
------ ------ ------
Net realized investment gains (losses).......................... $(47.2) $ (2.9) $ 40.6
====== ====== ======
During 2006, we recognized net realized investment losses of $47.2 million,
which were comprised of $24.8 million of net losses from the sales of
investments (primarily fixed maturities) with proceeds of $6.4 billion, and
$22.4 million of writedowns of investments for other than temporary declines in
fair value. During 2005, we recognized net realized investment losses of $2.9
million, which were comprised of $11.8 million of net gains from the sales of
investments (primarily fixed maturities) with proceeds of $11.5 billion, net of
$14.7 million of writedowns of investments for other than temporary declines in
fair value. During 2004, we recognized net realized investment gains of $40.6
million, which were comprised of $58.7 million of net gains from the sales of
investments (primarily fixed maturities) with proceeds of $12.7 billion, net of
$18.1 million of writedowns of investments for other than temporary declines in
fair value. At December 31, 2006, investments in default as to the payment of
principal or interest had an aggregate amortized cost of $7.0 million and a
carrying value of $7.2 million.
During 2006, we sold $3.2 billion of fixed maturity investments which
resulted in gross investment losses (before income taxes) of $98.5 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; or (v) changes in
expected liability cash flows. During 2006, we sold no investments at a loss
which had been continuously in an unrealized loss position exceeding 20 percent
of the amortized cost basis for over a month.
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.
111
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
During 2006, we recorded a $7.3 million writedown related to an investment
in preferred stock of a privately held insurance holding company. The decline in
value was primarily attributable to weak operating results that contributed to a
deferred interest payment. Our remaining investment in the preferred stock at
December 31, 2006 is $7.0 million.
During 2006, we recorded writedowns of certain actively managed fixed
maturities totaling $10.7 million as a result of our intent not to hold the
investments for a period of time sufficient to allow for any anticipated
recovery. Such securities, with an amortized cost of $306.4 million, were sold
in early January 2007.
During 2006, we recorded writedowns totaling $4.4 million on investments as
a result of analysis that led us to conclude that the declines in the values of
these investments were other than temporary.
Investments with Unrealized Losses
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at December
31, 2006, by contractual maturity. Actual maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties. Most of the structured
securities shown below provide for periodic payments throughout their lives
(dollars in millions):
Estimated
Amortized fair
cost value
--------- ---------
Due in one year or less................................................................... $ 314.1 $ 312.1
Due after one year through five years..................................................... 1,877.1 1,851.0
Due after five years through ten years.................................................... 4,124.1 4,043.2
Due after ten years....................................................................... 4,849.1 4,692.4
--------- ---------
Subtotal............................................................................... 11,164.4 10,898.7
Structured securities..................................................................... 4,705.9 4,629.3
--------- ---------
Total.................................................................................. $15,870.3 $15,528.0
========= =========
At December 31, 2006, we held no investments in our fixed maturity
portfolio which were rated below-investment grade and had unrealized loss
positions exceeding 20 percent of their cost bases.
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.
112
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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
December 31, 2006 (dollars in millions):
Less than 12 months 12 months or greater Total
---------------------- ---------------------- -----------------
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........ $ 86.8 $ (1.2) $1,252.7 $ (22.1) $ 1,339.5 $ (23.3)
States and political subdivisions... 218.6 (3.1) 185.2 (8.3) 403.8 (11.4)
Debt securities issued by
foreign governments.............. 23.1 (.2) 6.9 (.1) 30.0 (.3)
Corporate securities................ 4,711.6 (75.2) 4,413.8 (155.5) 9,125.4 (230.7)
Structured securities............... 1,724.5 (13.2) 2,904.8 (63.4) 4,629.3 (76.6)
-------- ------ -------- ------ --------- -------
Total actively managed
fixed maturities................. $6,764.6 $(92.9) $8,763.4 $(249.4) $15,528.0 $(342.3)
======== ====== ======== ======= ========= =======
Equity securities................... $1.6 $(.2) $3.0 $(.1) $4.6 $(.3)
==== ==== ==== ==== ==== ====
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
December 31, 2005 (dollars in millions):
Less than 12 months 12 months or greater Total
---------------------- --------------------- -----------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 1,300.9 $ (14.2) $111.9 $ (3.5) $ 1,412.8 $ (17.7)
States and political subdivisions. 245.3 (4.1) 73.1 (3.3) 318.4 (7.4)
Debt securities issued by
foreign governments............ 17.6 (.2) - - 17.6 (.2)
Corporate securities.............. 5,917.5 (117.6) 446.3 (18.6) 6,363.8 (136.2)
Structured securities............. 4,533.4 (72.3) 149.2 (4.1) 4,682.6 (76.4)
--------- ------- ------ ------ --------- -------
Total actively managed
fixed maturities............... $12,014.7 $(208.4) $780.5 $(29.5) $12,795.2 $(237.9)
========= ======= ====== ====== ========= =======
Equity securities................. $3.5 $(.1) $2.5 $(.2) $6.0 $(.3)
==== ==== ==== ==== ==== ====
113
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Based on management's current assessment of investments with unrealized
losses at December 31, 2006, the Company believes the issuers of the securities
will continue to meet their obligations (or with respect to equity-type
securities, the investment value will recover to its cost basis). The Company
has no current plans to sell these securities and has the ability to hold them
to maturity. If the Company concludes in future periods that the unrealized loss
is other than temporary, a charge to earnings would be recognized.
Structured Securities
At December 31, 2006, fixed maturity investments included $5.9 billion of
structured securities (or 26 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations and commercial mortgage-backed securities. The yield
characteristics of structured securities differ in some respects from those of
traditional fixed-income securities. For example, interest and principal
payments on mortgage-backed securities may occur more frequently, often monthly.
In many instances, we are subject to the risk that the timing of principal
payments may vary from expectations. For example, prepayment rates are
influenced by a number of factors that cannot be predicted with certainty,
including: the relative sensitivity of the underlying mortgages backing the
assets to changes in interest rates; a variety of economic, geographic and other
factors; and various security-specific structural considerations (for example,
the repayment priority of a given security in a securitization structure).
In general, the rate of prepayments on structured securities increases when
prevailing interest rates decline significantly in absolute terms and also
relative to the interest rates on the underlying loans. The yields 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 December 31, 2006 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 201.1 $ 201.0 $ 197.6
4 percent - 5 percent............................................................... 1,132.7 1,087.6 1,075.3
5 percent - 6 percent............................................................... 3,880.6 3,829.3 3,778.1
6 percent - 7 percent............................................................... 729.1 739.1 736.8
7 percent - 8 percent............................................................... 115.4 118.9 118.6
8 percent and above................................................................. 26.4 27.0 27.8
-------- -------- --------
Total structured securities (a).............................................. $6,085.3 $6,002.9 $5,934.2
======== ======== ========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an
amortized cost and estimated fair value of $18.2 million and $18.4
million, respectively.
</FN>
114
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The amortized cost and estimated fair value of structured securities at
December 31, 2006, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
----------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs and sequential and targeted amortization classes.......... $3,709.4 $3,662.4 16%
Planned amortization classes and accretion-directed bonds............... 894.1 882.5 4
Commercial mortgage-backed securities................................... 1,383.1 1,373.0 6
Other................................................................... 16.3 16.3 -
-------- -------- --
Total structured securities (a).................................. $6,002.9 $5,934.2 26%
======== ======== ==
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an
amortized cost and estimated fair value of $18.2 million and $18.4
million, respectively.
</FN>
Pass-through securities and sequential and targeted amortization class
securities typically have different prepayment variability characteristics.
Pass-through securities typically return principal to the holders based on cash
payments from the underlying mortgage obligations. Sequential classes return
principal to tranche holders in a detailed hierarchy. Targeted amortization
classes, planned amortization classes and accretion-directed bonds adhere to
fixed schedules of principal payments as long as the underlying mortgage loans
experience prepayments within certain estimated ranges. Changes in prepayment
rates are first absorbed by support or companion classes. This insulates the
timing of receipt of cash flows from the consequences of both faster prepayments
(average life shortening) and slower prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are secured by commercial
real estate mortgages, generally income producing properties that are managed
for profit. Property types include multi-family dwellings including apartments,
retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and
office buildings. CMBS generally offer higher yields than corporate bonds with
similar credit ratings. Most CMBS have call protection features whereby
underlying borrowers may not prepay their mortgages for stated periods of time
without incurring prepayment penalties.
Mortgage Loans
At December 31, 2006, the mortgage loan balance was primarily comprised of
commercial loans. Approximately 8 percent, 7 percent, 6 percent and 6 percent of
the mortgage loan balance were on properties located in Minnesota, Ohio, New
York and California, respectively. No other state comprised greater than 6
percent of the mortgage loan balance. Substantially less than one percent of the
mortgage loan balance was noncurrent at December 31, 2006. Our allowance for
loss on mortgage loans was $2.4 million at both December 31, 2006 and 2005.
Other Investment Disclosures
Life insurance companies are required to maintain certain investments on
deposit with state regulatory authorities. Such assets had aggregate carrying
values of $99.9 million and $129.3 million at December 31, 2006 and 2005,
respectively.
115
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Conseco had two fixed maturity investments in excess of 10 percent of
shareholders' equity at December 31, 2006 and 2005 (other than investments
issued or guaranteed by the United States government or a United States
government agency), which are summarized below (dollars in millions):
2006 2005
--------------------------- -------------------------
Amortized Estimated Amortized Estimated
Issuer cost fair value cost fair value
------ ---- ---------- ---- ----------
Federal Home Loan Mortgage
Corporation....................... $2,426.4 $2,387.2 $2,900.6 $2,878.9
Federal National Mortgage
Association....................... 1,414.3 1,396.7 1,631.2 1,622.2
5. LIABILITIES FOR INSURANCE PRODUCTS
These liabilities consisted of the following (dollars in millions):
Interest
Withdrawal Mortality rate
assumption assumption assumption 2006 2005
---------- ---------- ---------- ---- ----
Future policy benefits:
Interest-sensitive products:
Investment contracts.................... N/A N/A (c) $ 9,326.0 $ 8,970.1
Universal life contracts................ N/A N/A N/A 3,692.0 3,716.7
--------- ---------
Total interest-sensitive products..... 13,018.0 12,686.8
--------- ---------
Traditional products:
Traditional life insurance contracts.... Company (a) 5% 2,264.2 2,276.1
experience
Limited-payment annuities............... Company (b) 5% 970.7 997.2
experience,
if applicable
Individual and group accident and
health ............................... Company Company 6% 8,859.2 8,566.9
experience experience --------- ---------
Total traditional products............ 12,094.1 11,840.2
--------- ---------
Claims payable and other
policyholder funds ....................... N/A N/A N/A 832.3 842.1
Liabilities related to separate
accounts.................................. N/A N/A N/A 28.9 29.8
--------- ---------
Total................................. $25,973.3 $25,398.9
========= =========
<FN>
- --------------------
(a) Principally, modifications of the 1965 - 70 and 1975 - 80 Basic,
Select and Ultimate Tables.
(b) Principally, the 1984 United States Population Table and the NAIC 1983
Individual Annuitant Mortality Table.
(c) In 2006 and 2005, all of this liability represented account balances
where future benefits are not guaranteed.
</FN>
116
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The Company establishes reserves for insurance policy benefits based on
assumptions as to investment yields, mortality, morbidity, withdrawals, lapses
and maintenance expenses. These reserves include amounts for estimated future
payment of claims based on actuarial assumptions. The balance is based on the
Company's best estimate of the future policyholder benefits to be incurred on
this business, given recent and expected future changes in experience.
Changes in the unpaid claims reserve (included in claims payable) and
disabled life reserves related to accident and health insurance (included in
individual and group accident and health liabilities) were as follows (dollars
in millions):
2006 2005 2004
---- ---- -----
Balance, beginning of the year....................................... $1,636.0 $1,576.9 $1,528.5
Incurred claims (net of reinsurance) related to:
Current year...................................................... 1,667.2 1,554.7 1,558.6
Prior years (a)................................................... 43.0 60.3 27.5
-------- -------- --------
Total incurred................................................. 1,710.2 1,615.0 1,586.1
-------- -------- --------
Interest on claim reserves........................................... 88.2 80.3 71.2
-------- -------- --------
Paid claims (net of reinsurance) related to:
Current year...................................................... 844.9 811.3 840.6
Prior years....................................................... 807.7 814.8 733.9
-------- -------- --------
Total paid..................................................... 1,652.6 1,626.1 1,574.5
Net change in balance for reinsurance assumed and ceded.............. (9.5) (10.1) (34.4)
-------- -------- --------
Balance, end of the year............................................. $1,772.3 $1,636.0 $1,576.9
======== ======== ========
<FN>
- --------------------
(a) The reserves and liabilities we establish are necessarily based on
estimates, assumptions and prior years' statistics. It is possible
that actual claims will exceed our reserves and have a material
adverse effect on our results of operations and financial condition.
We have incurred significant losses beyond our estimates as a result
of actual claim costs exceeding our initial estimates in the Other
Business in Run-off segment. For example, our insurance policy
benefits in that segment reflected reserve deficiencies from prior
years of $77.2 million, $59.9 million and $44.5 million in 2006, 2005
and 2004, respectively.
</FN>
117
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
6. INCOME TAXES
The components of income tax expense were as follows (dollars in millions):
2006 2005 2004
---- ---- ----
Current tax expense (benefit)............................................ $ 1.4 $ - $ (9.3)
Deferred tax provision................................................... 54.4 178.5 168.6
----- ------ ------
Income tax expense on period income............................. $55.8 $178.5 $159.3
===== ====== ======
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
2006 2005 2004
---- ---- ----
U.S. statutory corporate rate............................................ 35.0% 35.0% 35.0%
Other nondeductible expenses............................................. 1.6 .4 .1
State taxes.............................................................. .2 .7 -
Provision for tax issues, tax credits and other.......................... (.2) (.6) -
---- ---- ----
Effective tax rate.............................................. 36.6% 35.5% 35.1%
==== ==== ====
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
2006 2005
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries...................................................... $ 800.3 $ 812.8
Non-life companies............................................................... 780.0 796.5
Tax credits......................................................................... 14.2 14.2
Capital loss carryforwards.......................................................... 391.7 397.3
Deductible temporary differences:
Insurance liabilities............................................................ 1,320.0 1,433.2
Unrealized depreciation of investments........................................... 41.2 -
Reserve for loss on loan guarantees.............................................. 145.8 155.5
-------- ---------
Gross deferred tax assets...................................................... 3,493.2 3,609.5
-------- ---------
Deferred tax liabilities:
Actively managed fixed maturities................................................... (42.2) (67.8)
Value of policies inforce at the Effective Date and cost of policies produced....... (764.8) (752.7)
Unrealized appreciation of investments.............................................. - (39.7)
Other............................................................................... (117.6) (201.1)
-------- ---------
Gross deferred tax liabilities................................................. (924.6) (1,061.3)
-------- ---------
Net deferred tax assets before valuation allowance............................. 2,568.6 2,548.2
Valuation allowance..................................................................... (777.8) (1,043.8)
-------- ---------
Net deferred tax assets........................................................ 1,790.8 1,504.4
Current income taxes accrued............................................................ (3.9) (7.8)
-------- ---------
Income tax assets, net......................................................... $1,786.9 $ 1,496.6
======== =========
118
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting 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 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. During 2004, 2005
and 2006, we concluded that it was no longer necessary to hold certain portions
of the previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $947.0 million in 2004, $585.8 million in 2005 and $260.0
million in 2006. However, we are required to continue to record a valuation
allowance of $777.8 million at December 31, 2006 because we have determined that
it is more likely than not that a portion of our deferred tax assets will not be
realized. This determination was made by evaluating each component of the
deferred tax asset and assessing the effects of limitations or interpretations
on the value of such component to be fully recognized in the future.
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 extent to which losses realized by a life insurance entity (or
entities) may offset income from a non-life entity (or entities).
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 $142 million per year with any unused amounts
carried forward to the following year. Our Section 382 limitation for 2007 will
be approximately $424 million (including $282 million of unused amounts carried
forward from prior years).
We have also evaluated the likelihood that we will have sufficient taxable
income to offset the available deferred tax assets. This assessment required
significant judgment. Based upon our current projections of future income that
we completed at December 31, 2006, we believe that we will more likely than not
recover $1.8 billion of our deferred tax assets through reductions of our tax
liabilities in future periods. However, recovery is dependent on achieving such
projections and failure to do so would result in an increase in the valuation
allowance in a future period. Any future increase in the valuation allowance
would result in additional income tax expense and reduce shareholders' equity,
and such an increase could have a significant impact upon our earnings in the
future.
At the fresh-start date, we were required to estimate our tax basis in
Conseco Finance Corp. ("CFC") in order to determine the tax loss carryforward
related to the worthlessness of CFC. The determination of this amount and how
the loss was recognized were subject to interpretation of various tax laws and
regulations. During the third quarter of 2004, the Company and the IRS entered
into a closing agreement which determined that the tax loss on the worthlessness
of CFC was $6.7 billion, instead of our original estimate of $5.4 billion. This
determination resulted in $500.1 million of additional deferred tax assets. We
also recognized a $500.1 million valuation allowance, as we had deemed it more
likely than not that such deferred tax asset would not be realized. As this
increase related to the period prior to the Effective Date, a reduction of any
portion of the deferred income tax valuation allowance will be accounted for as
additions to paid-in capital pursuant to SOP 90-7. The closing agreement with
the IRS also determined that the loss recognized on the worthlessness of CFC was
an ordinary loss for tax purposes and not a capital loss.
119
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Changes in our valuation allowance are summarized as follows (dollars in
millions):
Balance at December 31, 2003............................................. $2,362.1
Realization of deferred income taxes recognized
in 2004 (a)......................................................... (168.6)
Release of tax valuation reserve related to unrealized
gains during 2004 (a)............................................... (65.4)
Recovery of amounts related to our bankruptcy and
state taxes (a)..................................................... (4.1)
Increase in deferred tax assets related to the worthlessness
of CFC.............................................................. 500.1
Release of valuation allowance (a)..................................... (947.0)
Deferred tax assets not realizable..................................... (47.5)
--------
Balance at December 31, 2004............................................. 1,629.6
Release of valuation allowance (b)..................................... (585.8)
--------
Balance at December 31, 2005............................................. 1,043.8
Decrease due to expiration of NOL and capital loss carryforwards....... (6.0)
Release of valuation allowance (b)..................................... (260.0)
--------
Balance at December 31, 2006............................................. $ 777.8
========
<FN>
- --------------------
(a) There is a corresponding increase (decrease) for these items in the
following accounts: (i) goodwill - ($952.2) million; (ii) other
intangible assets - $(171.1) million; and (iii) additional paid-in
capital - $61.8 million.
(b) There is a corresponding increase to additional paid-in capital.
</FN>
120
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
As of December 31, 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
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
2007....... $ - $ .1 $ 449.1 $ 449.2 $ 449.2 $ -
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....... - 1.6 - 1.6 1.6 -
2016....... 16.9 - - 16.9 16.9 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6 (a) .7 - 2,171.3 44.8 2,126.5
2019....... - .8 - .8 .8 -
2021....... 66.0 - - 66.0 - 66.0
2023....... - 2,070.7 (a) - 2,070.7 60.6 2,010.1
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 29.0 - 29.0 - 29.0
-------- -------- -------- -------- -------- --------
Total...... $2,286.7 $2,228.7 $1,119.0 $5,634.4 $1,194.6 $4,439.8
======== ======== ======== ======== ======== ========
<FN>
- --------------------
(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.
</FN>
The following paragraphs describe an open matter related to the
classification of our NOLs.
In July 2006, the Joint Committee of Taxation accepted the audit and the
settlement which characterized $2.1 billion of the tax losses on our
Predecessor's investment in 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.
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 $.6 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital if realized.
Prior to January 1, 1984, life insurance subsidiaries of the Company were
entitled to exclude certain amounts from taxable income and accumulate such
amounts in a "Policyholders Surplus Account". The aggregate balance in this
account at December 31, 2005 was $150.7 million, which could have resulted in
federal income taxes payable of $52.7 million if such
121
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
amounts had been distributed or deemed distributed from the Policyholders
Surplus Account. No provision for taxes had ever been made for this item since
the affected subsidiaries had no intention of distributing such amounts.
Pursuant to provisions of the American Jobs Creation Act of 2004, our
subsidiaries distributed amounts from the Policyholders Surplus Account in 2006
without incurring any tax liability, thereby permanently eliminating this
potential tax liability.
7. NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of December 31, 2006 and 2005 (dollars in millions):
2006 2005
---- ----
3.50% convertible debentures............................................................ $ 330.0 $330.0
Secured credit agreement................................................................ 673.3 524.6
Unamortized discount on convertible debentures.......................................... (2.5) (3.1)
-------- ------
Direct corporate obligations....................................................... $1,000.8 $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 December 31, 2006,
unamortized issuance costs (classified as other assets) related to the
Debentures were $5.9 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.
The Debentures are senior, unsecured obligations and bear interest at a
rate of 3.50 percent per year, payable semi-annually, beginning on March 31,
2006 and ending on September 30, 2010. Thereafter, the principal balance of the
Debentures will accrete at a rate that provides holders with an aggregate yield
to maturity of 3.50 percent, computed on a semi-annual, bond-equivalent basis.
Beginning with the six-month interest period commencing September 30, 2010, the
Company will pay contingent interest on the Debentures if the average trading
price per Debenture for the five trading day period immediately preceding the
six-month interest period equals or exceeds a certain level, as described in the
Indenture.
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).
On or after October 5, 2010, the Company may redeem for cash all or a
portion of the Debentures at any time at a redemption price equal to 100 percent
of the accreted principal amount of the Debentures plus accrued and unpaid
interest, including additional interest and contingent interest, if any, to the
redemption date. Holders may require the Company to repurchase in cash all or
any portion of the Debentures on September 30, 2010, 2015, 2020, 2025 and 2030
at a repurchase price equal to 100 percent of the accreted principal amount of
the Debentures to be repurchased, plus accrued and unpaid interest, including
additional interest and contingent interest, if any, to the applicable
repurchase date.
If an event of default occurs and is continuing with respect to the
Debentures, either the trustee or the holders of at least 25 percent of the
aggregate accreted principal amount of the Debentures then outstanding may
declare the accreted principal amount, plus accrued and unpaid interest,
including additional interest and contingent interest, if any, on the Debentures
to be due and payable immediately. If an event of default relating to certain
events of bankruptcy, insolvency or reorganization occurs, the accreted
principal amount plus accrued and unpaid interest, including additional interest
and contingent interest, if any, on the Debentures will become immediately due
and payable. The following are events of default with respect to the Debentures:
o default for 30 days in payment of any interest, contingent interest or
additional interest due and payable on the Debentures;
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
o default in payment of accreted principal of the Debentures at
maturity, upon redemption, upon repurchase or following a fundamental
change, when the same becomes due and payable;
o default by the Company or any of its subsidiaries in the payment of
principal, interest or premium when due under any other instruments of
indebtedness having an aggregate outstanding principal amount of $50.0
million (or its equivalent in any other currency or currencies) or
more following a specified period for cure;
o default in the Company's conversion obligations upon exercise of a
holder's conversion right, following a specified period for cure;
o default in the Company's obligations to give notice of the occurrence
of a fundamental change within the time required to give such notice;
o acceleration of any of the Company's indebtedness or the indebtedness
of any of its subsidiaries under any instrument or instruments
evidencing indebtedness (other than the Debentures) having an
aggregate outstanding principal amount of $50.0 million (or its
equivalent in any other currency or currencies) or more, subject to
certain exceptions; and
o certain events of bankruptcy, insolvency and reorganization of the
Company or any of its subsidiaries.
In connection with the sale of the Debentures, the Company also entered
into a Registration Rights Agreement with the initial purchasers. Pursuant to
that agreement, the Company filed with the SEC, a shelf registration statement
with respect to the resale of the Debentures and the sale of our shares of
common stock issuable upon conversion of the Debentures which became effective
on March 16, 2006.
The Company's credit facilities have been repaid or amended during each of
the last three years as further described below.
In the second quarter of 2004, our $1.3 billion credit agreement (the
"Previous Credit Facility") was repaid as follows: (i) $620.0 million from the
proceeds from our issuance of common and preferred stock as further discussed in
the note entitled "Shareholders' Equity"; (ii) $674.3 million from amounts
borrowed under our Credit Facility as further described below; and (iii) a $5.7
million required prepayment made pursuant to a provision in the Previous Credit
Facility. The repayment of the Previous Credit Facility resulted in a gain from
the extinguishment of debt totaling $2.8 million. The gain resulted from the
release of a $6.3 million accrual for a fee that would have been required to be
paid under the Previous Credit Facility, partially offset by the write-off of
unamortized amendment fees.
On June 22, 2004, we entered into the Credit Facility with a principal
balance of $800.0 million. The Credit Facility was a six-year term loan, the
proceeds of which were used: (i) to refinance in full all indebtedness,
including accrued interest, under the Previous Credit Facility; (ii) to
repurchase $106.6 million of certain affiliated preferred stock; and (iii) for
other general corporate purposes. During 2004, we made required principal
payments totaling $4.0 million as well as an optional prepayment of $28.0
million.
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 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 2005, we made principal payments totaling $2.4
million on our Amended Credit Facility as well as a mandatory prepayment of $.9
million on the Credit Facility (after consideration of a $28.0 million
prepayment made in December 2004) based on the Company's excess cash flows at
December 31, 2004, as defined in the Credit Facility. During 2006, we made
scheduled principal payments totaling $1.3 million on our Amended Credit
Facility as well as a mandatory prepayment of $45.0 million based on the
Company's excess cash flows at December 31, 2005, as defined in the Amended
Credit Facility. There were $5.6 million of unamortized issuance costs
(classified as other assets) related to our Amended Credit Facility at December
31, 2005.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
On October 10, 2006, we entered into a $675.0 million secured credit
agreement (the "Second Amended Credit Facility"). As a result of the
refinancing, the principal amount outstanding under the credit facility was
increased from $478.3 million to $675.0 million. Approximately $195 million of
the proceeds were used to strengthen the capital of our insurance subsidiaries.
The Company recognized a $.7 million loss on the extinguishment of debt during
the fourth quarter of 2006 for the write-off of certain debt issuance costs and
other costs incurred related to the transaction. 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. There were $6.2
million of unamortized issuance costs (classified as other assets) related to
our Second Amended Credit Facility at December 31, 2006.
The amounts outstanding under the Second Amended Credit Facility bear
interest, payable at least quarterly, based on either a Eurodollar rate or a
base rate. The Eurodollar rate is equal to LIBOR plus 2 percent, compared to
LIBOR plus 3.5 percent under the Credit Facility. The base rate 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. The
interest rate terms of the Amended Credit Facility were the same as those
described above for the Second Amended Credit Facility. 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
December 31, 2006, the interest rate on our Second Amended Credit Facility was
7.4 percent.
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
2007.......................................... $ 6.8
2008.......................................... 6.7
2009.......................................... 6.8
2010.......................................... 336.7
2011.......................................... 6.8
Thereafter.................................... 639.5
--------
$1,003.3
========
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.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The Second Amended Credit Facility requires, and the Amended Credit
Facility required, 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 Second
Amended Credit Facility at December 31, 2006.
The Amended Credit Facility included, and the Second Amended Credit
Facility includes, an $80.0 million revolving credit facility that can be used
for general corporate purposes and that would mature on June 22, 2009. There
were no amounts outstanding under the revolving credit facility at December 31,
2006 and 2005. 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). As further discussed in the note to the consolidated financial
statements entitled "Shareholders' Equity", we repurchased 1.2 million shares of
our common stock for $25.0 million in January 2007.
8. COMMITMENTS AND CONTINGENCIES
Litigation
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
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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.
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. 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. The court has not yet ruled on this motion. 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
126
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 receiving cash or electing to reinstate their policies with enhanced
benefits. Finalizing the settlement will require court review and approval, a
fairness hearing, notice to all class members, 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 third quarter of 2007. On February 12, 2007 the court
granted preliminary approval of the settlement. The fairness hearing is
scheduled to occur on May 21, 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
December 31, 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. On November 7, 2006 the Bankruptcy Court authorized such release by
approving applicable claims filed by plaintiffs. In determining our current
estimate of the net costs related to the tentative settlement, these shares were
valued based on the December 31, 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.
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
127
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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).
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. Mr.
Guffey has settled with plaintiffs. Plaintiffs filed a motion to add an
additional count to the complaint against CVIC and a motion for summary judgment
on that new count. The court denied plaintiffs' motion for summary judgment, and
plaintiffs are appealing that denial. 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. This case was
settled on February 22, 2007.
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 May 9,
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.
128
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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: 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. On August 25, 2006
the court awarded the plaintiff judgment in the sum of $3.8 million plus
interest from December 16, 1997. We are 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 Capital Management (now known as 40|86 Advisors, Inc.)
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 alleged 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. On January 9, 2007, the case
was settled.
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 granted in part and denied in part, and the
plaintiffs have until March 29, 2007, to file a second amended complaint. The
case is set for trial commencing February 12, 2008. 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.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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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 Insurance Company'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. An order was issued on
February 15, 2007 granting plaintiff's motion for class certification. The order
specifically certifies two sub-classes identifying them as the radiation
treatment sub-class and the chemotherapy treatment sub-class. We are in the
process of filing an appeal of the class certification order. 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. The case was settled and
dismissed on November 17, 2006.
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.
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
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 was pending in the District Court of Clark
County, Nevada, Cause No. A478843, Dept. No. VIII. Ms. Bailey's suit centered
around her request for disability benefits in the spring of 2003 and alleged
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. This matter was settled
on January 31, 2007.
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
August 6, 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 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 two past board
members with outstanding loan balances, James D. Massey and Dennis E. Murray,
Sr. In addition, these directors have sued the companies for declaratory relief
concerning their liability for the loans. The specific lawsuits now pending
include: Murray and Massey v. Conseco, Case No. 1:03-CV-1701-LJM-VSS (Southern
District, Indiana); Conseco Services v. Murray, Case No. 29D02-0404-CC-381
(Superior Court, Hamilton County, Indiana); Conseco Services v. Massey, Case No.
29D01-0406-CC-477 (Superior Court, Hamilton County, Indiana); Conseco, Inc. v.
Massey, Case No. 2005-L-011316 (Circuit Court, Cook County, Illinois) and
Conseco and Conseco Services v. J. David Massey et al., Case No.
29D02-0611-PL-1169 (Superior Court, Hamilton County, Indiana). On June 21, 2006,
the Company obtained a judgment against Mr. Massey in the sum of $4.4 million
plus interest at 11.5 percent from June 30, 2002. We are attempting to execute
on this judgment. 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. On December 6, 2006, we settled all
pending litigation with Mr. Hilbert.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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James S. Adams filed for bankruptcy on July 29, 2005, Case No.
1:02-cv-1332-DFH-TAB (Southern District, Indiana). On January 11, 2007, we
settled all pending litigation with Mr. Adams.
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 December 31, 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 December 31, 2006, we estimated that
approximately $22.9 million, net of collection costs, of the remaining amounts
due under the loan program will be collected (including amounts that remain to
be collected from borrowers with whom we have settled) 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.
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, may 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 $2.5 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 in
the section of this note entitled "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.
Guaranty Fund Assessments
The balance sheet at December 31, 2006, included: (i) accruals of $7.2
million, representing our estimate of all known assessments that will be levied
against the Company's insurance subsidiaries by various state guaranty
associations based on
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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premiums written through December 31, 2006; and (ii) receivables of $3.4 million
that we estimate will be recovered through a reduction in future premium taxes
as a result of such assessments. At December 31, 2005, such guaranty fund
assessment accruals were $10.8 million and such receivables were $7.5 million.
These estimates are subject to change when the associations determine more
precisely the losses that have occurred and how such losses will be allocated
among the insurance companies. We recognized expense (benefit) for such
assessments of $2.5 million, $4.0 million and $(.6) million in 2006, 2005 and
2004, respectively.
Guarantees
We hold bank loans made to certain former directors and employees to enable
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 December 31, 2006, we have estimated
that approximately $22.9 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. In 2006 and 2005, other operating costs and expenses are net of
recoveries of $3.0 million and $3.2 million, respectively, related to our
evaluation of the collectibility of the D&O loans.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by Old Conseco's subsidiary trusts and eliminated in our reorganization)
who did not opt out of the bankruptcy settlement, will be entitled to receive 45
percent of any net proceeds from the collection of certain D&O loans in an
aggregate amount not to exceed $30 million. As of December 31, 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 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 December
31, 2006 and 2005, was $22.5 million and $23.2 million, respectively, and is
included in the caption "Other liabilities" in the consolidated balance sheet.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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Leases and Certain Other Long-Term Commitments
The Company rents office space, equipment and computer software under
noncancellable operating lease agreements. In addition, the Company has entered
into certain sponsorship agreements which require future payments. Total expense
pursuant to these lease and sponsorship agreements was $43.3 million, $41.3
million and $44.1 million in 2006, 2005 and 2004, respectively. Future required
minimum payments as of December 31, 2006, were as follows (dollars in millions):
2007 ........................................................................... $ 35.1
2008 ........................................................................... 29.9
2009 ........................................................................... 25.5
2010 ........................................................................... 20.5
2011 ........................................................................... 18.7
Thereafter........................................................................ 82.2
------
Total..................................................................... $211.9
======
9. OTHER DISCLOSURES
Agent Deferred Compensation Plan and Postretirement Plans
For our agent deferred compensation plan and postretirement plans, it is
our policy to immediately recognize changes in the actuarial benefit obligation
resulting from either actual experience being different than expected or from
changes in actuarial assumptions.
One of our insurance subsidiaries has a noncontributory, unfunded deferred
compensation plan for qualifying members of its career agency force. Benefits
are based on years of service and career earnings. The actuarial measurement
date of this deferred compensation plan is December 31. The liability recognized
in the consolidated balance sheet for the agents' deferred compensation plan was
$94.6 million and $79.0 million at December 31, 2006 and 2005, respectively.
Costs incurred on this plan were $8.9 million, $11.3 million and $8.9 million
during 2006, 2005 and 2004, respectively (including the recognition of losses of
$.1 million, $4.0 million and $2.7 million in 2006, 2005 and 2004, respectively,
resulting from actual experience being different than expected or from changes
in actuarial assumptions). The estimated net loss for the agent deferred
compensation plan that will be amortized from accumulated other comprehensive
income into the net periodic benefit cost during 2007 is $.9 million. In 2006,
we purchased Company-owned life insurance ("COLI") as an investment vehicle to
fund the agent deferred compensation plan. The COLI assets are not assets of the
agent deferred compensation plan, and as a result, are accounted for outside the
plan and are recorded in the consolidated balance sheet as other invested
assets. We account for the COLI assets in accordance with FASB Technical
Bulletin No. 85-4, "Accounting for Purchases of Life Insurance". The carrying
value of the COLI assets at December 31, 2006, was $19.7 million. Changes in the
cash surrender value (which approximates net realizable value) of the COLI
assets are recorded as net investment income.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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Effective December 31, 2005, the Company terminated certain postretirement
benefit plans. Prior to the termination of such plans, we provided certain
health care and life insurance benefits for certain eligible retired employees
under partially funded and unfunded plans in existence at the date on which
certain subsidiaries were acquired. Certain postretirement benefit plans were
contributory, with participants' contributions adjusted annually. Actuarial
measurement dates of September 30 and December 31 were used for those
postretirement benefit plans. In 2005, we recognized gains of $13.2 million on
the termination of these plans. The costs incurred on these plans during 2004
were reduced by $7.9 million related to the recognition of changes in the
actuarial benefit obligation resulting either from actual experience being
different than expected or from changes in actuarial assumptions. The remaining
liability at December 31, 2006, relates to benefits to be paid in 2007. Amounts
related to the postretirement benefit plans were as follows (dollars in
millions):
2006 2005
---- ----
Benefit obligation, beginning of year....................... $ .5 $ 13.8
Interest cost........................................... - .6
Plan participants' contributions........................ - 1.0
Gain on plan terminations............................... - (13.2)
Benefits paid........................................... (.2) (1.7)
---- ------
Benefit obligation, end of year............................. $ .3 $ .5
==== ======
Funded status - accrued benefit cost........................ $ .3 $ .5
==== ======
We used the following weighted average assumptions to calculate:
2006 2005
---- ----
Benefit obligations:
Discount rate.............................................. 5.75% 5.50%
Net periodic cost:
Discount rate.............................................. 5.50% 5.75%
The discount rate is based on the yield of a hypothetical portfolio of high
quality debt instruments which could effectively settle plan benefits on a
present value basis as of the measurement date. At both December 31, 2006 and
2005, for our deferred compensation plan for qualifying members of our career
agency force, we assumed a 5 percent annual increase in compensation until the
participant's normal retirement date (age 65 and completion of five years of
service).
There was no expense recognized in 2006 related to the postretirement
benefit plans which were terminated in 2005. Components of the cost (benefit) we
recognized related to such postretirement plans in 2005 and 2004 were as follows
(dollars in millions):
2005 2004
---- ----
Cost of postretirement benefits:
Interest cost.............................................. $ .6 $ 1.3
Curtailment gains.......................................... (13.2) -
Recognized net actuarial gain.............................. - (7.9)
------ -----
Net periodic cost (benefit)............................. $(12.6) $(6.6)
====== =====
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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The benefits expected to be paid pursuant to our agent deferred
compensation plan and postretirement benefit plans as of December 31, 2006 were
as follows (dollars in millions):
2007................................................. $ 3.6
2008................................................. 3.6
2009................................................. 3.7
2010................................................. 3.9
2011................................................. 4.1
2012 - 2016.......................................... 28.5
The Company has qualified defined contribution plans for which
substantially all employees are eligible. Company contributions, which match
certain voluntary employee contributions to the plan, totaled $4.1 million, $4.0
million and $4.1 million in 2006, 2005 and 2004, respectively. Employer matching
contributions are discretionary.
Reclassification Adjustments Included in Comprehensive Income (Loss)
The changes in unrealized appreciation (depreciation) included in
comprehensive income (loss) are net of reclassification adjustments for
after-tax net gains (losses) from the sale of investments included in net income
(loss) of approximately $70 million, $165 million and $75 million for the years
ended December 31, 2006, 2005 and 2004, respectively.
10. SHAREHOLDERS' EQUITY
Pursuant to the Plan, CNO issued 34.4 million shares of class A convertible
exchangeable preferred stock with an aggregate liquidation preference of
approximately $859.7 million. The preferred stock had a par value of $.01 per
share and a liquidation preference of $25 per share. Dividends were payable
semi-annually in additional shares of class A preferred stock on March 1 and
September 1 at a rate equal to 10.5 percent of the liquidation preference per
share. The class A preferred stock was redeemed in the second quarter of 2004,
as further discussed below.
In the second quarter of 2004, we completed the public offerings, including
underwriter over-allotments, of 50.6 million shares of our common stock at an
offering price of $18.25 per share and 27.6 million shares of our 5.5 percent
Class B mandatorily convertible preferred stock (the "Preferred Stock") at an
offering price of $25 per share. Proceeds from the offerings, net of issuance
costs of $63.4 million, totaled $1,550.1 million. Such proceeds were used as
follows:
o $928.9 million to redeem all outstanding shares of our class A
preferred stock.
o $620.7 million to repay indebtedness under our Previous Credit
Facility, including accrued interest of $.7 million.
o $.5 million for general corporate purposes.
The Preferred Stock has a par value of $.01 per share and a liquidation
preference of $25 per share. Dividends are payable in cash at a rate of 5.5
percent of the liquidation preference per share, payable quarterly on February
15, May 15, August 15 and November 15.
The Preferred Stock is mandatorily convertible into common stock of Conseco
on May 15, 2007. The conversion rate for each share of Preferred Stock will
range from 1.1228 to 1.3699 shares of Conseco common stock, depending on the
applicable market value of our common stock, as defined in the certificate of
designations, on the mandatory conversion date. As of December 31, 2006, the
Preferred Stock would have been convertible into 34.2 million shares of Conseco
common stock. At any time prior to May 15, 2007, the holders of the Preferred
Stock may convert such shares at the minimum conversion rate of 1.1228 shares of
our common stock for each share of Preferred Stock. If at any time prior to May
15, 2007, the closing price of our common stock exceeds 150 percent of the
threshold appreciation price of $22.27, subject to adjustment under certain
circumstances, the Company, at its option for a certain period of time, may
elect to convert all outstanding Preferred Stock at the minimum conversion rate
of 1.1228 shares of our common stock for each share of Preferred Stock. In
addition, if the Company elects such conversion, it must pay the holders of the
Preferred Stock, in cash, an amount equal to the present value of all remaining
unpaid dividends on the Preferred Stock through and including May 15, 2007.
136
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
If the Company is involved in a merger prior to May 15, 2007, in which at
least 30 percent of the consideration for our common stock consists of cash or
cash equivalents, then the holders of the Preferred Stock have the right to
convert their shares into shares of our common stock at the conversion rate in
effect immediately prior to such merger.
Holders of the Preferred Stock are only entitled to voting rights in
limited circumstances as further described in the certificate of designations.
Pursuant to the Plan, we issued warrants to purchase 6.0 million shares of
our common stock (the "Series A Warrants") entitling the holders to purchase
shares of CNO common stock at a price of $27.60 per share. The Series A Warrants
expire on September 10, 2008. The exercise price and number of common shares
issuable are subject to adjustment based on the occurrence of certain events,
including: (i) stock dividends; (ii) stock splits; and (iii) the issuance of
instruments or securities which are exercisable for or convertible into shares
of common stock entitling the holders to purchase shares of common stock at a
price per share that is less than the market price on the date of issuance.
In December 2006, the Company's board of directors authorized a common
share repurchase program of up to $150 million. This program may be implemented
through purchases made from time to time in either the open market or through
private transactions. With respect to $25 million of the program, the Company
entered into an accelerated share buy back agreement ("ASB") to repurchase 1.2
million shares. The initial price paid per share as part of the ASB transaction
was $20.12. The repurchased shares were subject to a settlement price adjustment
based upon the difference between: (i) the volume weighted average price of
Conseco common stock (as defined in the ASB); and (ii) $20.12. The settlement
price adjustment was calculated to be $.3 million and was paid to the Company.
The Company will recognize a reduction in common stock and additional paid-in
capital of $24.7 million in the first quarter of 2007 related to the ASB
transaction.
Changes in the number of shares of common stock outstanding were as follows
(shares in thousands):
2006 2005 2004
---- ---- ----
Balance, beginning of year.............................................. 151,513 151,058 100,116
Stock options exercised............................................. 48 23 - (b)
Issuance of shares.................................................. - - 50,600
Shares issued under employee benefit
compensation plans............................................... 645(a) 443 (a) 342 (b)
Other............................................................... (41) (11) -
------- ------- -------
Balance, end of year.................................................... 152,165 151,513 151,058
======= ======= =======
<FN>
- --------------------
(a) In 2006 and 2005, such amounts were reduced by 220 thousand shares and
148 thousand shares, respectively, which were tendered for the payment
of federal and state taxes owned on the issuance of restricted stock.
(b) Such amount has been reduced by an aggregate of 310 thousand shares
which were withheld for the payment of the exercise price of the stock
options and federal and state taxes owed by a former executive.
</FN>
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. The
vesting periods for our restricted stock awards range from immediate vesting to
a period of four years.
137
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
A summary of the Company's stock option activity and related information
for 2006 is presented below (shares in thousands):
Weighted Weighted
average average Aggregate
exercise remaining intrinsic
Shares price life value
------ ----- ---- -----
Outstanding at the beginning of
the year....................................................... 3,536 $19.89
Options granted................................................... 1,295 22.57
Exercised......................................................... (48) 20.80 $ .3
Forfeited or terminated........................................... (566) 19.47
----
Outstanding at the end of the year................................ 4,217 20.76 7.6 years $27.4
===== ===
Options exercisable at the end of the year........................ 2,257 6.4 years $14.9
===== ===
Available for future grant........................................ 4,020
=====
A summary of the Company's stock option activity and related information
for 2005 and 2004 is presented below (shares in thousands):
2005 2004
----------------- ----------------
Weighted Weighted
average average
exercise exercise
Shares price Shares price
------ ----- ------ -----
Outstanding at the beginning of
the year..................................................................... 3,448 $19.82 1,000 $18.01
Options granted................................................................. 560 21.22 3,506 19.95
Exercised....................................................................... (23) 20.83 (241) 16.40
Forfeited or terminated......................................................... (449) 20.92 (817) 19.16
----- -----
Outstanding at the end of the year.............................................. 3,536 19.89 3,448 19.82
===== =====
Options exercisable at the end of
the year..................................................................... 1,406 699
===== ===
Available for future grant...................................................... 4,247 4,320
===== =====
We recognized compensation expense related to stock options totaling $6.5
million ($4.2 million after income taxes) in 2006. Compensation expense related
to stock options reduced both basic and diluted earnings per share by less than
3 cents in 2006. At December 31, 2006, the unrecognized compensation expense for
non-vested stock options totaled $13.4 million which is expected to be
recognized over a weighted average period of 2.7 years. Cash received from the
exercise of stock options was $1.0 million, $.5 million and nil during 2006,
2005 and 2004, respectively.
138
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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):
2005 2004
---- ----
Net income, as reported ............................................................. $324.9 $294.8
Less stock-based employee compensation ..expense determined under the
fair value method for all awards, net of income taxes........................... 3.5 5.1
------ ------
Pro forma net income................................................................. $321.4 $289.7
====== ======
Earnings per share:
Basic, as reported.............................................................. $1.90 $1.73
===== =====
Basic, pro forma................................................................ $1.87 $1.69
===== =====
Diluted, as reported............................................................ $1.76 $1.63
===== =====
Diluted, pro forma.............................................................. $1.74 $1.59
===== =====
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:
2006 Grants 2005 Grants 2004 Grants
----------- ----------- -----------
Weighted average risk-free interest rates.............................. 5.0% 4.0% 4.2%
Weighted average dividend yields....................................... 0.0% 0.0% 0.0%
Volatility factors..................................................... 22% 25% 30%
Weighted average expected life......................................... 6.2 years 6.1 years 5.9 years
Weighted average fair value per share.................................. $7.90 $7.06 $6.41
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.
The exercise price was equal to the market price of our stock for all
options granted in 2006 and 2005. The weighted average fair value of options
granted in 2004 whose exercise price is equal to the market price of our stock
on the grant date was $6.67 per share. The weighted average fair value of
options granted in 2004 whose exercise price exceeds the market price of our
stock on the grant date was $6.29 per share.
The following table summarizes information about stock options outstanding
at December 31, 2006 (shares in thousands):
Options outstanding Options exercisable
-------------------------------------------- ----------------------------
Number Remaining Average exercise Number Average exercise
Range of exercise prices outstanding life (in years) price exercisable price
- ------------------------ ----------- --------------- ----- ----------- -----
$16.20 - $20.91................... 1,652 6.6 $19.18 1,076 $18.63
$21.00 - $25.45................... 2,565 8.1 21.78 1,181 21.04
----- -----
4,217 2,257
===== =====
139
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
During 2006, 2005 and 2004, the Company granted .1 million, .2 million and
2.0 million restricted shares, respectively, of CNO common stock to certain
directors, officers and employees of the Company at a weighted average fair
value of $22.68 per share, $21.41 per share and $18.85 per share, respectively.
The fair value of such grants totaled $1.3 million, $4.7 million and $37.1
million in 2006, 2005 and 2004, respectively. Such amounts are recognized as
compensation expense over the vesting period of the restricted stock. A summary
of the Company's non-vested restricted stock activity for 2006 is presented
below (shares in thousands):
Weighted
average
grant date
Shares fair value
------ ----------
Non-vested shares, beginning of year................................ 1,392 $18.57
Granted.......................................................... 58 22.68
Vested.......................................................... (865) 18.68
Forfeited....................................................... (340) 17.93
-----
Non-vested shares, end of year...................................... 245 20.06
=====
At December 31, 2006, the unrecognized compensation expense for non-vested
restricted stock totaled $3.3 million which is expected to be recognized over a
weighted average period of 1.2 years. At December 31, 2005, the unrecognized
compensation expense for non-vested restricted stock totaled $18.3 million. We
recognized compensation expense related to restricted stock awards totaling
$10.2 million, $11.4 million and $13.7 million in 2006, 2005 and 2004,
respectively. The fair value of restricted stock that vested during 2006, 2005
and 2004 was $16.1 million, $11.5 million and $7.6 million, respectively.
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.
The Company does not currently recognize tax benefits resulting from tax
deductions in excess of the compensation expense recognized because of NOLs
which are available to offset future taxable income.
140
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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):
2006 2005 2004
---- ---- ----
Net income.............................................................. $ 96.5 $324.9 $294.8
Preferred stock dividends............................................... (38.0) (38.0) (65.5)
------ ------ ------
Net income applicable to common
stock for basic earnings per share............................... 58.5 286.9 229.3
Effect of dilutive securities:
Preferred stock dividends.......................................... - 38.0 24.2
------ ------ ------
Net income applicable to common
stock and assumed conversions for
diluted earnings per share....................................... $ 58.5 $324.9 $253.5
====== ====== ======
Shares:
Weighted average shares outstanding for basic
earnings per share................................................. 151,690 151,160 132,280
------- ------- -------
Effect of dilutive securities on weighted average shares:
Class B Mandatorily convertible preferred
stock............................................................ - 33,027 23,145
Stock option and restricted stock plans............................ 819 853 505
------- ------- -------
Dilutive potential common shares................................... 819 33,880 23,650
------- ------- -------
Weighted average shares outstanding for diluted
earnings per share............................................... 152,509 185,040 155,930
======= ======= =======
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share, because
doing so would have been antidilutive in such periods.
2006 2005 2004
---- ---- ----
(shares in thousands)
Equivalent common shares that were antidilutive during the year:
Class A convertible exchangeable preferred stock................... - - 19,859
Class B mandatorily convertible preferred stock.................... 32,178 - -
------ ----- ------
32,178 - 19,859
====== ===== ======
In August 2005, as further discussed in the note to the consolidated
financial statements entitled "Notes Payable - Direct Corporate Obligations", we
completed the private offering of $330.0 million of 3.50% Convertible Debentures
due September 30, 2035. 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. During 2006 and 2005, the conversion feature of these
Debentures did not have a dilutive effect because the weighted average market
price of our common stock did not exceed the initial conversion price of $26.66.
Therefore, the Debentures had no effect on our diluted shares outstanding or our
diluted
141
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
earnings per share in 2006 or 2005.
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).
11. OTHER OPERATING STATEMENT DATA
Insurance policy income consisted of the following (dollars in millions):
2006 2005 2004
---- ---- ----
Traditional products:
Direct premiums collected............................................ $ 4,749.8 $ 4,434.4 $ 4,400.2
Reinsurance assumed.................................................. 124.0 60.1 70.2
Reinsurance ceded.................................................... (215.2) (232.2) (255.2)
--------- --------- ---------
Premiums collected, net of reinsurance......................... 4,658.6 4,262.3 4,215.2
Change in unearned premiums.......................................... 48.5 18.3 1.6
Less premiums on universal life and products
without mortality and morbidity risk which
are recorded as additions to insurance
liabilities ...................................................... (2,067.7) (1,709.8) (1,648.3)
--------- --------- ---------
Premiums on traditional products with
mortality or morbidity risk................................. 2,639.4 2,570.8 2,568.5
Fees and surrender charges on interest-sensitive
products............................................................ 349.6 359.3 380.8
--------- --------- ---------
Insurance policy income........................................ $ 2,989.0 $ 2,930.1 $ 2,949.3
========= ========= =========
The four states with the largest shares of 2006 collected premiums were
Florida (9.4 percent), California (7.4 percent), Texas (6.3 percent) and
Pennsylvania (5.4 percent). No other state accounted for more than five percent
of total collected premiums.
Other operating costs and expenses were as follows (dollars in millions):
2006 2005 2004
---- ---- ----
Commission expense....................................................... $151.4 $154.0 $171.4
Salaries and wages....................................................... 184.0 186.0 195.5
Other.................................................................... 239.0 213.8 256.1
------ ------ ------
Total other operating costs and expenses.......................... $574.4 $553.8 $623.0
====== ====== ======
142
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Changes in the value of policies inforce at the Effective Date were as
follows (dollars in millions):
2006 2005 2004
---- ---- ----
Balance, beginning of year............................................... $2,382.0 $2,597.6 $2,966.4
Additional acquisition expense....................................... 2.1 2.6 3.4
Amortization......................................................... (276.2) (294.7) (320.0)
Amounts related to fair value adjustment of actively managed
fixed maturities.................................................. 29.3 76.5 (52.2)
-------- -------- --------
Balance, end of year..................................................... $2,137.2 $2,382.0 $2,597.6
======== ======== ========
Based on current conditions and assumptions as to future events on all
policies inforce, the Company expects to amortize approximately 13 percent of
the December 31, 2006 balance of the value of policies inforce at the Effective
Date in 2007, 11 percent in 2008, 10 percent in 2009, 9 percent in 2010 and 7
percent in 2011. The discount rate used to determine the amortization of the
value of policies inforce at the Effective Date averaged 5 percent in the years
ended December 31, 2006, 2005 and 2004.
In accordance with 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.
During the second quarter of 2004, we evaluated certain amortization
assumptions used to estimate gross profits for universal life products and
investment-type products by comparing them to our actual experience. We made
refinements to the previous assumptions related to investment income to match
actual experience and our estimates for future assumptions. The changes we made
did not affect our expectations for the total estimated profits to be earned on
this business, but did affect how we expect the profits to emerge over time.
These new assumptions resulted in a retroactive reduction to the amortization of
the value of policies inforce at the Effective Date of $7.7 million 2004.
Changes in the cost of policies produced were as follows (dollars in
millions):
2006 2005 2004
---- ---- ----
Balance, beginning of year............................................... $ 758.8 $409.1 $101.8
Additions............................................................. 482.5 439.5 361.0
Amortization.......................................................... (147.2) (99.7) (43.5)
Amounts related to fair value adjustment of actively
managed fixed maturities............................................ 12.6 9.9 (10.2)
-------- ------ ------
Balance, end of year..................................................... $1,106.7 $758.8 $409.1
======== ====== ======
143
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
12. CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
2006 2005 2004
---- ---- ----
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............................. $11.4 $8.6 $12.4
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start date.................. 6.7 1.4 -
Issuance of convertible preferred shares............................ - - 41.4
The following reconciles net income to net cash provided by operating
activities (dollars in millions):
2006 2005 2004
---- ---- ----
Cash flows from operating activities:
Net income............................................................ $ 96.5 $ 324.9 $ 294.8
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization and depreciation..................................... 480.7 410.8 397.6
Income taxes...................................................... 57.2 206.9 176.9
Insurance liabilities............................................. 528.6 391.0 354.5
Accrual and amortization of investment income..................... (5.8) 86.4 176.3
Deferral of policy acquisition costs.............................. (484.6) (400.9) (364.4)
Net realized investment (gains) losses............................ 47.2 2.9 (40.6)
(Gain) loss on extinguishment of debt............................. .3 3.4 (2.8)
Net sales of trading securities................................... 36.0 165.8 21.1
Other............................................................. 175.1 (29.1) 34.2
------- -------- --------
Net cash provided by operating activities....................... $ 931.2 $1,162.1 $1,047.6
======= ======== ========
At December 31, 2006, restricted cash and cash equivalents consisted of:
(i) $15.7 million held by a variable interest entity; (ii) $.1 million of
segregated cash held for the benefit of the former holders of TOPrS; and (iii)
$8.2 million held in an escrow account pursuant to a litigation settlement.
At December 31, 2005, restricted cash and cash equivalents consisted of:
(i) $33.3 million held by a variable interest entity; and (ii) $1.9 million of
segregated cash held for the benefit of the former holders of TOPrS.
13. STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES)
Statutory accounting practices prescribed or permitted by regulatory
authorities for the Company's insurance subsidiaries differ from GAAP. The
Company's insurance subsidiaries reported the following amounts to regulatory
agencies, after appropriate elimination of intercompany accounts among such
subsidiaries (dollars in millions):
2006 2005
---- ----
Statutory capital and surplus.................................................................... $1,554.5 $1,603.8
Asset valuation reserve.......................................................................... 179.1 142.7
Interest maintenance reserve..................................................................... 249.7 273.0
-------- --------
Total...................................................................................... $1,983.3 $2,019.5
======== ========
Statutory capital and surplus included investments in upstream affiliates
of $52.4 million at both December 31, 2006 and 2005, which were eliminated in
the consolidated financial statements prepared in accordance with GAAP. In the
second
144
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
quarter of 2004, $106.6 million of affiliated preferred stock held by our
insurance subsidiaries was redeemed by the parent using the proceeds from the
refinancing of our Previous Credit Facility. In 2004, a non-cash dividend of
$45.8 million representing affiliated preferred stock was paid to CDOC.
Statutory earnings build the capital required by ratings agencies and
regulators. Statutory earnings, fees and interest paid by the insurance
companies to the parent company create the "cash flow capacity" the parent
company needs to meet its obligations, including debt service. The consolidated
statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries
was $(232.4) million, $97.3 million and $(3.3) million in 2006, 2005 and 2004,
respectively. Included in such net income (loss) were net realized capital gains
(losses), net of income taxes, of $(1.8) million, $7.8 million and $(17.7)
million in 2006, 2005 and 2004, respectively. In addition, such net income
(loss) included pre-tax amounts for fees and interest to Conseco or its non-life
subsidiaries totaling $157.6 million, $145.6 million and $283.1 million
(including $148 million related to prior years) in 2006, 2005 and 2004,
respectively.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the ability of our insurance subsidiaries to pay dividends is subject
to state insurance department regulations. Insurance regulations generally
permit dividends to be paid from statutory earned surplus of the insurance
company without regulatory approval 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 statutory 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. All of the dividends we plan to
have our insurance subsidiaries pay in 2007 will require regulatory approval.
During 2006, our top tier insurance subsidiary paid dividends of $72.5 million
to CDOC. Also, during 2006, CDOC made capital contributions totaling $127.0
million to our top tier insurance subsidiary including $50.0 million of capital
contributions which were accrued at December 31, 2006, and paid in February
2007.
In connection with monitoring the financial condition of insurers, certain
state insurance departments have requested additional information from two of
the Company's insurance subsidiaries, Conseco Senior Health Insurance Company
("Conseco Senior") and Conseco Life Insurance Company ("Conseco Life"), as such
insurance subsidiaries have incurred statutory losses in a 12 month period in
excess of 50 percent of its capital and surplus. The statutory losses of Conseco
Life are primarily attributable to a tentative litigation settlement. 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 "Commitments and Contingencies". The statutory losses of
Conseco Senior are primarily attributable to the adverse development on
long-term care claims incurred in prior periods and an increase in reserves
based on the results of required asset adequacy testing. Based on our
discussions with state insurance departments, we do not expect the regulators to
take any actions against Conseco Senior or Conseco Life due to the causes of our
statutory losses and the actions being undertaken by the Company.
Conseco Senior has 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. 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 or increase the asset adequacy 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.
In accordance with orders from the Florida Office of Insurance Regulation,
Conseco Senior may not distribute funds to any affiliate or shareholder unless
such distributions have been approved by the Florida Office of Insurance
Regulation and Washington National Insurance Company may not make similar
distributions without prior notice to the Florida Office of Insurance
Regulation. In addition, the risk-based capital and other capital requirements
described below can also limit, in certain circumstances, the ability of our
insurance subsidiaries to pay dividends.
Risk-Based Capital ("RBC") requirements provide a tool for insurance
regulators to determine the levels of statutory
145
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
capital and surplus an insurer must maintain in relation to its insurance and
investment risks and the need for possible regulatory attention. The RBC
requirements provide four levels of regulatory attention, varying with the ratio
of the insurance company's total adjusted capital (defined as the total of its
statutory capital and surplus, AVR and certain other adjustments) to its RBC as
follows: (i) if a company's total adjusted capital is less than 100 percent but
greater than or equal to 75 percent of its RBC (the "Company Action Level"), the
company must submit a comprehensive plan to the regulatory authority proposing
corrective actions aimed at improving its capital position; (ii) if a company's
total adjusted capital is less than 75 percent but greater than or equal to 50
percent of its RBC (the "Regulatory Action Level"), the regulatory authority
will perform a special examination of the company and issue an order specifying
the corrective actions that must be taken; (iii) if a company's total adjusted
capital is less than 50 percent but greater than or equal to 35 percent of its
RBC (the "Authorized Control Level"), the regulatory authority may take any
action it deems necessary, including placing the company under regulatory
control; and (iv) if a company's total adjusted capital is less than 35 percent
of its RBC (the "Mandatory Control Level"), the regulatory authority must place
the company under its control. In addition, the RBC requirements provide for a
trend test if a company's total adjusted capital is between 100 percent and 125
percent of its RBC at the end of the year. The trend test calculates the greater
of the decrease in the margin of total adjusted capital over RBC: (i) between
the current year and the prior year; and (ii) for the average of the last 3
years. It assumes that such decrease could occur again in the coming year. Any
company whose trended total adjusted capital is less than 95 percent of its RBC
would trigger a requirement to submit a comprehensive plan as described above
for the Company Action Level.
In addition to the RBC requirements, certain states have established
minimum capital requirements for insurance companies licensed to do business in
their state. These additional requirements generally have not had a significant
impact on the Company's insurance subsidiaries, but the capital requirements in
Florida have caused Conseco Health Insurance Company to maintain a higher level
of capital and surplus than it would otherwise maintain and have thus limited
its ability to pay dividends.
In addition, we may need to contribute additional capital to strengthen the
surplus of certain insurance subsidiaries and this could affect the ability of
our top tier insurance subsidiary to pay dividends. The ability of our insurance
subsidiaries to pay dividends is also impacted by various criteria established
by rating agencies for higher ratings. During 2006 and 2005, we made capital
contributions of $75.0 million to Conseco Life and $160.5 million to Bankers
Life and Casualty, respectively, in an effort to meet such criteria.
The 2006 and 2005 statutory annual statements filed with the state
insurance regulators of each of our insurance subsidiaries reflected total
adjusted capital in excess of the levels subjecting the subsidiaries to any
regulatory action. However, as a result of losses on the long-term care
business, we made capital contributions to Conseco Senior of $110.0 million
(including $80 million which was accrued at December 31, 2006 and paid in
February 2007) in 2006 and $24.9 million in 2005 in order to avoid triggering
the trend test with respect to Conseco Senior.
During 2006, the financial statements of three of our subsidiaries prepared
in accordance with statutory accounting practices prescribed or permitted by
regulatory authorities reflected the establishment of asset adequacy and premium
deficiency reserves primarily related to long-term care policies. Total asset
adequacy and premium deficiency reserves for Conseco Senior, Washington National
and Bankers Conseco Life Insurance Company were $30.0 million, $47.0 million and
$16.6 million, respectively at December 31, 2006. Due to increases to insurance
liabilities at the fresh-start date, we were not required to recognize a similar
premium deficiency reserve in our consolidated financial statements prepared in
accordance with GAAP.
At December 31, 2006, the consolidated RBC ratio of our insurance
subsidiaries exceeded the minimum risk-based capital requirement included in our
Second Amended Credit Facility. See the note to the consolidated financial
statements entitled "Notes Payable - Direct Corporate Obligations" for further
discussion of various financial ratios and balances we are required to maintain.
We calculate the consolidated RBC ratio by assuming all of the assets,
liabilities, capital and surplus and other aspects of the business of our
insurance subsidiaries are combined together in one insurance subsidiary, with
appropriate intercompany eliminations.
14. BUSINESS SEGMENTS
We manage our business through the following: three primary operating
segments, Bankers Life, Conseco Insurance Group and Colonial Penn, which are
defined on the basis of product distribution; a fourth segment comprised of
other business in run-off; and corporate operations, which consists of holding
company activities and certain noninsurance businesses. These segments reflect
the addition of Colonial Penn as a separate segment resulting from a change in
how management disaggregates the Company's operations for making internal
operating decisions in the fourth quarter of 2006.
146
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Colonial Penn's operations were previously aggregated with the Bankers Life
segment. We have restated all prior period segment disclosures to conform to
management's current view of the Company's operating segments.
Operating information by segment was as follows (dollars in millions):
2006 2005 2004
---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities.................................................... $ 64.7 $ 58.6 $ 52.7
Supplemental health.......................................... 1,240.7 1,203.7 1,163.2
Life......................................................... 155.5 132.7 80.1
Other........................................................ 84.6 10.7 11.5
Net investment income (a)......................................... 525.6 448.0 386.9
Fee revenue and other income (a).................................. 6.0 1.1 1.5
Net realized investment gains (losses) (a)........................ (19.5) (4.2) 15.3
-------- -------- --------
Total Bankers Life revenues.............................. 2,057.6 1,850.6 1,711.2
-------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities.................................................... 16.0 18.6 22.1
Supplemental health.......................................... 614.4 659.6 719.1
Life......................................................... 353.4 372.7 390.9
Other........................................................ 11.0 13.1 16.3
Net investment income (a)......................................... 733.3 702.0 723.8
Fee revenue and other income (a).................................. 1.0 1.9 4.8
Net realized investment gains (losses) (a)........................ (19.5) 1.6 21.5
-------- -------- --------
Total Conseco Insurance Group
revenues............................................. 1,709.6 1,769.5 1,898.5
-------- -------- --------
Colonial Penn:
Insurance policy income:
Supplemental health.......................................... 11.1 13.0 14.5
Life......................................................... 99.7 86.8 81.4
Other........................................................ 1.3 1.5 1.7
Net investment income (a)......................................... 38.2 38.2 38.3
Fee revenue and other income (a).................................. .6 .7 .4
Net realized investment gains (a)................................. .2 .6 2.1
-------- -------- --------
Total Colonial Penn revenues............................. 151.1 140.8 138.4
-------- -------- --------
Other Business in Run-off:
Insurance policy income - supplemental health..................... 336.6 359.1 395.8
Net investment income (a)......................................... 179.5 177.6 167.5
Fee revenue and other income (a).................................. .4 .5 .8
Net realized investment gains (losses) (a)........................ (8.0) .5 4.5
-------- -------- --------
Total Other Business in Run-off
revenues............................................. 508.5 537.7 568.6
-------- -------- --------
Corporate operations:
Net investment income (a)......................................... 29.8 8.8 2.1
Net realized investment losses (a)................................ (.4) (1.4) (2.8)
Fee and other income.............................................. 11.2 20.5 14.0
-------- -------- --------
Total corporate revenues................................. 40.6 27.9 13.3
-------- -------- --------
Total revenues........................................... 4,467.4 4,326.5 4,330.0
-------- -------- --------
(continued on next page)
147
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
(continued from previous page)
2006 2005 2004
---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits......................................... 1,437.0 1,294.2 1,172.0
Amortization...................................................... 220.6 183.7 171.1
Interest expense on investment borrowings......................... .1 1.3 2.3
Other operating costs and expenses................................ 157.8 140.2 144.3
-------- -------- --------
Total Bankers Life expenses.................................. 1,815.5 1,619.4 1,489.7
-------- -------- --------
Conseco Insurance Group:
Insurance policy benefits......................................... 1,077.7 1,065.6 1,151.1
Amortization...................................................... 167.6 166.8 165.4
Interest expense on investment borrowings......................... .8 4.9 5.2
Costs related to the tentative litigation settlement.............. 165.8 9.2 4.9
Other operating costs and expenses................................ 278.3 262.9 301.4
-------- -------- --------
Total Conseco Insurance Group
expenses................................................... 1,690.2 1,509.4 1,628.0
-------- -------- --------
Colonial Penn:
Insurance policy benefits......................................... 96.4 89.7 86.0
Amortization...................................................... 17.3 15.1 16.2
Interest expense on investment borrowings......................... - .4 .3
Other operating costs and expenses................................ 15.6 15.0 15.8
-------- -------- --------
Total Colonial Penn expenses................................. 129.3 120.2 118.3
-------- -------- --------
Other Business in Run-off:
Insurance policy benefits......................................... 457.3 351.1 386.1
Amortization...................................................... 17.9 22.8 18.5
Interest expense on investment borrowings......................... - - .2
Other operating costs and expenses................................ 83.2 86.1 93.5
-------- -------- --------
Total Other Business in Run-off
expenses................................................... 558.4 460.0 498.3
-------- -------- --------
Corporate operations:
Interest expense on corporate debt................................ 52.9 48.1 71.5
Interest expense on variable interest entity...................... 19.7 3.6 -
Costs related to the tentative litigation settlement.............. 8.9 9.1 4.9
Other operating costs and expenses................................ 39.5 49.6 68.0
(Gain) loss on extinguishment of debt............................. .7 3.7 (2.8)
-------- -------- --------
Total corporate expenses..................................... 121.7 114.1 141.6
-------- -------- --------
Total expenses............................................... 4,315.1 3,823.1 3,875.9
-------- -------- --------
Income (loss) before income taxes:
Bankers Life................................................. 242.1 231.2 221.5
Conseco Insurance Group...................................... 19.4 260.1 270.5
Colonial Penn................................................ 21.8 20.6 20.1
Other Business in Run-off.................................... (49.9) 77.7 70.3
Corporate operations......................................... (81.1) (86.2) (128.3)
-------- -------- --------
Income before income taxes............................... $ 152.3 $ 503.4 $ 454.1
======== ======== ========
<FN>
- --------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
148
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Segment balance sheet information was as follows (dollars in millions):
2006 2005
---- ----
Assets:
Bankers Life......................................................................... $11,880.1 $10,952.5
Conseco Insurance Group.............................................................. 15,652.7 15,485.6
Colonial Penn........................................................................ 866.4 863.2
Other Business in Run-off............................................................ 3,678.0 3,723.6
Corporate operations................................................................. 640.1 500.4
--------- ---------
Total assets.................................................................... $32,717.3 $31,525.3
========= =========
Liabilities:
Bankers Life......................................................................... $10,222.6 $ 9,362.4
Conseco Insurance Group.............................................................. 12,276.3 12,298.2
Colonial Penn........................................................................ 729.4 737.1
Other Business in Run-off............................................................ 3,298.2 3,371.3
Corporate operations................................................................. 1,477.7 1,236.5
--------- ---------
Total liabilities............................................................... $28,004.2 $27,005.5
========= =========
The following table presents selected financial information of our segments
(dollars in millions):
Value of
policies
inforce
at the Cost of
Effective policies Insurance
Segment Date produced liabilities
- ------- ---- -------- -----------
2006
- ----
Bankers Life................................ $ 914.7 $ 740.5 $ 9,963.3
Conseco Insurance Group..................... 979.9 277.3 11,897.4
Colonial Penn............................... 71.7 88.9 714.1
Other Business in Run-off................... 170.9 - 3,398.5
-------- -------- ---------
Total.................................... $2,137.2 $1,106.7 $25,973.3
======== ======== =========
2005
- ----
Bankers Life................................ $1,017.3 $539.1 $ 9,149.1
Conseco Insurance Group..................... 1,094.6 161.9 12,141.5
Colonial Penn............................... 81.3 57.8 716.4
Other Business in Run-off................... 188.8 - 3,391.9
-------- ------ ---------
Total.................................... $2,382.0 $758.8 $25,398.9
======== ====== =========
149
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
15. QUARTERLY FINANCIAL DATA (UNAUDITED)
We compute earnings per common share for each quarter independently of
earnings per share for the year. The sum of the quarterly earnings per share may
not equal the earnings per share for the year because of: (i) transactions
affecting the weighted average number of shares outstanding in each quarter; and
(ii) the uneven distribution of earnings during the year. Quarterly financial
data (unaudited) were as follows (dollars in millions, except per share data).
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.(a)
-------- -------- -------- -----------
2006
- ----
Revenues.............................................................. $1,121.7 $1,084.1 $1,118.3 $1,143.3
Income (loss) before income taxes..................................... 101.1 (34.9) 76.7 9.4
Net income (loss)..................................................... 64.6 (22.3) 48.4 5.8
Income per common share:
Basic:
Net income (loss)................................................. $.36 $(.21) $.26 $(.02)
Diluted:
Net income (loss)................................................. $.35 $(.21) $.26 $(.02)
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
-------- -------- -------- --------
2005
- ----
Revenues.............................................................. $1,048.0 $1,086.7 $1,113.5 $1,078.3
Income before income taxes............................................ 127.2 139.9 121.4 114.9
Net income............................................................ 81.8 88.1 77.9 77.1
Income per common share:
Basic:
Net income........................................................ $.48 $.52 $.45 $.45
Diluted:
Net income........................................................ $.44 $.48 $.42 $.42
<FN>
- -------------
(a) In the fourth quarter of 2006, our net loss reflected the following:
(i) an after tax charge of $35.2 million as a result of changes in
estimates in the long-term care block of business in the Other
Business in Run-off segment; (ii) an after tax charge of $4.6 million
related to refinements of data used to estimate certain long-term care
claim liabilities in the Other Business in Run-off segment; (iii) an
after tax charge of $10.5 million in connection with changes in
management's intent regarding the administration of certain life
policies; (iv) an after tax charge of $7.6 million related to
valuation errors for certain specified disease policies; and (v) an
after tax gain of $4.8 million related to a block of single premium
immediate annuities that were no longer inforce but were incorrectly
carried in the reserve valuation system.
</FN>
16. INVESTMENT IN A VARIABLE INTEREST ENTITY
The Company has an investment in a special purpose entity, that is a
variable interest entity under FIN 46R, as described in the note to the
consolidated financial statements entitled "Summary of Significant Accounting
Policies". The following is description of our significant investment in a
variable interest entity:
150
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Fall Creek CLO Ltd.
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. Our total investment in Fall Creek was $48.8 million
and $32.8 million at December 31, 2006 and 2005, respectively. 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):
December 31,
-------------------
2006 2005
---- ----
Assets:
Actively managed fixed maturities............................ $454.5 $299.2
Cash and cash equivalents - restricted....................... 15.7 33.3
Accrued investment income.................................... 3.9 1.8
Other assets................................................. 7.5 8.1
------ ------
Total assets............................................. $481.6 $342.4
====== ======
Liabilities:
Other liabilities............................................ $ 26.8 $ 8.8
Investment borrowings due to others.......................... 401.7 298.7
Investment borrowings due to the Company..................... 47.0 31.5
------ ------
Total liabilities........................................ 475.5 339.0
------ ------
Equity:
Capital provided by the Company.............................. 1.8 1.3
Capital provided by others................................... 4.7 3.5
Accumulated other comprehensive loss......................... (2.1) (1.4)
Retained earnings............................................ 1.7 -
------ ------
Total equity............................................. 6.1 3.4
------ ------
Total liabilities and equity............................. $481.6 $342.4
====== ======
151
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Years ended
December 31,
------------------
2006 2005
---- ----
Revenues:
Net investment income - deposit accounts..................... $ 25.2 $ 3.4
Fee revenue and other income................................. .3 .5
------ -----
Total revenues........................................... 25.5 3.9
------ -----
Expenses:
Interest expense............................................. 19.7 3.5
Other operating expenses..................................... .9 .3
------ -----
Total expenses........................................... 20.6 3.8
------ -----
Income before net realized investment losses
and income taxes....................................... 4.9 .1
Net realized investment losses............................... (.3) (.1)
------ -----
Income before income taxes...................................... $ 4.6 $ -
====== =====
152
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. Conseco's management,
under the supervision and with the participation of the Chief Executive Officer
and the Chief Financial Officer, evaluated the effectiveness of Conseco's
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended). Based on this
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that Conseco's disclosure controls and procedures were not effective as of
December 31, 2006, as a result of a material weakness in internal control over
financial reporting.
In light of the material weakness, the Company performed additional
analyses and other post-closing procedures to ensure that its consolidated
financial statements included in this Form 10-K were prepared in accordance with
generally accepted accounting principles and presented fairly in all material
respects its financial position, results of operations and cash flows for the
periods presented.
Management's Report on Internal Control over Financial Reporting.
Management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rules 13a-15(f) and
15d-15(f) under the Securities Exchange Act of 1934. A company's internal
control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles in the United States.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
Conseco's management assessed the effectiveness of the Company's internal
control over financial reporting as of December 31, 2006. In making this
assessment, management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -
Integrated Framework. Based on this assessment, management concluded that the
Company's internal control over financial reporting was not effective at
December 31, 2006. A material weakness is a control deficiency, or combination
of control deficiencies, that results in more than a remote likelihood that a
material misstatement of our annual or interim financial statements would not be
prevented or detected.
We did not maintain effective controls over the accounting and disclosure
of insurance policy benefits and the liabilities for insurance products. We
identified a material weakness in internal controls over the actuarial reporting
processes related to the design of controls to ensure the completeness and
accuracy of the inforce policies for a block of single premium immediate
annuities in our Bankers Life segment, controls to ensure that accurate reserves
are established for all policy benefits related to certain supplemental
insurance coverages applicable to a block of specified disease policies in the
Conseco Insurance Group segment, and controls to ensure the accuracy of benefit
reserves on certain long-term care policies with inflation riders, lifetime
benefit features or non-forfeiture provisions in our Other Business in Run-off
segment. These control deficiencies resulted in adjustments to insurance policy
benefits and the liabilities for insurance products in the consolidated
financial statements for the year ended December 31, 2006. Additionally, these
control deficiencies could result in the misstatement of the aforementioned
accounts that would result in a material misstatement in our annual or interim
consolidated financial statements that would not be prevented or detected.
Our management's assessment of the effectiveness of our internal control
over financial reporting as of December 31, 2006 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report which is included herein.
Effect on consolidated financial statements. None of the adjustments
discussed above were material individually, or in the aggregate, to our current
year or prior period consolidated financial statements taken as a whole. In
addition, such adjustments were recorded in the period identified.
153
Remediation Efforts. Since the time the above material weakness was
identified, we have initiated the following remediation plans:
(i) adding additional procedures to the actuarial financial reporting
process including a roll-forward reconciliation of single premium
immediate annuity balances, additional testing of specified disease
policy reserve calculations when new plans or benefits are introduced
and for plan codes with significant new sales, and more comprehensive
control procedures over changes made to our estimation processes;
(ii) adding or enhancing analytical procedures in an effort to ensure the
accuracy of the long-term care claim reserve estimation methods in our
Other Business in Run-off segment; and
(iii) strengthening management review of claim reserve trends and methods
used to estimate long-term care claim reserves in our Other Business
in Run-off segment.
The material weakness will not be fully remediated until, in the opinion of
the Company's management, the revised control processes have been operating for
a sufficient period of time to provide reasonable assurance as to their
effectiveness.
Evaluation of Changes in Internal Controls over 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 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 and
upgrades in the future. We believe that the new and upgraded 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.
The new system conversions discussed above were the only changes in our
internal control over financial reporting (as defined in Rule 13a-15(f) under
the Securities Exchange Act of 1934) during the quarter ended December 31, 2006
that have materially affected, or are reasonably likely to materially affect our
internal control over financial reporting.
154
ITEM 9B. OTHER INFORMATION.
None.
PART III
The information required by Part III is hereby incorporated by reference
from the Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A within 120 days after December 31, 2006 except that
the information required by Item 10 regarding Executive Officers is included
herein under a separate caption at the end of Part I.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) 1. Financial Statements. See Index to Consolidated Financial
Statements on page 89 for a list of financial statements included
in this Report.
2. Financial Statement Schedules. The following financial statement
schedules are included as part of this Report immediately
following the signature page:
Schedule II -- Condensed Financial Information of Registrant
(Parent Company)
Schedule IV -- Reinsurance
All other schedules are omitted, either because they are not applicable,
not required, or because the information they contain is included elsewhere in
the consolidated financial statements or notes.
3. Exhibits. See Exhibit Index immediately preceding the Exhibits
filed with this report.
155
SIGNATURES
Pursuant to the requirements of Section 13 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, this 9th day of March, 2007.
CONSECO, INC.
By: /s/ C. James Prieur
--------------------
C. James Prieur
Chief Executive Officer
156
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
Signature Title (Capacity) Date
- --------- ---------------- ----
/s/ C. JAMES PRIEUR Director and Chief Executive Officer March 9, 2007
- ------------------------------------ (Principal Executive Officer)
C. James Prieur
/s/ EUGENE M. BULLIS Executive Vice President March 9, 2007
- ------------------------------------ and Chief Financial Officer
Eugene M. Bullis (Principal Financial Officer)
/s/ JOHN R. KLINE Senior Vice President March 9, 2007
- ------------------------------------ and Chief Accounting Officer
John R. Kline (Principal Accounting Officer)
/s/ R. GLENN HILLIARD Director March 9, 2007
- ------------------------------------
R. Glenn Hilliard
/s/ NEAL SCHNEIDER Director March 9, 2007
- ------------------------------------
Neal Schneider
/s/ PHILIP R. ROBERTS Director March 9, 2007
- ------------------------------------
Philip R. Roberts
/s/ JOHN G. TURNER Director March 9, 2007
- ------------------------------------
John G. Turner
/s/ MICHAEL T. TOKARZ Director March 9, 2007
- ------------------------------------
Michael T. Tokarz
/s/ MICHAEL S. SHANNON Director March 9, 2007
- ------------------------------------
Michael S. Shannon
/s/ DEBRA J. PERRY Director March 9, 2007
- ------------------------------------
Debra J. Perry
157
Report of Independent Registered Public Accounting Firm
on Financial Statement Schedules
To the Shareholders and Board of Directors
Conseco, Inc.:
Our audits of the consolidated financial statements, of management's assessment
of the effectiveness of internal control over financial reporting and of the
effectiveness of internal control over financial reporting of Conseco, Inc. and
subsidiaries referred to in our report dated March 9, 2007 appearing under Item
8 of this Form 10-K also included an audit of the financial statement schedules
at December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005
and 2004 listed in Item 15(a)(2) of this Form 10-K. In our opinion, these
financial statement schedules present fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
Indianapolis, Indiana
March 9, 2007
158
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Balance Sheet
as of December 31, 2006 and 2005
(Dollars in millions)
ASSETS
2006 2005
---- ----
Cash and cash equivalents:
Unrestricted.......................................................................... $ 95.8 $ 89.4
Restricted............................................................................ .1 2.0
Other invested assets..................................................................... .2 .1
Investment in wholly-owned subsidiaries (eliminated in consolidation)..................... 5,811.6 5,574.0
Receivable from subsidiaries (eliminated in consolidation)................................ 68.9 10.5
Income tax assets, net.................................................................... 59.1 40.0
Other assets.............................................................................. 45.0 59.3
-------- --------
Total assets.................................................................... $6,080.7 $5,775.3
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Notes payable......................................................................... $1,000.8 $ 851.5
Payable to subsidiaries (eliminated in consolidation)................................. 295.4 332.0
Other liabilities..................................................................... 71.4 72.0
-------- --------
Total liabilities............................................................... 1,367.6 1,255.5
-------- --------
Commitments and Contingencies
Shareholders' equity:
Preferred stock....................................................................... 667.8 667.8
Common stock and additional paid-in capital ($.01 par value, 8,000,000,000
shares authorized, shares issued and outstanding: 2006 - 152,165,108;
2005 - 151,513,434) ............................................................... 3,474.7 3,195.6
Accumulated other comprehensive income (loss)......................................... (72.6) 71.7
Retained earnings..................................................................... 643.2 584.7
-------- --------
Total shareholders' equity...................................................... 4,713.1 4,519.8
-------- --------
Total liabilities and shareholders' equity...................................... $6,080.7 $5,775.3
======== ========
The accompanying notes are an integral part
of the condensed financial information.
159
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Statement of Operations
for the years ended December 31, 2006, 2005 and 2004
(Dollars in millions)
2006 2005 2004
---- ---- ----
Revenues:
Net investment income................................................. $ 1.9 $ 3.7 $ .2
Fee and interest income from subsidiaries (eliminated in
consolidation)...................................................... .7 - -
------- ------- -------
Total revenues.................................................... 2.6 3.7 .2
------- ------- -------
Expenses:
Interest expense on notes payable..................................... 52.9 48.1 71.5
Intercompany expenses (eliminated in consolidation)................... 15.2 8.7 1.3
Costs related to the tentative litigation settlement.................. 8.9 9.1 4.9
Operating costs and expenses.......................................... 35.6 39.8 43.2
(Gain) loss on extinguishment of debt................................. .7 3.7 (2.8)
------- ------- -------
Total expenses.................................................... 113.3 109.4 118.1
------- ------- -------
Loss before income taxes and equity in
undistributed earnings of subsidiaries............................ (110.7) (105.7) (117.9)
Income tax benefit on period income...................................... (41.7) (40.1) (36.1)
------- ------- -------
Loss before equity in undistributed
earnings of subsidiaries........................................ (69.0) (65.6) (81.8)
Equity in undistributed earnings of subsidiaries
(eliminated in consolidation)......................................... 165.5 390.5 376.6
------- ------- -------
Net income........................................................ 96.5 324.9 294.8
Preferred stock dividends................................................ 38.0 38.0 65.5
------- ------- -------
Income applicable to common stock................................. $ 58.5 $ 286.9 $ 229.3
======= ======= =======
The accompanying notes are an integral part
of the condensed financial information.
160
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Statement of Cash Flows
for the years ended December 31, 2006, 2005 and 2004
(Dollars in millions)
2006 2005 2004
---- ---- ----
Cash flows used by operating activities..................................... $(39.4) $ (92.8) $ (128.9)
------ ------- ---------
Cash flows from investing activities:
Investments and advances to consolidated subsidiaries*................... .4 (80.1) (110.2)
Change in restricted cash................................................ 1.9 1.9 13.4
------ ------- ---------
Net cash used by investing activities.............................. 2.3 (78.2) (96.8)
------ ------- ---------
Cash flows from financing activities:
Issuance of notes payable, net........................................... 196.7 853.7 790.2
Issuance of preferred stock, net......................................... - - 667.8
Issuance of common stock, net............................................ 1.0 .5 882.2
Payments on notes payable................................................ (48.0) (770.4) (1,332.0)
Redemption of preferred stock............................................ - - (928.9)
Issuance of notes payable to affiliates*................................. 324.9 250.3 298.0
Payments on notes payable to affiliates*................................. (393.1) (63.5) (112.0)
Dividends paid on preferred stock........................................ (38.0) (38.0) (19.3)
Other.................................................................... - - (3.6)
------ ------- ---------
Net cash provided by financing activities.......................... 43.5 232.6 242.4
------ ------- ---------
Net increase in cash and cash
equivalents...................................................... 6.4 61.6 16.7
Cash and cash equivalents, beginning of the year......................... 89.4 27.8 11.1
------ ------- ---------
Cash and cash equivalents, end of the year............................... $ 95.8 $ 89.4 $ 27.8
====== ======= =========
* Eliminated in consolidation
The accompanying notes are an integral part
of the condensed financial information.
161
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Notes to Condensed Financial Information
1. Basis of Presentation
The condensed financial information should be read in conjunction with the
consolidated financial statements of Conseco, Inc. The condensed financial
information includes the accounts and activity of the parent company. We have
reclassified certain amounts in our 2005 and 2004 consolidated financial
statements and notes to conform with the 2006 presentation.
162
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE IV
Reinsurance
for the years ended December 31, 2006, 2005 and 2004
(Dollars in millions)
2006 2005 2004
---- ---- ----
Life insurance inforce:
Direct................................................................ $ 69,674.2 $ 71,682.6 $75,343.7
Assumed............................................................... 860.5 839.4 1,164.1
Ceded................................................................. (16,583.4) (17,989.3) (20,067.1)
---------- ---------- ---------
Net insurance inforce........................................... $ 53,951.3 $ 54,532.7 $56,440.7
========== ========== =========
Percentage of assumed to net 1.6% 1.5% 2.1%
=== === ===
2006 2005 2004
---- ---- ----
Insurance policy income:
Direct................................................................ $2,722.4 $2,742.9 $2,753.5
Assumed............................................................... 130.3 60.1 70.2
Ceded................................................................. (213.3) (232.2) (255.2)
-------- -------- --------
Net premiums.................................................... $2,639.4 $2,570.8 $2,568.5
======== ======== ========
Percentage of assumed to net.................................... 4.9% 2.3% 2.7%
=== === ===
163
EXHIBIT INDEX
Exhibit
No. Description
--- -----------
2.1 Sixth Amended Joint Plan of Reorganization of Conseco, Inc. and
affiliated Debtors, incorporated by reference to Exhibit 2.2 of our
Current Report on Form 8-K filed September 15, 2003.
2.2 Order Confirming Reorganizing Debtors' Sixth Amended Joint Plan of
Reorganization, incorporated by reference to Exhibit 2.3 of our Current
Report on Form 8-K filed September 15, 2003.
3.1 Amended and Restated Certificate of Incorporation of Conseco, Inc.,
incorporated by reference to Exhibit 3.1 of our Current Report on Form
8-K filed September 15, 2003.
3.2 Amended and Restated Bylaws of Conseco, Inc. dated as of August 24,
2004, incorporated by reference to Exhibit 3.2 of our Current Report on
Form 8-K filed August 26, 2004.
4.2 Series A Warrant Agreement between Conseco, Inc. and Wachovia Bank,
N.A., as Warrant Agent, incorporated by reference to Exhibit 4.2 of our
Current Report on Form 8-K filed September 15, 2003.
4.3 Certificate of Designations relating to 5.50% Mandatorily Convertible
Preferred Stock, Class B, of Conseco, Inc., incorporated by reference to
Exhibit 4.3 of our Quarterly Report on Form 10-Q for the quarter ended
June 30, 2004.
4.4 Indenture dated as of August 15, 2005 for 3.50% Convertible Debentures
due September 30, 2035 between Conseco, Inc. and The Bank of New York
Trust Company, N.A., as Trustee, incorporated by reference to Exhibit
4.4 of our Current Report on Form 8-K filed August 16, 2005.
4.5 Registration Rights Agreement dated as of August 15, 2005 among Conseco,
Inc. and Goldman, Sachs & Co., Morgan Stanley & Co. Incorporated and
J.P. Morgan Securities, Inc., as representatives of the several
purchasers of the 3.50% Convertible Debentures due September 30, 2035,
incorporated by reference to Exhibit 4.5 of our Current Report on Form
8-K filed August 16, 2005.
10.1 Second Amended and Restated Credit Agreement dated as of October 10,
2006 among Conseco, Inc., Bank of America, N.A., as Agent, J.P. Morgan
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.
10.4 Guarantee and Security Agreement dated as of June 22, 2004 among
Conseco, Inc., the Subsidiary Guarantors Party Thereto and Bank of
America, N.A., as Agent, incorporated by reference to Exhibit 10.4 of
our Current Report on Form 8-K filed June 23, 2004.
10.8 Agreement dated as of August 20, 2004 between Conseco, Inc. and R. Glenn
Hilliard, incorporated by reference to Exhibit 10.8 of our Current
Report on Form 8-K filed September 17, 2004.
10.9 Agreement dated May 3, 2006, between Conseco, Inc. and William S.
Kirsch, incorporated by reference to Exhibit 10.9 of our Current Report
on Form 8-K filed May 5, 2006.
10.10 Employment Agreement dated as of September 10, 2003 between Conseco,
Inc. and Eugene M. Bullis, incorporated by reference to Exhibit 10.9 of
our Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312), as amended by Amendment to Employment Agreement dated June
13, 2006 between Conseco, Inc. and Eugene M. Bullis, incorporated by
reference to Exhibit 10.10.1 of our Current Report on Form 8-K filed
June 19, 2006.
10.11 Employment Agreement dated as of July 15, 2004 between Conseco Services,
LLC and John R. Kline, incorporated by reference to Exhibit 10.11 of our
Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.
10.12 Amended and Restated Employment Agreement dated as of October 6, 2006
between 40|86 Advisors, Inc. and Eric R. Johnson, incorporated by
reference to Exhibit 10.12 of our Current Report on Form 8-K filed
October 12, 2006.
10.13 Conseco, Inc. 2003 Amended and Restated Long-Term Incentive Plan,
incorporated by reference to Exhibit A of our Proxy Statement filed on
July 26, 2005.
10.14 Form of executive stock option agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by reference
to Exhibit 10.14 of our Annual Report on Form 10-K for the year ended
December 31, 2005.
10.15 Form of executive restricted stock agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by reference
to Exhibit 10.15 of our Annual Report on Form 10-K for the year ended
December 31, 2004.
10.16 Form of Indemnification Agreement among Conseco, Inc., CDOC, Inc.,
Conseco Services, LLC and each director of Conseco, Inc., incorporated
by reference to Exhibit 10.14 of Amendment No. 3 to our Registration
Statement on Form S-1 (No. 333-112312).
10.18 Closing Agreement on Final Determination Covering Specific Matters,
incorporated by reference to Exhibit 10.14 of our Current Report on Form
8-K filed September 14, 2004.
10.19 Agreement dated as of December 20, 2006 between Conseco, Inc. and James
E. Hohmann, incorporated by reference to Exhibit 10.19 of our Current
Report on Form 8-K filed December 21, 2006.
10.20 Conseco, Inc. Pay for Performance Incentive Plan, incorporated by
reference to Exhibit 10.20 of our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2005.
10.21 Closing Agreement on Final Determination Covering Specific Matters,
incorporated by reference to Exhibit 10.21 of our Current Report on Form
8-K filed August 1, 2006.
10.22 Form of performance unit award agreement under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by reference
to Exhibit 10.22 of our Quarterly Report on Form 10-Q for the quarter
ended June 30, 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,
incorporated by reference to Exhibit 10.24 of our Quarterly Report on
Form 10-Q for the quarter ended September 30, 2006.
10.25 Employment Agreement dated as of May 3, 2005 between Conseco Services,
LLC and Susan L. Menzel, incorporated by reference to Exhibit 10.25 of
our Quarterly Report on Form 10-Q for the quarter ended September 30,
2006.
10.26 Employment Agreement dated as of March 7, 2005 between Conseco Services,
LLC and Russell M. Bostick, incorporated by reference to Exhibit 10.31
of our Quarterly Report on Form 10-Q for the quarter ended September 30,
2006.
10.27 Employment Agreement dated as of September 8, 2005 between Conseco
Services, LLC and Christopher J. Nickele, incorporated by reference to
Exhibit 10.27 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2006.
10.28 Employment Agreement dated as of October 1, 2004 between Conseco
Services, LLC and Scott R. Perry, incorporated by reference to Exhibit
10.28 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2006.
10.29 Employment Agreement dated as of April 1, 2006 between Conseco Services,
LLC and Daniel G. Walseth, incorporated by reference to Exhibit 10.29 of
our Quarter Report on Form 10-Q for the quarter ended September 30,
2006.
10.30 Employment Agreement dated as of November 6, 2006 between Conseco
Services, LLC and Michael J. Dubes, incorporated by reference to Exhibit
10.30 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2006.
10.31 Stipulation of Settlement - In Re Conseco Life Insurance Co. Cost of
Insurance Litigation, Cause No. MDL 1610 (Central District, California).
12.1 Computation of Ratio of Earnings to Fixed Charges and Preferred
Dividends.
21 Subsidiaries of the Registrant.
23.1 Consent of PricewaterhouseCoopers LLP.
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.
COMPENSATION PLANS AND ARRANGEMENTS
10.8 Agreement dated as of August 20, 2004 between Conseco, Inc. and R. Glenn
Hilliard, incorporated by reference to Exhibit 10.8 of our Current
Report on Form 8-K filed September 17, 2004.
10.9 Amended and Restated Employment Agreement dated as of September 2, 2005
between Conseco, Inc. and William S. Kirsch, incorporated by reference
to Exhibit 10.9 of our Current Report on Form 8-K filed September 8,
2005.
10.10 Employment Agreement dated as of September 10, 2003 between Conseco,
Inc. and Eugene M. Bullis, incorporated by reference to Exhibit 10.9 of
our Registration Statement on Form S-1 filed January 29, 2004 (No.
333-112312).
10.11 Employment Agreement dated as of July 15, 2004 between Conseco Services,
LLC and John R. Kline, incorporated by reference to Exhibit 10.11 of our
Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.
10.12 Employment Agreement dated as of September 10, 2003 between 40|86
Advisors, Inc. and Eric R. Johnson, incorporated by reference to Exhibit
10.11 of our Registration Statement on Form S-1 filed January 29, 2004
(No. 333-112312).
10.13 Conseco, Inc. 2003 Amended and Restated Long-Term Incentive Plan,
incorporated by reference to Exhibit A of our Proxy Statement filed on
July 26, 2005.
10.14 Form of executive stock option agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by reference
to Exhibit 10.14 of our Annual Report on Form 10-K for the year ended
December 31, 2005.
10.15 Form of executive restricted stock agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by reference
to Exhibit 10.15 of our Annual Report on Form 10-K for the year ended
December 31, 2004.
10.19 Employment Agreement dated as of November 29, 2004 between Conseco, Inc.
and James E. Hohmann, incorporated by reference to Exhibit 10.16 of our
Current Report on Form 8-K filed December 21, 2004.
10.20 Conseco, Inc. Pay for Performance Incentive Plan, incorporated by
reference to Exhibit 10.20 of our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2005.
10.22 Form of performance unit award agreement under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by reference
to Exhibit 10.22 of our Quarterly Report on Form 10-Q for the quarter
ended June 30, 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,
incorporated by reference to Exhibit 10.24 of our Quarterly Report on
Form 10-Q for the quarter ended September 30, 2006.
10.25 Employment Agreement dated as of May 3, 2005 between Conseco Services,
LLC and Susan L. Menzel, incorporated by reference to Exhibit 10.25 of
our Quarterly Report on Form 10-Q for the quarter ended September 30,
2006.
10.26 Employment Agreement dated as of March 7, 2005 between Conseco Services,
LLC and Russell M. Bostick, incorporated by reference to Exhibit 10.31
of our Quarterly Report on Form 10-Q for the quarter ended September 30,
2006.
10.27 Employment Agreement dated as of September 8, 2005 between Conseco
Services, LLC and Christopher J. Nickele, incorporated by reference to
Exhibit 10.27 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2006.
10.28 Employment Agreement dated as of October 1, 2004 between Conseco
Services, LLC and Scott R. Perry, incorporated by reference to Exhibit
10.28 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2006.
10.29 Employment Agreement dated as of April 1, 2006 between Conseco Services,
LLC and Daniel G. Walseth, incorporated by reference to Exhibit 10.29 of
our Quarter Report on Form 10-Q for the quarter ended September 30,
2006.
10.30 Employment Agreement dated as of November 6, 2006 between Conseco
Services, LLC and Michael J. Dubes, incorporated by reference to Exhibit
10.30 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2006.