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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------ -------
Commission File Number 001-31792
Conseco, Inc.
Delaware 75-3108137
---------------------- -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
- -------------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [ X ] No [ ]
Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer or a non-accelerated filer (see definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act). Large
accelerated filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act): Yes [ ] No [ X ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court: Yes [ X ] No [ ]
Shares of common stock outstanding as of July 26, 2007: 188,699,343
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of June 30, 2007 and December 31, 2006................................... 3
Consolidated Statement of Operations for the three and six months ended June 30, 2007 and 2006......... 5
Consolidated Statement of Shareholders' Equity for the six months ended June 30, 2007 and 2006......... 6
Consolidated Statement of Cash Flows for the six months ended June 30, 2007 and 2006................... 7
Notes to Consolidated Financial Statements............................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements.............................................. 30
Overview .............................................................................................. 31
Critical Accounting Policies .......................................................................... 32
Results of Operations.................................................................................. 35
Premium Collections.................................................................................... 55
Liquidity and Capital Resources........................................................................ 60
Investments............................................................................................ 66
Investment in Variable Interest Entity................................................................. 72
New Accounting Standards .............................................................................. 73
Item 3. Quantitative and Qualitative Disclosures About Market Risk ............................................ 73
Item 4. Controls and Procedures................................................................................ 73
PART II - OTHER INFORMATION
Item 1. Legal Proceedings ..................................................................................... 74
Item 1A. Risk Factors........................................................................................... 74
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds............................................ 74
Item 4. Submission of Matters to a Vote of Security Holders.................................................... 75
Item 6. Exhibits .............................................................................................. 76
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
June 30, December 31,
2007 2006
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
June 30, 2007 - $23,414.4; December 31, 2006 - $22,946.9)............................ $22,824.6 $22,802.9
Equity securities at fair value (cost: June 30, 2007 - $38.9;
December 31, 2006 - $23.9)........................................................... 40.2 24.8
Mortgage loans......................................................................... 1,736.6 1,642.2
Policy loans........................................................................... 410.3 412.5
Trading securities..................................................................... 800.6 675.2
Other invested assets ................................................................. 203.5 178.8
--------- ---------
Total investments.................................................................. 26,015.8 25,736.4
Cash and cash equivalents:
Unrestricted........................................................................... 522.5 385.9
Restricted............................................................................. 29.8 24.0
Accrued investment income................................................................. 353.7 344.5
Value of policies inforce at the Effective Date........................................... 1,998.7 2,137.2
Cost of policies produced................................................................. 1,296.7 1,106.7
Reinsurance receivables................................................................... 855.7 850.8
Income tax assets, net.................................................................... 1,966.6 1,786.9
Assets held in separate accounts.......................................................... 28.6 28.9
Other assets.............................................................................. 369.8 316.0
--------- ---------
Total assets....................................................................... $33,437.9 $32,717.3
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
June 30, December 31,
2007 2006
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $13,060.1 $13,018.0
Traditional products................................................................... 12,352.9 12,094.1
Claims payable and other policyholder funds............................................ 847.4 832.3
Liabilities related to separate accounts............................................... 28.6 28.9
Other liabilities........................................................................ 706.9 611.8
Investment borrowings.................................................................... 868.9 418.3
Notes payable - direct corporate obligations............................................. 1,197.8 1,000.8
--------- ---------
Total liabilities.................................................................. 29,062.6 28,004.2
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Preferred stock.......................................................................... - 667.8
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: June 30, 2007 - 188,699,343; December 31, 2006 - 152,165,108)......... 1.9 1.5
Additional paid-in capital............................................................... 4,126.4 3,473.2
Accumulated other comprehensive loss..................................................... (329.9) (72.6)
Retained earnings........................................................................ 576.9 643.2
--------- ---------
Total shareholders' equity......................................................... 4,375.3 4,713.1
--------- ---------
Total liabilities and shareholders' equity......................................... $33,437.9 $32,717.3
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Revenues:
Insurance policy income................................. $ 767.8 $ 739.7 $1,530.6 $1,494.4
Net investment income:
General account assets................................ 382.2 357.3 760.1 708.6
Policyholder and reinsurer accounts and other
special-purpose portfolios.......................... 42.3 (13.7) 47.2 .4
Net realized investment losses.......................... (28.3) (3.7) (63.2) (6.8)
Fee revenue and other income............................ 5.2 4.5 9.0 9.2
-------- -------- -------- --------
Total revenues...................................... 1,169.2 1,084.1 2,283.7 2,205.8
-------- -------- -------- --------
Benefits and expenses:
Insurance policy benefits............................... 930.9 705.2 1,732.2 1,432.0
Interest expense........................................ 27.9 17.1 51.5 33.5
Amortization............................................ 116.3 97.6 232.5 216.2
Costs related to the proposed litigation settlement..... 35.0 157.0 48.0 174.7
Other operating costs and expenses...................... 151.8 142.1 296.0 283.2
-------- -------- -------- --------
Total benefits and expenses......................... 1,261.9 1,119.0 2,360.2 2,139.6
-------- -------- -------- --------
Income (loss) before income taxes................... (92.7) (34.9) (76.5) 66.2
Income tax expense (benefit) on period income.............. (32.8) (12.6) (27.0) 23.9
-------- -------- -------- --------
Net income (loss)................................... (59.9) (22.3) (49.5) 42.3
Preferred stock dividends.................................. 4.6 9.5 14.1 19.0
-------- -------- -------- --------
Net income (loss) applicable to common stock........ $ (64.5) $ (31.8) $ (63.6) $ 23.3
======== ======== ======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding................... 169,139,000 151,514,000 160,038,000 151,518,000
=========== =========== =========== ===========
Net income (loss)..................................... $(.38) $(.21) $(.40) $.15
===== ===== ===== ====
Diluted:
Weighted average shares outstanding................... 169,139,000 151,514,000 160,038,000 152,556,000
=========== =========== =========== ===========
Net income (loss)..................................... $(.38) $(.21) $(.40) $.15
===== ===== ===== ====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income (loss) earnings
----- --------- --------------- ----------------- --------
Balance, January 1, 2007............................. $4,713.1 $667.8 $3,474.7 $ (72.6) $643.2
Comprehensive loss, net of tax:
Net loss........................................ (49.5) - - - (49.5)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $143.9)............................ (257.8) - - (257.8) -
--------
Total comprehensive loss.................... (307.3)
Cost of shares acquired........................... (29.6) - (29.6) - -
Stock option and restricted stock plans........... 9.4 - 9.4 - -
Change in unrecognized net loss related to
deferred compensation plan (net of applicable
income tax expense of $.2 million).............. .5 - - .5 -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date in conjunction with adoption of FIN 48..... 6.0 - 6.0 - -
Cumulative effect of accounting change............ (2.7) - - - (2.7)
Conversion of preferred stock into common shares.. - (667.8) 667.8 - -
Dividends on preferred stock...................... (14.1) - - - (14.1)
-------- ------ -------- ------- ------
Balance, June 30, 2007............................... $4,375.3 $ - $4,128.3 $(329.9) $576.9
======== ====== ======== ======= ======
Balance, January 1, 2006............................. $4,519.8 $667.8 $3,195.6 $ 71.7 $584.7
Comprehensive loss, net of tax:
Net income...................................... 42.3 - - - 42.3
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $289.7)............................ (517.3) - - (517.3) -
--------
Total comprehensive loss.................... (475.0)
Reduction of deferred income tax valuation
allowance....................................... 260.0 - 260.0 - -
Stock option and restricted stock plans........... 8.7 - 8.7 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date............................................ 2.1 - 2.1 - -
Dividends on preferred stock...................... (19.0) - - - (19.0)
-------- ------ -------- ------- ------
Balance, June 30, 2006............................... $4,296.6 $667.8 $3,466.4 $(445.6) $608.0
======== ====== ======== ======= ======
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Six months ended
June 30,
----------------------
2007 2006
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 1,355.9 $ 1,316.3
Net investment income................................................................. 796.4 754.2
Fee revenue and other income.......................................................... 9.0 9.2
Net sales (purchases) of trading securities........................................... (138.0) 23.0
Insurance policy benefits............................................................. (1,120.6) (1,095.1)
Interest expense...................................................................... (51.3) (31.4)
Policy acquisition costs.............................................................. (244.4) (230.6)
Other operating costs................................................................. (278.3) (276.2)
Taxes................................................................................. (1.6) 1.8
--------- ---------
Net cash provided by operating activities........................................... 327.1 471.2
--------- ---------
Cash flows from investing activities:
Sales of investments.................................................................. 3,810.3 3,118.9
Maturities and redemptions of investments............................................. 585.6 336.5
Purchases of investments.............................................................. (5,072.0) (3,837.3)
Change in restricted cash............................................................. (5.8) (4.0)
Other................................................................................. 6.4 6.0
--------- ---------
Net cash used by investing activities .............................................. (675.5) (379.9)
--------- ---------
Cash flows from financing activities:
Issuance of notes payable............................................................. 200.0 -
Issuance of common stock.............................................................. 3.4 .9
Payments to repurchase common stock................................................... (29.6) -
Payments on notes payable............................................................. (3.4) (46.3)
Amounts received for deposit products................................................. 969.2 930.0
Withdrawals from deposit products..................................................... (1,086.2) (1,023.8)
Investment borrowings................................................................. 450.6 35.3
Dividends paid on preferred stock..................................................... (19.0) (19.0)
--------- ---------
Net cash provided (used) by financing activities.................................. 485.0 (122.9)
--------- ---------
Net increase (decrease) in cash and cash equivalents.............................. 136.6 (31.6)
Cash and cash equivalents, beginning of period........................................... 385.9 237.8
--------- ---------
Cash and cash equivalents, end of period................................................. $ 522.5 $ 206.2
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2006 Form 10-K of Conseco,
Inc.
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"),
in connection with our bankruptcy reorganization which became effective on
September 10, 2003 (the "Effective Date"). The terms "Conseco", the "Company",
"we", "us", and "our" as used in this report refer to CNO and its subsidiaries
or, when the context requires otherwise, Old Conseco and its subsidiaries. We
focus on serving the senior and middle-income markets, which we believe are
attractive, high growth markets. We sell our products through three distribution
channels: career agents, professional independent producers (some of whom sell
one or more of our product lines exclusively) and direct marketing.
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary for a fair statement of our financial position
and results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission (the "SEC") applicable to quarterly reports
on Form 10-Q, we have condensed or omitted certain information and disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles ("GAAP"). We have reclassified certain amounts
from the prior periods to conform to the 2007 presentation. These
reclassifications have no effect on net income or shareholders' equity. Results
for interim periods are not necessarily indicative of the results that may be
expected for a full year.
The balance sheet at December 31, 2006, presented herein, has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by GAAP in the United States for complete
financial statements.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect reported
amounts of various assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions to calculate values for the cost of policies produced, the value
of policies inforce at the Effective Date, certain investments, assets and
liabilities related to income taxes, liabilities for insurance products,
liabilities related to litigation, guaranty fund assessment accruals and amounts
recoverable from loans to certain former directors and former employees. If our
future experience differs from these estimates and assumptions, our financial
statements would be materially affected.
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into one of three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); and (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
Our trading securities are designed to act as hedges for embedded
derivatives related to our equity-indexed annuity products and certain modified
coinsurance agreements. See the notes entitled "Accounting for Derivatives" and
"Investment Borrowings and Interest Rate Swaps" 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 and other
special-purpose portfolios (a component of investment income), is substantially
offset by the change in insurance
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
policy benefits for these products. Our trading securities totaled $800.6
million and $675.2 million at June 30, 2007 and December 31, 2006, respectively.
Accumulated other comprehensive loss is primarily comprised of the net
effect of unrealized appreciation (depreciation) on our investments. These
amounts, included in shareholders' equity as of June 30, 2007 and December 31,
2006, were as follows (dollars in millions):
June 30, December 31,
2007 2006
---- ----
Net unrealized depreciation on investments............................................ $(581.4) $(136.3)
Adjustment to value of policies inforce at the Effective Date......................... 25.2 20.1
Adjustment to cost of policies produced............................................... 50.8 12.3
Adjustment to initially apply SFAS No. 158 related to the unrecognized net loss
related to deferred compensation plan............................................ - (9.9)
Unrecognized net loss related to deferred compensation plan........................... (9.4) -
Deferred income tax asset............................................................. 184.9 41.2
------- -------
Accumulated other comprehensive loss............................................. $(329.9) $ (72.6)
======= =======
EARNINGS PER SHARE
A reconciliation of net income (loss) and shares used to calculate basic
and diluted earnings (loss) per share is as follows (dollars in millions and
shares in thousands):
Three months ended Six months ended
June 30, June 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Net income (loss).............................................. $(59.9) $(22.3) $(49.5) $ 42.3
Preferred stock dividends...................................... (4.6) (9.5) (14.1) (19.0)
------ ------ ------- ------
Net income (loss) applicable to common stock
for basic and diluted earnings per share................ $(64.5) $(31.8) $(63.6) $ 23.3
====== ====== ====== ======
Shares:
Weighted average shares outstanding
for basic earnings per share.............................. 169,139 151,514 160,038 151,518
------- ------- ------- -------
Effect of dilutive securities on weighted average shares:
Stock option and restricted stock plans................... - - - 1,038
------- ------- ------- -------
Dilutive potential common shares.......................... - - - 1,038
------- ------- ------- -------
Weighted average shares outstanding for diluted
earnings per share........................................ 169,139 151,514 160,038 152,556
======= ======= ======= =======
There were no dilutive common stock equivalents during: (i) the three
months ended June 30, 2007 and 2006; and (ii) the six months ended June 30,
2007, because of the net loss recognized by the Company during such periods.
Therefore, all potentially dilutive shares are excluded in the weighted average
shares outstanding for diluted earnings per share, and the preferred stock
dividends on the Class B mandatorily convertible preferred stock are not added
back to net income (loss) applicable to common stock. The potentially dilutive
shares related to the Class B mandatorily convertible preferred stock were not
dilutive during the six months ended June 30, 2006, but the common stock
equivalents related to stock option and restricted stock plans were dilutive.
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and six months ended June 30, 2007 and 2006, because doing so would have
been antidilutive in such periods (shares in thousands).
Three months ended Six months ended
June 30, June 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Equivalent common shares that were antidilutive
during the period:
Class B mandatorily convertible preferred stock...... 19,528 30,989 28,669 30,989
Stock option and restricted stock plans.............. 263 1,047 196 -
------ ------ ------ ------
Antidilutive equivalent common shares............. 19,791 32,036 28,865 30,989
====== ====== ====== ======
In the first quarter of 2007, the Company granted 379,900 performance
shares pursuant to its long-term incentive plan to certain officers of the
Company. The criteria for payment related to 227,940 of such awards (which had a
grant date fair value of $1.5 million) is based upon the cumulative return on
the Company's stock with dividends reinvested ("total shareholder return")
compared to the total shareholder return of a group of Conseco's peers
(represented by the companies comprising the Standard & Poor's Life and Health
Index and the Russell 3000 Health and Life Index) over a three year performance
measurement period ending December 31, 2009. If the Company's results are below
the 50th percentile of the comparison group, no portion of the award is earned.
If the Company's results are equal to or greater than the 75th percentile, then
the maximum award is earned. The criteria for payment of the remaining 151,960
performance shares (which had a grant date fair value of $2.7 million) is based
upon the Company's operating return on equity, as defined in the award
agreement, for the year ended December 31, 2009. If the Company's operating
return on equity is less than 10.0 percent, no portion of the award is earned.
If the Company's operating return on equity is equal to or greater than 12
percent, then the maximum award is earned. Unless antidilutive, the diluted
weighted average shares outstanding would reflect the number of performance
shares expected to be issued, using the treasury stock method.
In August 2005, we completed the private offering of $330.0 million of
3.50% Convertible Debentures due September 30, 2035 (the "Debentures"). In
future periods, our diluted shares outstanding may include incremental shares
issuable upon conversion of all or part of such Debentures. Since the $330.0
million principal amount can only be redeemed for cash, it has no impact on the
diluted earnings per share calculation. In accordance with the conversion
feature of these Debentures, we may be required to pay a stock premium along
with redeeming the accreted principal amount for cash, if our common stock
reaches a certain market price. In accordance with the consensus from EITF No.
04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings
per Share", we will include the dilutive effect of our Debentures in the
calculation of diluted earnings per share when the impact is dilutive. During
the three and six months ended June 30, 2007 and 2006, the conversion feature of
these Debentures did not have a dilutive effect because the weighted average
market price of our common stock did not exceed the initial conversion price of
$26.66. Therefore, the Debentures had no effect on our diluted shares
outstanding or our diluted earnings per share for the three or six months ended
June 30, 2007 and 2006.
Basic earnings per common share is computed by dividing net income
applicable to common stock by the weighted average number of common shares
outstanding for the period. Restricted shares are not included in basic earnings
per share until vested. Diluted earnings per share reflect the potential
dilution that could occur if outstanding stock options were exercised and
restricted stock was vested. The dilution from options and restricted shares is
calculated using the treasury stock method. Under this method, we assume the
proceeds from the exercise of the options (or the unrecognized compensation
expense with respect to restricted stock) will be used to purchase shares of our
common stock at the average market price during the period, reducing the
dilutive effect of the exercise of the options (or the vesting of the restricted
stock).
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
Operating information by segment was as follows (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities......................................... $ 15.6 $ 17.5 $ 32.3 $ 30.0
Supplemental health............................... 340.5 309.4 667.7 617.0
Life.............................................. 44.8 39.5 86.0 75.6
Other............................................. 23.1 18.2 50.0 45.0
Net investment income (a).............................. 155.1 122.4 296.0 245.9
Fee revenue and other income (a)....................... 2.7 2.0 3.9 3.4
Net realized investment losses (a)..................... (1.9) (1.9) (7.1) (3.4)
-------- -------- -------- --------
Total Bankers Life revenues................... 579.9 507.1 1,128.8 1,013.5
-------- -------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities......................................... 3.9 5.0 6.8 8.5
Supplemental health............................... 148.1 153.2 298.5 311.2
Life.............................................. 81.9 86.0 168.2 178.1
Other............................................. 2.4 3.2 4.8 6.0
Net investment income (a).............................. 202.5 161.3 377.9 343.3
Fee revenue and other income (a)....................... .1 (.1) .3 .3
Net realized investment losses (a)..................... (25.4) (4.0) (54.7) (9.1)
-------- -------- -------- --------
Total Conseco Insurance Group revenues........ 413.5 404.6 801.8 838.3
-------- -------- -------- --------
Colonial Penn:
Insurance policy income:
Supplemental health............................... 2.5 2.9 5.0 5.8
Life.............................................. 26.7 22.4 53.2 45.6
Other............................................. .2 .3 .5 .6
Net investment income (a).............................. 9.4 9.1 18.9 18.8
Fee revenue and other income (a)....................... .1 .2 .3 .3
Net realized investment gains (a)...................... .3 1.2 .1 1.7
-------- -------- -------- --------
Total Colonial Penn revenues.................. 39.2 36.1 78.0 72.8
-------- -------- -------- --------
Other Business in Run-off:
Insurance policy income - supplemental health.......... 78.1 82.1 157.6 171.0
Net investment income (a).............................. 47.6 44.6 94.6 89.3
Fee revenue and other income (a)....................... .1 .1 .2 .2
Net realized investment gains (losses) (a)............. (.1) 1.0 (.3) 4.0
-------- -------- -------- --------
Total Other Business in Run-off revenues...... 125.7 127.8 252.1 264.5
-------- -------- -------- --------
Corporate:
Net investment income.................................. 9.9 6.2 19.9 11.7
Fee and other income................................... 2.2 2.3 4.3 5.0
Net realized investment losses(a)...................... (1.2) - (1.2) -
-------- -------- -------- --------
Total corporate revenues...................... 10.9 8.5 23.0 16.7
-------- -------- -------- --------
Total revenues................................ 1,169.2 1,084.1 2,283.7 2,205.8
-------- -------- -------- --------
(continued on next page)
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits.............................. $ 399.7 $ 348.8 $ 792.7 $ 705.8
Amortization........................................... 70.4 56.3 151.1 113.2
Interest expense on investment borrowings.............. - .1 - .1
Other operating costs and expenses..................... 45.3 39.6 82.2 75.9
-------- -------- -------- --------
Total Bankers Life expenses....................... 515.4 444.8 1,026.0 895.0
-------- -------- -------- --------
Conseco Insurance Group:
Insurance policy benefits.............................. 275.4 238.5 527.8 500.9
Amortization........................................... 35.2 33.7 60.2 87.7
Interest expense on investment borrowings.............. 4.2 .3 5.3 .5
Costs related to the proposed litigation settlement.... 17.5 157.0 24.0 165.8
Other operating costs and expenses..................... 68.5 68.4 136.4 138.4
-------- -------- -------- --------
Total Conseco Insurance Group expenses............ 400.8 497.9 753.7 893.3
-------- -------- -------- --------
Colonial Penn:
Insurance policy benefits.............................. 24.2 21.0 50.1 44.1
Amortization........................................... 4.9 4.1 9.7 8.3
Other operating costs and expenses..................... 3.1 3.3 6.8 7.1
-------- -------- -------- --------
Total Colonial Penn expenses...................... 32.2 28.4 66.6 59.5
-------- -------- -------- --------
Other Business in Run-off:
Insurance policy benefits.............................. 231.6 96.9 361.6 181.2
Amortization........................................... 5.8 3.5 11.5 7.0
Other operating costs and expenses..................... 21.6 22.0 43.4 43.9
-------- -------- -------- --------
Total Other Business in Run-off expenses.......... 259.0 122.4 416.5 232.1
-------- -------- -------- --------
Corporate:
Interest expense on corporate debt..................... 16.9 12.0 33.0 24.4
Interest expense on variable interest entity........... 6.8 4.7 13.2 8.5
Costs related to the proposed litigation settlement.... 17.5 - 24.0 8.9
Other operating costs and expenses..................... 13.3 8.8 27.2 17.9
-------- -------- -------- --------
Total corporate expenses.......................... 54.5 25.5 97.4 59.7
-------- -------- -------- --------
Total expenses.................................... 1,261.9 1,119.0 2,360.2 2,139.6
-------- -------- -------- --------
Income (loss) before income taxes:
Bankers Life...................................... 64.5 62.3 102.8 118.5
Conseco Insurance Group........................... 12.7 (93.3) 48.1 (55.0)
Colonial Penn..................................... 7.0 7.7 11.4 13.3
Other Business in Run-off......................... (133.3) 5.4 (164.4) 32.4
Corporate operations.............................. (43.6) (17.0) (74.4) (43.0)
-------- -------- -------- --------
Income (loss) before income taxes............. $ (92.7) $ (34.9) $ (76.5) $ 66.2
======== ======== ======== ========
<FN>
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return that is based on a percentage (the
"participation rate") of a particular index, such as the Standard & Poor's 500
Index, over a specified period. Typically, 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
and other special-purpose portfolios). Net investment income (loss) related to
equity-indexed products was $24.9 million and $(4.7) million in the six months
ended June 30, 2007 and 2006, respectively. These amounts were substantially
offset by the corresponding charge to insurance policy benefits. The estimated
fair value of these options was $113.2 million and $93.7 million at June 30,
2007 and December 31, 2006, 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 $324.5 million and $275.3
million at June 30, 2007 and December 31, 2006, 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 and other
special-purpose portfolios). The change in value of these trading securities
should largely offset the portion of the change in the value of the embedded
derivative that is caused by interest rate fluctuations.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At June 30, 2007, 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 $(.1) million and $9.6 million at June 30, 2007 and
December 31, 2006, 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 and other special-purpose portfolios).
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 and other special-purpose
portfolios). The change in value of these trading securities should largely
offset the change in value of the embedded derivatives.
REINSURANCE
The cost of reinsurance ceded totaled $108.7 million and $114.9 million in
the first six months of 2007 and 2006, respectively. We deduct this cost from
insurance policy income. In each case, the ceding Conseco subsidiary is directly
liable for claims reinsured even if the assuming company is unable to pay.
Reinsurance recoveries netted against insurance policy benefits totaled $116.7
million and $119.7 million in the first six months of 2007 and 2006,
respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced. Reinsurance premiums
assumed totaled $110.8 million and $68.4 million in the first six months of 2007
and 2006, respectively.
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
See the note entitled "Accounting for Derivatives" for a discussion of the
derivative embedded in the payable related to certain modified coinsurance
agreements.
PENDING COINSURANCE TRANSACTION
On May 8, 2007, we announced that three of our insurance subsidiaries will
coinsure most of their older inforce equity-indexed annuity and fixed annuity
business with Reassure America Life Insurance Company ("REALIC"), a subsidiary
of Swiss Re Life & Health America Inc. In the transaction, REALIC will: (i) pay
a ceding commission of approximately $76.5 million; (ii) assume the investment
and persistency risk and administration of these policies; and (iii) recognize
policy profits as they emerge over time. Our insurance subsidiaries will
transfer to REALIC approximately $3 billion of policy and other reserves, as
well as the invested assets backing these policies. Our insurance subsidiaries
remain primarily liable to the policyholders in the event REALIC does not
fulfill its obligations under the agreements. The transaction is subject to
insurance regulatory approval in several states and is expected to close before
the end of 2007.
As a result of the transaction, we no longer plan to hold investments with
an aggregate amortized cost of $2,180.1 million and an estimated fair value of
$2,127.2 million at June 30, 2007, until maturity or until the market value of
each investment recovers to its cost basis. Accordingly, we recognized: (i) net
after-tax realized losses of $8.7 million (net of related amortization expense
of $10.8 million and taxes of $4.7 million) in the first quarter of 2007; and
(ii) net after-tax realized losses of $10.4 million (net of related amortization
expense of $12.8 million and taxes of $5.6 million) in the second quarter of
2007.
Upon closing the transaction, Conseco expects to record additional charges
(resulting principally from the extinguishment of the insurance intangibles
associated with this business) totaling approximately $63 million plus the after
tax earnings on this block of business from July 1, 2007 through the close of
the transaction.
INCOME TAXES
The components of income tax expense (benefit) were as follows (dollars in
millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Current tax expense............................................ $ 1.2 $ - $ 1.7 $ -
Deferred tax provision (benefit)............................... (34.0) (12.6) (28.7) 23.9
------ ------ ------ -----
Income tax expense (benefit) on period income......... $(32.8) $(12.6) $(27.0) $23.9
====== ====== ====== =====
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Six months ended
June 30,
-----------------------
2007 2006
---- ----
U.S. statutory corporate rate............................................................ (35.0)% 35.0%
Other nondeductible expense (benefit).................................................... (1.0) 2.3
State taxes.............................................................................. (.6) 2.4
Provision for tax issues, tax credits and other.......................................... 1.3 (3.6)
----- ----
Effective tax rate.............................................................. (35.3)% 36.1%
===== ====
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
June 30, December 31,
2007 2006
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries.................................................... $ 801.5 $ 800.3
Non-life companies............................................................. 841.0 780.0
Tax credits....................................................................... 14.2 14.2
Capital loss carryforwards........................................................ 394.8 391.7
Deductible temporary differences:
Insurance liabilities.......................................................... 1,176.5 1,320.0
Unrealized depreciation of investments......................................... 184.9 41.2
Reserve for loss on loan guarantees............................................ 70.3 145.8
Other.......................................................................... 43.5 -
-------- --------
Gross deferred tax assets.................................................... 3,526.7 3,493.2
-------- --------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. (17.4) (42.2)
Value of policies inforce at the Effective Date and cost of policies produced.. (766.7) (764.8)
Other.......................................................................... - (117.6)
-------- --------
Gross deferred tax liabilities............................................... (784.1) (924.6)
-------- ---------
Net deferred tax assets before valuation allowance........................... 2,742.6 2,568.6
Valuation allowance................................................................... (777.8) (777.8)
--------- --------
Net deferred tax assets...................................................... 1,964.8 1,790.8
Current income taxes prepaid (accrued)................................................ 1.8 (3.9)
-------- --------
Income tax assets, net....................................................... $1,966.6 $1,786.9
======== ========
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
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.
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 June 30, 2007 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
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 $2.7 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.
As of June 30, 2007, we had $4.7 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 9.0 10.6 1.6 9.0
2016....... 17.0 - - 17.0 17.0 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6 (a) .7 - 2,171.3 44.8 2,126.5
2019....... - .7 - .7 .7 -
2021....... 68.5 - - 68.5 - 68.5
2022....... .7 - - .7 - .7
2023....... - 2,066.1 (a) - 2,066.1 57.1 2,009.0
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 29.6 - 29.6 - 29.6
2027....... - 178.3 - 178.3 - 178.3
-------- -------- -------- -------- -------- --------
Total...... $2,290.0 $2,402.9 $1,128.0 $5,820.9 $1,191.1 $4,629.8
======== ======== ======== ======== ======== ========
<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.
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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, approximately $631 million of the NOLs expiring in 2018 would be
characterized as non-life NOLs.
</FN>
The Company adopted FASB Interpretation No. 48 "Accounting for Uncertainty
in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48") on
January 1, 2007, which resulted in a $6 million increase to additional paid-in
capital. As of January 1, 2007 and June 30, 2007, the amount of unrecognized tax
benefits was not significant. While it is expected that the amount of
unrecognized tax benefits will change in the next twelve months, the Company
does not expect the change to have a significant impact on its results of
operations.
As more fully discussed below, the Company's interpretation of the tax law,
as it relates to the application of the cancellation of indebtedness income to
its NOLs, is an uncertain tax position. Since all other life NOLs must be
utilized prior to this portion of the NOL, it has not yet been utilized nor is
it expected to be utilized within the next twelve months. As a result, an
uncertain tax position has not yet been taken on the Company's tax return.
Although FIN 48 allowed a change in accounting, the Company has chosen to
continue its past accounting policy of classifying interest and penalties as
income tax expense in the consolidated statement of operations. No such amounts
were recognized in the first six months of 2007. The liability for accrued
interest and penalties was not significant at June 30, 2007 or December 31,
2006.
Tax years 2004 through 2006 are open to examination by the IRS, and tax
year 2002 remains open only for potential adjustments related to certain
partnership investments. The Company does not anticipate any material
adjustments related to these partnership investments. The Company's various
state income tax returns are generally open for tax years 2003 through 2006
based on the individual state statutes of limitation.
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 approximately $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
approximately $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 adopted Statement of Financial Accounting Standards No. 123R,
"Accounting for Stock-Based Compensation" in calendar year 2006. Pursuant to
this accounting rule, the Company is precluded from recognizing the tax benefits
of any tax windfall upon the exercise of a stock option or the vesting of
restricted stock unless such deduction resulted in actual cash savings to the
Company. Because of the Company's NOLs, no cash savings have occurred. NOL
carryforwards of $1.8 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital if realized.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of June 30, 2007 and December 31, 2006 (dollars in millions):
June 30, December 31,
2007 2006
---- ----
3.50% convertible debentures............................................................ $ 330.0 $ 330.0
Secured credit agreement................................................................ 869.9 673.3
Unamortized discount on convertible debentures.......................................... (2.1) (2.5)
-------- --------
Direct corporate obligations....................................................... $1,197.8 $1,000.8
======== ========
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
On October 10, 2006, we entered into a $675.0 million secured credit
agreement. On June 12, 2007, Conseco amended its current credit facility
(collectively, the "Second Amended Credit Facility"). The amendment of the
credit facility provided for, among other things:
o an increase of $200.0 million in the principal amount of the facility;
o an increase in the general basket for restricted payments to $200
million for the fiscal year commencing June 12, 2007 and $300 million
thereafter (in each case less any amount thereof paid in any prior
fiscal year but following June 12, 2007); and
o the Company to be able to request the addition of up to two new
facilities or up to two increases in the credit facility of up to $330
million (but with the commitment increases made between June 12, 2007
and June 12, 2008 limited to $130 million), subject to compliance with
certain financial covenants and other conditions. Such increases would
be effective as of a date that is at least 90 days prior to the
scheduled maturity date.
No changes were made to the interest rate or the maturity schedule of the
amounts borrowed under the credit facility. We are required to make minimum
quarterly principal payments of $2.2 million through September 30, 2013. The
remaining unpaid principal balance is due on October 10, 2013. There were no
changes to the various financial ratios and balances that are required to be
maintained by the Company. We intend to use the additional borrowings for
general corporate purposes, including the repurchase of Conseco common stock and
the strengthening of the Company's insurance subsidiaries.
During the first six months of 2007, we made scheduled principal payments
totaling $3.4 million on our Second Amended Credit Facility. There were $7.3
million and $6.2 million of unamortized issuance costs (classified as other
assets) related to our Second Amended Credit Facility at June 30, 2007 and
December 31, 2006, respectively.
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. The base rate
is equal to 1 percent plus the greater of: (i) the Federal funds rate plus .50
percent; or (ii) Bank of America's prime rate. Under the terms of the Second
Amended Credit Facility, if the Company's senior secured long-term debt is rated
at least "Ba2" 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. At June 30, 2007, the interest
rate on our Second Amended Credit Facility was 7.3 percent.
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
Remainder of 2007............................. $ 4.4
2008.......................................... 8.7
2009.......................................... 8.7
2010.......................................... 338.8
2011.......................................... 8.7
Thereafter.................................... 830.6
--------
$1,199.9
========
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 or 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.
The Second Amended Credit Facility requires the Company to maintain various
financial ratios and balances, as defined in the agreement, including: (i) a
debt to total capitalization ratio of not more than 30 percent at all times
(such ratio
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
was 20 percent at June 30, 2007); (ii) an interest coverage ratio greater than
or equal to 2.00 to 1 for each rolling four quarters (such ratio exceeded the
minimum requirement for the four quarters ending June 30, 2007); (iii) an
aggregate risk-based capital ratio, as defined in the Second Amended Credit
Facility, greater than or equal to 250 percent for each quarter (such ratio
exceeded the minimum risk-based capital requirements at June 30, 2007); and (iv)
a combined statutory capital and surplus level of greater than $1,270.0 million
(combined statutory capital and surplus at June 30, 2007 exceeded such
requirement).
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 June 30, 2007 and 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. 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 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 $300.0 million over the term of the
facility (of which, only $200.0 million may be paid in the fiscal year beginning
June 12, 2007). As further discussed in the note to the consolidated financial
statements entitled "Changes in Common Stock", we repurchased 1.5 million shares
of our common stock for $29.6 million in the first six months of 2007.
INVESTMENT BORROWINGS AND INTEREST RATE SWAPS
In the first quarter of 2007, one of the Company's insurance subsidiaries
(Conseco Life Insurance Company, "Conseco Life") became a member of the Federal
Home Loan Bank of Indianapolis ("FHLBI"). As a member of the FHLBI, Conseco Life
has the ability to borrow on a collateralized basis from FHLBI. Conseco Life
intends to use these advances to earn incremental income and as a source of
liquidity for its operations. Conseco Life is required to hold a certain minimum
amount of FHLBI common stock as a requirement of membership in the FHLBI, and
additional amounts based on the amount of advances. At June 30, 2007, the
carrying value of the FHLBI common stock was $20.0 million. Advances from the
FHLBI (the "Advances") totaled $400.0 million as of June 30, 2007, and the
proceeds were used to purchase primarily investment-grade fixed maturity
securities. The Advances are classified as investment borrowings in the
accompanying consolidated balance sheet. The Advances are collateralized by
investments with an estimated fair value of $471.0 million at June 30, 2007,
which are maintained in a custodial account for the benefit of the FHLBI.
Conseco Life recognized interest expense of $4.8 million in the first six months
of 2007 related to the Advances. The following summarizes the terms of the
Advances (dollars in millions):
Amount Maturity Interest rate
borrowed date at June 30, 2007
-------- ---- ----------------
$100.0 February 2012 Variable rate - 5.345%
100.0 March 2012 Variable rate - 5.350%
54.0 May 2012 Variable rate - 5.360%
146.0 November 2015 Fixed rate - 5.300%
Conseco Life purchased $147.5 million par value of fixed maturity
investments for $147.7 million (which are classified as trading securities) with
a portion of the proceeds from the Advances. Such fixed rate securities, with a
carrying value of $144.6 million at June 30, 2007, are matched with an interest
rate swap, which converts the securities from a fixed rate to a floating rate
basis. The trading securities are carried at estimated fair value with changes
in such value recognized as trading income. The change in the value of the
interest rate swaps is recognized in trading income. In the first six months of
2007, the change in the value of the trading securities was $(3.2) million and
the change in the value of the interest rate swaps was
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
$3.6 million. Pursuant to the interest rate swaps, Conseco Life pays interest,
semi-annually, at a fixed rate and receives interest, quarterly, at a variable
rate from the counterparties on the outstanding notional amounts. At June 30,
2007, the weighted average fixed rate being paid was 6.12 percent and the
weighted average variable rate being received was 6.17 percent.
At June 30, 2007, investment borrowings consisted of: (i) Advances of
$400.0 million; (ii) $452.3 million of securities issued to other entities by a
variable interest entity which is consolidated in our financial statements; and
(iii) other borrowings of $16.6 million.
At December 31, 2006, investment borrowings consisted of: (i) $406.8
million of securities issued to other entities by a variable interest entity
which is consolidated in our financial statements; and (ii) other borrowings of
$11.5 million.
CHANGES IN COMMON STOCK
Changes in the number of shares of common stock outstanding were as follows
(shares in thousands):
Balance at December 31, 2006........................................... 152,165
Treasury stock purchased and retired............................... (1,533)
Conversion of preferred stock into common shares................... 37,809
Stock options exercised............................................ 208
Shares issued under employee benefit compensation plans............ 58 (a)
Other.............................................................. (8)
-------
Balance at June 30, 2007............................................... 188,699
=======
<FN>
- ---------
(a) Such amount was reduced by 10 thousand shares which were tendered for the
payment of federal and state taxes owed on the issuance of restricted
stock.
</FN>
In May 2007, all of our 5.5 percent Class B mandatorily convertible
preferred stock (the "Preferred Stock") was converted into shares of Conseco
common stock in accordance with the terms of issuance. Under those terms, each
of the 27.6 million shares of Preferred Stock outstanding was converted into
1.3699 shares of common stock. As a result of the conversion, our common shares
outstanding increased by 37.8 million.
In December 2006, the Company's board of directors authorized a common
share repurchase program of up to $150 million. In May 2007, the Company's board
of directors increased the authorized common share repurchase program to a
maximum of $350 million. As further discussed in the note to the consolidated
financial statements entitled "Notes Payable - Direct Corporate Obligations," we
currently may pay cash dividends on our common stock or repurchase our common
stock in an aggregate amount of up to $300 million over the term of our credit
facility (of which, only $200 million may be paid in the fiscal year beginning
June 12, 2007). Our share repurchase 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 recognized 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.
During the first six months of 2007, the Company repurchased an additional
..3 million shares of its common stock for $4.9 million.
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 $28.4 million and $27.4 million during the six
months ended June 30, 2007 and 2006, respectively. Amounts amortized totaled
$10.5 million and $8.9 million during the six months ended June 30, 2007 and
2006, respectively. The unamortized balance of deferred sales inducements at
June 30, 2007 and December 31, 2006 was $132.9 million and $115.0 million,
respectively. The balance of insurance liabilities for persistency bonus
benefits was $278.7 million and $296.3 million at June 30, 2007 and December 31,
2006, respectively.
RECENTLY ISSUED ACCOUNTING STANDARDS
Pending Accounting Standards
In September 2006, the Financial Accounting Standards Board ("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 February 2007, the FASB issued Statement of Financial Accounting
Standards No. 159, "The Fair Value Option for Financial Assets and Financial
Liabilities - Including an Amendment of FASB Statement No. 115" ("SFAS 159").
SFAS 159 allows entities to choose to measure many financial instruments and
certain other items at fair value (on an instrument-by-instrument basis) that
are not currently required to be measured at fair value. The objective is to
improve financial reporting by providing entities with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS 159 is effective for us on January 1, 2008. We are currently
evaluating the effect SFAS 159 will have on our results of operations and
financial condition.
Adopted Accounting Standards
In July 2006, the FASB issued 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. The adoption of FIN 48 resulted in a $6.0
million increase to additional paid-in capital during the six months ended June
30, 2007. The Company classifies interest and, if applicable, penalties as
income tax expense in the consolidated statement of operations. No such amounts
were recognized in the first six months of 2007. The liability for accrued
interest was not significant at June 30, 2007 or December 31, 2006.
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
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 initial adoption of SFAS 155 did 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. The initial
adoption of SOP 05-1 did not have a material impact on our results of operations
or financial position. The adoption of SOP 05-1 resulted in the shortening of
the period over which the value of policies inforce at the Effective Date and
the cost of policies produced related to a small block of our group health
insurance business are amortized. Transition to the shorter amortization period
resulted in a January 1, 2007 cumulative effect adjustment to retained earnings
of $2.7 million, net of tax.
In September 2006, the FASB issued SFAS No. 158, "Employers Accounting for
Defined Benefit and Other Retirement Plans - an amendment of FASB Statements No.
87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires employers to recognize
the overfunded or underfunded status of defined benefit pension and other
postretirement benefit plans as an asset or liability in its statement of
financial position, measured as the difference between the fair value of plan
assets and the projected benefit obligation as of the end of our fiscal year
end. In addition, SFAS 158 requires employers to recognize changes in the funded
status of defined benefit pension and other post retirement plans in the year in
which the changes occur through other accumulated comprehensive income. The
Company adopted SFAS 158 effective December 31, 2006.
The impact of the adoption of SFAS 158 on our consolidated balance sheet at
December 31, 2006, was 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)
LITIGATION AND OTHER LEGAL PROCEEDINGS
Legal Proceedings
The Company and its subsidiaries are involved in various legal actions in
the normal course of business, in which claims for compensatory and punitive
damages are asserted, some for substantial amounts. Some of the pending matters
have been filed as purported class actions and some actions have been filed in
certain jurisdictions that permit punitive damage awards that are
disproportionate to the actual damages incurred. Although there can be no
assurances, at the present time the Company does not anticipate that the
ultimate liability from either pending or threatened legal actions, after
consideration of existing loss provisions, will have a material adverse effect
on the financial condition, operating results or cash flows of the Company. The
amounts sought in certain of these actions are often large or indeterminate and
the ultimate outcome of certain actions is difficult to predict. In the event of
an adverse outcome in one or more of these matters, the ultimate liability may
be in excess of the liabilities we have established and could have a material
adverse effect on our business, financial condition,
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 Conseco Finance Corp.'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,
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 sought unspecified compensatory,
punitive and exemplary damages as well as an injunction that would require the
Company to reinstate the prior method of calculating cost of insurance charges
and refund any increased charges that resulted from the change. On April 26,
2005, the Judge in the multi-district action certified a nationwide class on the
claims for breach of contract and injunctive relief. On April 27, 2005, the
Judge issued an order certifying a statewide California class for injunctive and
restitutionary relief pursuant to California Business and Professions Code
Section 17200 and breach of the duty of good faith and fair dealing, but denied
certification on the claims for fraud and intentional misrepresentation and
fraudulent concealment. The
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Company announced on August 1, 2006, that it had reached a proposed settlement
of this case. Under the proposed settlement, inforce policyholders were given 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. The settlement was
subject to court review and approval, a fairness hearing, notice to all class
members, election of options by the class members, implementation of the
settlement and other conditions. On February 12, 2007 the court granted
preliminary approval of the settlement. At the May 21, 2007 fairness hearing,
the court granted final approval of the settlement and issued an order doing so
on June 8, 2007. The Court entered final judgment in the case on July 5, 2007.
We expect to implement the settlement with the inforce and certain former
policyholders in the third quarter of 2007.
As a result of the settlement, we recorded $157.0 million of costs (before
income taxes) related to the proposed settlement in the second quarter of 2006.
In the first six months of 2007, we refined our estimates related to certain
provisions of the proposed settlement and recognized additional expenses of
$48.0 million ($35.0 million of which was recognized in the second quarter of
2007). 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 proposed settlement at
June 30, 2007, 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 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 proposed settlement, these shares were
valued based on the June 30, 2007 closing price of a share of our common stock.
The implementation of the proposed settlement includes enhanced benefits to the
inforce insurance policies, which eliminates the future estimated profits from
these policies in periods subsequent to the proposed 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
1-100, Case No. CV05-00594 (United States District Court, District of Hawaii).
This suit involves approximately 800 plaintiffs all of whom purport to have
opted out of the In Re Conseco Life Insurance Co. Cost of Insurance Litigation
multi-
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. On November 12, 2004, a lawsuit was filed in Texas
captioned Charles R. Gnuse v. Conseco Life Insurance Co., Cause No. 04-11520
(District Court of Dallas County, Texas, 44th Judicial District) which has been
removed to the United Stated District Court for the Northern District of Texas,
transferred to California and consolidated and coordinated with MDL 1610.
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
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
count for breach of fiduciary duty. In April 2007, a settlement was reached with
seven of the ten plaintiffs. A settlement was reached with the remaining three
plaintiffs after the trial had commenced on May 16, 2007 and the case has been
dismissed. The amount recognized as expense in 2007 related to the settlement of
this case was not significant to our business, financial condition, results of
operations or cash flows.
On September 18, 2006, a purported class action was filed in the Superior
Court of the State of California for the County of Los Angeles, Holly Walker,
individually, and on behalf of all others similarly situated, and on behalf of
the general public v. Bankers Life & Casualty Company, an insurance company
domiciled in the State of Illinois, and Does 1 to 100, Case No. BC358690. In her
complaint, plaintiff alleged Bankers Life and Casualty Company intentionally
misclassified its California insurance agents as independent contractors when
they should have been classified as employees. Plaintiff sought relief on behalf
of the class alleging claims for preliminary and permanent injunction,
misclassification, indemnification, conversion and unfair business practices.
Bankers Life and Casualty Company caused the case to be removed to the U.S.
District Court, Central District of California on October 18, 2006. An order was
entered on November 20, 2006 transferring the case to the U.S. District Court,
Northern District of Illinois, Case No. 06C6906. The Court has dismissed with
prejudice plaintiff's allegations of preliminary and permanent injunction and
misclassification. A first amended complaint was filed on June 12, 2007 adding
Carole Paradise as the new class representative and naming Holly Walker as an
individual plaintiff. This complaint alleges claims of indemnification,
conversion and unfair business practices. On July 18, 2007, the plaintiffs filed
their motion for class certification. Our response to same is due August 17,
2007. 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.
Other Litigation
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
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 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 Marketing & Sales
Practices Litig. A motion to dismiss the amended complaint was granted in part
and denied in part, and the plaintiffs filed a second amended complaint on April
27, 2007. The second amended complaint includes the same causes of action as the
prior complaint, but added as defendants Conseco, Inc., Conseco Services, LLC,
Conseco Marketing, LLC and 40|86 Advisors, Inc. while deleting Friou Jones as a
named plaintiff. We filed a motion to dismiss the second amended complaint and
the plaintiffs have responded. The motion was heard on August 3, 2007. 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.
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 No. 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 have appealed
the certification order and on April 23, 2007, the 5th Circuit Court of Appeals
accepted jurisdiction over our appeal. Our initial appellate brief was filed on
July 16, 2007. 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.
Beneficial Standard Life Insurance Company, a predecessor company to
Conseco Insurance Company, filed suit for declaratory judgment against J.C.
Penney Life Insurance Company a/k/a Stonebridge Life Insurance Company
("Stonebridge") in a case captioned, Beneficial Standard Life Insurance Company
v. J.C. Penney Life Insurance Company and J.C. Penney Company, Inc., United
States District Court for the Central District of California, Case No.
CV-98-02792-SVW. This litigation arises from the 1967 sale of Beneficial Fire &
Casualty ("BF&C") by Beneficial Standard Life Insurance Company to J.C. Penney
Company, Inc. The subject of the case is whether Conseco Insurance Company must
indemnify Stonebridge for losses and expenses incurred as a result of claims
arising under presale BF&C insurance policies. Conseco Insurance Company filed
suit in April 1998 seeking a judicial declaration that: (1) it is not generally
obligated to indemnify Stonebridge under the terms of the agreement governing
the 1967 sale; and (2) that it is not obligated to indemnify Stonebridge for
losses or expenses incurred in connection with specific known claims. Penney
counterclaimed for breach of contract and declaratory relief. The counterclaim
did not specify the damages sought by Penney on the breach of contract claims.
After a bench trial in 2002, certain rulings of the trial court were appealed to
the United States Court of Appeals for the Ninth Circuit. In June 2005, the
Ninth Circuit issued an opinion upholding a trial-court determination that the
terms of the 1967 sale generally require Conseco Insurance Company to indemnify
Stonebridge for net losses arising from pre-sale BF&C policies, but only after
Stonebridge pursues and exhausts available reinsurance. The Ninth Circuit
remanded the case to the trial court for further proceedings. The trial court
had previously found against Stonebridge on its breach of contract claims,
ruling that Stonebridge could not assert such claims until it pursued and
exhausted available reinsurance. Stonebridge did not appeal that specific
ruling. The remaining issue before the trial court is whether Conseco Insurance
Company's indemnification obligation with respect to certain environmental
claims asserted by the Port of Oakland is excused by Stonebridge's conduct in
handling the claims. On July 25, 2006, a second action was filed in the Circuit
Court of Hamilton County, Indiana, captioned Conseco Insurance Company v.
Stonebridge Life Insurance Company and J.C. Penney Life Insurance Company.
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 court has not yet ruled on this motion. 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.
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other arbitrations and lawsuits, including purported class actions,
related to their operations. The ultimate outcome of all of these other legal
matters pending against the Company or its subsidiaries cannot be predicted,
and, although such lawsuits are not expected individually to have a material
adverse effect on the Company, such lawsuits could have, in the aggregate, a
material adverse effect on the Company's consolidated financial condition, cash
flows or results of operations.
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,
in the Hamilton County case, the Company obtained a partial summary judgment
against Mr. Massey in the sum of $4.4 million plus interest at 11.5 percent from
June 30, 2002. The trial court stayed execution of the judgment pending appeal.
Trial of the remaining counts is currently set for October 22, 2007. The Murray
U.S. District Court case is currently set for trial on April 28, 2008.
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 June 30, 2007, 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 June 30, 2007, we estimated that
approximately $18.7 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 $10.1 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
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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
$1.0 million.
Conseco received a letter from the Congressional Committee on Energy and
Commerce (the "Committee") dated May 23, 2007 indicating the Committee is
conducting an investigation of companies that underwrite, market, and sell
long-term nursing home and home health care insurance policies. In that letter,
the Committee requested various documents from Conseco with regard to long-term
care insurance. Representatives from Conseco subsequently met with the Committee
staffers and reached an agreement on the scope of the documents requested.
Conseco responded to all agreed upon document requests by June 27, 2007. Conseco
intends to continue to fully cooperate with regard to this investigation.
The states of Pennsylvania, Illinois, Texas, Florida and Indiana are
leading a multistate examination of the long-term care claims administration and
complaint handling practices of Conseco Senior Health Insurance Company and
Bankers Life and Casualty Company, as well as the sales and marketing practices
of Bankers Life and Casualty Company. This examination commenced in July 2007.
More than 30 other states have joined or expressed an interest in joining the
multistate examination. This examination will cover the years 2005, 2006, and
the first quarter of 2007.
Certain state insurance regulators have previously 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 proposed litigation settlement
described in the section of this note entitled "Cost of Insurance Litigation".
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Six months ended
June 30,
----------------------
2007 2006
---- ----
Cash flows from operating activities:
Net income (loss).................................................................... $ (49.5) $ 42.3
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization and depreciation.................................................... 247.3 224.1
Income taxes..................................................................... (28.6) 25.7
Insurance liabilities............................................................ 436.9 158.8
Accrual and amortization of investment income.................................... (10.9) 45.2
Deferral of policy acquisition costs............................................. (244.4) (230.6)
Net realized investment losses................................................... 63.2 6.8
Net sales (purchases) of trading securities...................................... (138.0) 23.0
Other............................................................................ 51.1 175.9
------- -------
Net cash provided by operating activities...................................... $ 327.1 $ 471.2
======= =======
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............................................ $ 6.0 $7.8
Conversion of preferred stock into common shares................................... 667.8 -
Reduction of tax liabilities related to various contingencies recognized
at the fresh-start date.......................................................... 6.0 2.1
At June 30, 2007 and December 31, 2006, restricted cash and cash
equivalents consisted of: (i) $24.8 million and $15.7 million, respectively,
held by a variable interest entity; (ii) $1.9 million and $.1 million,
respectively, of segregated cash held for the benefit of the former holders of
TOPrS; and (iii) $3.1 million and $8.2 million, respectively, held in an escrow
account pursuant to a litigation settlement.
29
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at June 30, 2007, and the consolidated results of operations for the three and
six months ended June 30, 2007 and 2006, and, where appropriate, factors that
may affect future financial performance. Please read this discussion in
conjunction with the accompanying consolidated financial statements and notes.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Our statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the SEC, press
releases, presentations by Conseco or its management or oral statements)
relative to markets for Conseco's products and trends in Conseco's operations or
financial results, as well as other statements, contain forward-looking
statements within the meaning of the federal securities laws and the Private
Securities Litigation Reform Act of 1995. Forward-looking statements typically
are identified by the use of terms such as "anticipate," "believe," "plan,"
"estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" section of our 2006 Annual
Report on Form 10-K provides examples of risks, uncertainties and events that
could cause our actual results to differ materially from the expectations
expressed in our forward-looking statements. Assumptions and other important
factors that could cause our actual results to differ materially from those
anticipated in our forward-looking statements include, among other things:
o our ability to 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 remediate the material weakness in internal controls
over the actuarial reporting process that we identified at year-end
2006 and to maintain effective controls over financial reporting;
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;
30
CONSECO, INC. AND SUBSIDIARIES
-------------------
o regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, such as the
payment of dividends to us, regulation of financial services affecting
(among other things) bank sales and underwriting of insurance
products, regulation of the sale, underwriting and pricing of
products, and health care regulation affecting health insurance
products;
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 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, Medicare
Advantage products and certain annuity products to the senior market
through exclusive career agents and sales managers. Bankers Life and
Casualty markets its products under its own brand name and Medicare
Part D and Medicare Advantage products primarily through marketing
agreements 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
independent marketing organizations that represent independent agents.
This segment markets its products under the "Conseco" and "Washington
National" (a wholly-owned insurance subsidiary of Conseco) brand
names.
o 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
31
CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
CRITICAL ACCOUNTING POLICIES
We have updated our critical accounting policy related to our accounting
for marketing and quota-share agreements with Coventry as we entered into a
national distribution agreement under which our career agents began distributing
Coventry's Private-Fee-For-Service plan, Advantra Freedom ("PFFS"), beginning
January 1, 2007.
Refer to "Critical Accounting Policies" in Conseco's 2006 Annual Report on
Form 10-K for information on our other accounting policies that we consider
critical in preparing our consolidated financial statements.
Accounting for marketing and quota-share agreements with Coventry
The Medicare Prescription Drug, Improvement and Modernization Act of 2003
(the "Modernization Act") provided for the introduction of a prescription drug
benefit ("PDP"). 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.
The following describes how we account for and report our PDP business:
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.
32
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the pre-tax income (loss) of the PDP business
(dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Insurance policy income................................ $20.6 $15.6 $45.0 $39.8
Fee revenue and other.................................. 1.1 1.7 1.5 2.9
----- ----- ----- -----
Total revenues....................................... 21.7 17.3 46.5 42.7
----- ----- ----- -----
Insurance policy benefits.............................. 17.0 12.1 40.5 36.3
Commission expense..................................... 2.4 1.5 3.8 2.8
Other operating expenses............................... .2 2.1 .3 4.0
----- ----- ----- -----
Total expense........................................ 19.6 15.7 44.6 43.1
----- ----- ----- -----
Pre-tax income (loss)................................ $ 2.1 $ 1.6 $ 1.9 $ (.4)
===== ===== ===== =====
Conseco expanded its strategic alliance with Coventry by entering into a
national distribution agreement under which our career agents began distributing
Coventry's PFFS plan, 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 PFFS 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 53 percent of the net premiums and
related profits.
We receive distribution fees from Coventry and we pay sales commissions to
our agents for these enrollments. In addition, we participate at a 53 percent
level in the income (loss) related to this business pursuant to a quota-share
agreement with Coventry.
The following summarizes our accounting and reporting practices for the
PFFS business.
Our accounting for the distribution agreement
o We receive distribution income from Coventry and other parties based
on a fixed fee per PFFS contract. This income is deferred and
recognized over the remaining calendar year term of the initial
enrollment period.
o We also pay commissions to our agents who sell the plans on behalf of
Coventry and other parties. 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 revenue evenly over the period of the underlying PFFS
contracts.
o We recognize policyholder benefits and ceding commission expense as
incurred.
33
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the pre-tax income of the PFFS business in the
three and six months ended June 30, 2007 (dollars in millions):
Three months ended Six months ended
June 30, June 30,
2007 2007
------------------ ----------------
Insurance policy income............................ $26.4 $39.6
Fee revenue and other.............................. 1.6 2.0
----- -----
Total revenues................................. 28.0 41.6
----- -----
Insurance policy benefits.......................... 21.1 32.8
Commission expense................................. 1.1 1.6
Other operating expenses........................... 1.9 2.7
----- -----
Total expense.................................. 24.1 37.1
----- -----
Pre-tax income..................................... $ 3.9 $ 4.5
===== =====
34
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
The following tables and narratives summarize the operating results of our
segments for the periods presented (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Income (loss) before net realized investment gains (losses),
net of related amortization and income taxes
(a non-GAAP measure) (a):
Bankers Life................................................ $ 65.5 $ 63.7 $ 108.3 $120.9
Conseco Insurance Group..................................... 26.3 (92.3) 77.8 (50.4)
Colonial Penn............................................... 6.7 6.5 11.3 11.6
Other Business in Run-off................................... (133.2) 4.4 (164.1) 28.4
Corporate operations........................................ (42.4) (17.0) (73.2) (43.0)
------- ------ ------- ------
(77.1) (34.7) (39.9) 67.5
------- ------ ------- ------
Net realized investment gains (losses), net of related
amortization:
Bankers Life................................................ (1.0) (1.4) (5.5) (2.4)
Conseco Insurance Group..................................... (13.6) (1.0) (29.7) (4.6)
Colonial Penn............................................... .3 1.2 .1 1.7
Other Business in Run-off................................... (.1) 1.0 (.3) 4.0
Corporate operations........................................ (1.2) - (1.2) -
------- ------ ------- -----
(15.6) (.2) (36.6) (1.3)
------- ------ ------- ------
Income (loss) before income taxes:
Bankers Life................................................ 64.5 62.3 102.8 118.5
Conseco Insurance Group..................................... 12.7 (93.3) 48.1 (55.0)
Colonial Penn............................................... 7.0 7.7 11.4 13.3
Other Business in Run-off................................... (133.3) 5.4 (164.4) 32.4
Corporate operations........................................ (43.6) (17.0) (74.4) (43.0)
------- ------ ------- ------
Income (loss) before income taxes........................ $ (92.7) $(34.9) $ (76.5) $ 66.2
======= ====== ======= ======
<FN>
- --------------------
(a) These non-GAAP measures as presented in the above table and in the
following segment financial data and discussions of segment results exclude
net realized investment gains (losses), net of related amortization and
before income taxes. These are considered non-GAAP financial measures. A
non-GAAP measure is a numerical measure of a company's performance,
financial position, or cash flows that excludes or includes amounts that
are normally excluded or included in the most directly comparable measure
calculated and presented in accordance with GAAP.
These non-GAAP financial measures of "income (loss) before net realized
investment gains (losses), net of related amortization, and before income
taxes" differ from "income (loss) before income taxes" as presented in our
consolidated statement of operations prepared in accordance with GAAP due
to the exclusion of before tax realized investment gains (losses), net of
related amortization. We measure segment performance for purposes of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"), excluding realized
investment gains (losses) because we believe that this performance measure
is a better indicator of the ongoing businesses and trends in our business.
Our investment focus is on investment income to support our liabilities for
insurance products as opposed to the generation of realized investment
gains (losses), and a long-term focus is necessary to maintain
profitability over the life of the business. Realized investment gains
(losses) depend on market conditions and do not necessarily relate to
decisions regarding the underlying business of our segments. However,
"income (loss) before net realized investment gains (losses), net of
related amortization, and before income taxes" does not replace "income
(loss) before income taxes" as a measure of overall profitability. We may
experience
35
CONSECO, INC. AND SUBSIDIARIES
-------------------
realized investment gains (losses), which will affect future earnings
levels since our underlying business is long-term in nature and we need to
earn the assumed interest rates on the investments backing our liabilities
for insurance products to maintain the profitability of our business.
Accordingly, management reviews "income (loss) before income taxes" and
"income (loss) before realized investment gains (losses)" when analyzing
its financial results. 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-term care business
in run-off relates to business written by certain subsidiaries prior to their
acquisitions by Conseco in 1996 and 1997.
36
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Annuities................................................ $ 200.5 $ 238.3 $ 412.7 $ 471.7
Supplemental health...................................... 356.6 342.6 722.9 665.5
Life..................................................... 52.1 46.6 100.2 89.8
-------- -------- -------- --------
Total collections...................................... $ 609.2 $ 627.5 $1,235.8 $1,227.0
======== ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 283.0 $ 276.2 $ 281.9 $ 275.5
Equity-indexed....................................... 730.0 464.5 693.7 438.9
Deposit based........................................ 4,523.3 4,399.5 4,537.3 4,371.9
Health................................................. 3,546.2 3,275.6 3,509.6 3,242.5
Life:
Interest sensitive................................... 369.6 345.1 366.8 341.8
Non-interest sensitive............................... 292.0 240.7 284.2 234.2
-------- -------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded................. $9,744.1 $9,001.6 $9,673.5 $8,904.8
======== ======== ======== ========
Revenues:
Insurance policy income.................................. $ 424.0 $ 384.6 $ 836.0 $ 767.6
Net investment income:
General account invested assets........................ 142.2 126.9 282.9 248.0
Equity-indexed products based on the change
in value of options.................................. 11.9 (4.5) 8.9 (2.1)
Other special-purpose portfolios....................... 1.0 - 4.2 -
Fee revenue and other income............................. 2.7 2.0 3.9 3.4
-------- -------- -------- --------
Total revenues....................................... 581.8 509.0 1,135.9 1,016.9
-------- -------- -------- --------
Expenses:
Insurance policy benefits................................ 341.1 306.8 687.0 619.5
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than equity-indexed products.......... 45.1 42.8 89.8 84.6
Equity-indexed products................................ 13.5 (.8) 15.9 1.7
Amortization related to operations....................... 71.3 56.8 152.7 114.2
Interest expense on investment borrowings................ - .1 - .1
Other operating costs and expenses....................... 45.3 39.6 82.2 75.9
-------- -------- -------- --------
Total expenses....................................... 516.4 445.3 1,027.6 896.0
-------- -------- -------- --------
Income before net realized investment losses, net of
related amortization and income taxes...................... 65.5 63.7 108.3 120.9
-------- -------- -------- --------
Net realized investment losses........................... (1.9) (1.9) (7.1) (3.4)
Amortization related to net realized investment losses... .9 .5 1.6 1.0
-------- -------- -------- --------
Net realized investment losses, net of
related amortization .............................. (1.0) (1.4) (5.5) (2.4)
-------- -------- -------- --------
Income before income taxes.................................... $ 64.5 $ 62.3 $ 102.8 $ 118.5
======== ======== ======== ========
(continued)
37
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- ------------------
2007 2006 2007 2006
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................... $297.1 $265.6 $597.6 $540.9
Benefit ratio (a)....................................... 81.7% 81.1% 83.3% 81.7%
Medicare supplement:
Insurance policy benefits............................... $108.8 $111.2 $214.1 $224.3
Benefit ratio (a)....................................... 67.4% 67.8% 66.0% 67.8%
PDP and PFFS:
Insurance policy benefits............................... $38.1 $12.1 $73.3 $36.3
Benefit ratio (a)....................................... 80.9% 77.6% 86.5% 91.3%
Long-term care:
Insurance policy benefits............................... $150.2 $142.3 $310.2 $280.3
Benefit ratio (a)....................................... 96.8% 96.2% 100.6% 96.3%
Interest-adjusted benefit ratio (b)..................... 66.0% 66.8% 69.9% 66.8%
<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 policy income. These are considered non-GAAP
financial measures. A non-GAAP measure is a numerical measure of a
company's performance, financial position, or cash flows that excludes or
includes amounts that are normally excluded or included in the most
directly comparable measure calculated and presented in accordance with
GAAP.
These non-GAAP financial measures of "interest-adjusted benefit ratios"
differ from "benefit ratios" due to the deduction of interest income on the
accumulated assets backing the insurance liabilities from the product's
insurance policy benefits used to determine the ratio. Interest income is
an important factor in measuring the performance of health products that
are expected to be inforce for a longer duration of time, are not subject
to unilateral changes in provisions (such as non-cancelable or guaranteed
renewable contracts) and require the performance of various functions and
services (including insurance protection) for an extended period of time.
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) that 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 that
includes the effect of interest income is useful in analyzing product
performance. We utilize the interest-adjusted benefit ratio in measuring
segment performance for purposes of SFAS 131 because we believe that this
performance measure is a better indicator of the ongoing businesses and
trends in the business. However, the "interest-adjusted benefit ratio" does
not replace the "benefit ratio" as a measure of current period benefits to
current period insurance policy income. Accordingly, management reviews
both "benefit ratios" and "interest-adjusted benefit ratios" when analyzing
the financial results attributable to these products. The investment income
earned on the accumulated assets backing Bankers Life's long-term care
reserves was $47.9 million and $43.4 million in the three months ended June
30, 2007 and 2006, respectively, and $94.7 million and $85.8 million in the
six months ended June 30, 2007 and 2006, respectively.
</FN>
38
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections were $609.2 million in the second quarter of
2007, down 2.9 percent from 2006 and were $1,235.8 million in the first six
months of 2007, up .7 percent from 2006. Premium collections include $44.9
million and $32.1 million in the second quarters of 2007 and 2006, respectively,
and $83.5 million and $38.1 million in the first six months of 2007 and 2006,
respectively, of premiums collected pursuant to the PDP and PFFS quota-share
agreements with Coventry described in Critical Accounting Policies under the
caption "Accounting for marketing and quota-share agreements with Coventry". See
"Premium Collections" for further analysis of Bankers Life's premium
collections.
Average liabilities for insurance products, net of reinsurance ceded were
$9.7 billion in the second quarter of 2007, up 8.2 percent from 2006. Average
liabilities for insurance products, net of reinsurance ceded were $9.7 billion
in the first six months of 2007, up 8.6 percent from 2006. 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 includes $47.0 million and $15.6 million
in the second quarters of 2007 and 2006, respectively, and $84.6 million and
$39.8 million in the first six months of 2007 and 2006, respectively, of premium
income from the quota-share agreements with Coventry described in Critical
Accounting Policies under the caption "Accounting for marketing and quota-share
agreements with Coventry".
Net investment income on general account invested assets (which excludes
income on policyholder accounts) was $142.2 million in the second quarter of
2007, up 12 percent from 2006 and was $282.9 million in the first six months of
2007, up 14 percent from 2006. The average balance of general account invested
assets was $9.9 billion and $9.1 billion in the second quarters of 2007 and
2006, respectively. The average yield on these assets was 5.74 percent and 5.59
percent in the second quarters of 2007 and 2006, respectively. The average
balance of general account invested assets was $9.8 billion and $9.0 billion in
the first six months of 2007 and 2006, respectively. The average yield on these
assets was 5.76 percent and 5.54 percent in the first six months of 2007 and
2006, respectively. The increase in general account invested assets is primarily
due to sales of our annuity products in recent periods. The increase in yield is
primarily due to the purchase of higher yielding fixed maturity investments in
recent periods.
Net investment income related to equity-indexed products based on the
change in value of options represents the change in the estimated fair value of
options which are purchased in an effort to hedge certain potential benefits
accruing to the policyholders of our equity-indexed products. Our equity-indexed
products are designed so that the investment income spread earned on the related
insurance liabilities is more than adequate to cover the cost of the options and
other costs related to these policies. Investment gains (losses) related to
equity-indexed products were $11.9 million and $(4.5) million in the second
quarters of 2007 and 2006, respectively; and $8.9 million and $(2.1) million in
the first six months of 2007 and 2006, 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.
Net investment income on other special-purpose portfolios includes the
income related to Company-owned life insurance ("COLI") which was purchased in
the fourth quarter of 2006 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. Changes in
the cash surrender value (which approximates net realizable value) of the COLI
assets are recorded as net investment income and totaled $1.0 million and $1.5
million in the three and six months ended June 30, 2007, respectively. Also
during the first quarter of 2007, we recognized a death benefit of $2.7 million
under the COLI.
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
The Medicare supplement business consists of both individual and group
policies. Governmental regulations generally require us to attain and maintain a
ratio of total benefits incurred to total premiums earned (excluding changes in
policy benefit reserves), after three years from the original issuance of the
policy and over the lifetime of the policy, of not less than 65 percent on
individual products and not less than 75 percent on group products, as
determined in accordance with statutory accounting principles. Since the
insurance product liabilities we establish for Medicare supplement business are
subject to
39
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 from prior years of $3.4 million and
$6.4 million in the first six months of 2007 and 2006, respectively. Excluding
the effects of prior period claim reserve redundancies, our benefit ratios would
have been 67.0 percent and 69.7 percent in the first six months of 2007 and
2006, respectively. Such ratios are consistent with our expectations considering
premium rate increases implemented in recent periods.
The insurance policy benefits on our PDP and PFFS business result from our
quota-share reinsurance agreements with Coventry as described in Critical
Accounting Policies under the caption "Accounting for marketing and quota-share
agreements with Coventry". We began assuming the PDP business on January 1, 2006
and the PFFS business on January 1, 2007.
The net cash flows from our long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
typically increases, but the increase in reserves is partially offset by
investment income earned on the accumulated assets. The benefit ratio on this
business has increased over the last year, consistent with the aging of this
block. In addition, the older policies have not lapsed at the rate we assumed in
our pricing. In the first quarter of 2005, we began introducing several new
long-term care products to replace our previous 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 96.8 percent and 96.2 percent in the
second quarters of 2007 and 2006, respectively, and 100.6 percent and 96.3
percent in the first six months of 2007 and 2006, respectively. The
interest-adjusted benefit ratio on this business was 66.0 percent and 66.8
percent in the second quarters of 2007 and 2006, respectively, and 69.9 percent
and 66.8 percent in the first six months of 2007 and 2006, respectively.
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 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 89 percent of the
total dollar amount of our requested rate increases. The rate increases had
become effective for approximately 96 percent of the impacted inforce block as
of June 30, 2007. We expect the execution of our premium rate increases will
continue for the next quarter given the timing of the implementation as a result
of the regulatory approvals.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $45.1 million in the second quarter of
2007, up 5.4 percent from 2006 and were $89.8 million in the first six months of
2007, up 6.1 percent from 2006. The increase is primarily due to increases in
annuity reserves (resulting from higher sales of these products). The weighted
average crediting rate for these products were 3.7 percent and 3.6 percent in
the second quarters of 2007 and 2006, respectively, and 3.7 percent and 3.6
percent in the first six months of 2007 and 2006, 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 $71.3 million and
$56.8 million in the second quarters of 2007 and 2006, respectively, and $152.7
million and $114.2 million in the first six months of 2007 and 2006,
respectively. During the first six months of 2007 and 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
40
CONSECO, INC. AND SUBSIDIARIES
-------------------
recognized additional amortization expense of $25.4 million in the first six
months of 2007 ($6.5 million of which was recognized in the second quarter of
2007) and $7.9 million in the first six months of 2006 ($4.5 million of which
was recognized in the second quarter of 2006). The lapses of our Medicare
supplement products in the first six months of 2007 were higher than our
historical lapse experience. We believe such increases were partially related to
competition from Medicare Advantage products. Also, during the first quarter of
2007, amortization of insurance acquisition costs related to long-term care
policies increased by $4.1 million primarily as a result of changes to our
previous assumptions related to future premium rate increases on certain
long-term care policies due to either: (i) a delay in processing rate increases;
or (ii) the disapproval by certain states of rate increases.
Other operating costs and expenses in our Bankers Life segment were $45.3
million in the second quarter of 2007, up 14 percent from 2006 and were $82.2
million in the first six months of 2007, up 8.3 percent from 2006. Other
operating costs and expenses include the following (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ------------------
2007 2006 2007 2006
---- ---- ---- ----
Expenses related to the marketing and quota-share
agreements with Coventry........................... $ 5.6 $ 3.6 $ 8.4 $ 6.8
Commission expense.................................... 5.8 5.7 11.0 10.4
Other operating expenses.............................. 33.9 30.3 62.8 58.7
----- ----- ----- -----
Total.............................................. $45.3 $39.6 $82.2 $75.9
===== ===== ===== =====
Net realized investment losses fluctuate each period. During the first six
months of 2007 we recognized net realized investment losses in this segment of
$7.1 million from the sales of investments (primarily fixed maturities). During
the first six months of 2006, net realized investment losses in this segment
included $3.3 million of net losses from the sales of investments (primarily
fixed maturities), and $.1 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. There were
no such writedowns in the first six months of 2007.
Amortization related to net realized investment losses is the increase or
decrease in the amortization of insurance acquisition costs which results from
realized investment gains or losses. When we sell securities 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 a decrease in the
amortization of insurance acquisition costs of $.9 million and $.5 million in
the second quarters of 2007 and 2006, respectively, and $1.6 million and $1.0
million in the first six months of 2007 and 2006, respectively.
41
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Annuities................................................. $ 113.0 $ 92.4 $ 233.1 $ 128.6
Supplemental health....................................... 147.4 153.3 301.6 312.9
Life...................................................... 70.0 78.3 147.2 162.4
--------- --------- --------- ---------
Total collections....................................... $ 330.4 $ 324.0 $ 681.9 $ 603.9
========= ========= ========= =========
Average liabilities for insurance products:
Annuities:
Mortality based......................................... $ 230.9 $ 242.2 $ 232.5 $ 243.6
Equity-indexed.......................................... 1,633.4 1,320.6 1,597.2 1,315.3
Deposit based........................................... 2,845.8 3,185.4 2,893.4 3,238.7
Separate accounts....................................... 28.7 29.4 28.7 29.7
Health.................................................... 2,393.2 2,380.4 2,395.1 2,380.7
Life:
Interest sensitive...................................... 3,042.4 3,059.9 3,047.0 3,065.9
Non-interest sensitive.................................. 1,346.1 1,427.0 1,352.1 1,439.5
--------- --------- --------- ---------
Total average liabilities for insurance products, net
of reinsurance ceded................................ $11,520.5 $11,644.9 $11,546.0 $11,713.4
========= ========= ========= =========
Revenues:
Insurance policy income..................................... $ 236.3 $ 247.4 $ 478.3 $ 503.8
Net investment income:
General account invested assets........................... 182.3 175.9 361.9 350.7
Equity-indexed products................................... 16.9 (14.4) 13.1 (9.0)
Trading account income related to policyholder and
reinsurer accounts...................................... (.5) (1.7) .3 (2.2)
Change in value of embedded derivatives related to
modified coinsurance agreements......................... 2.5 1.5 2.2 3.8
Other special-purpose portfolios.......................... 1.3 - .4 -
Fee revenue and other income................................ .1 (.1) .3 .3
--------- --------- --------- ---------
Total revenues.......................................... 438.9 408.6 856.5 847.4
--------- --------- --------- ---------
Expenses:
Insurance policy benefits................................... 188.4 180.2 373.8 376.1
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products...................... 58.4 60.2 116.9 121.4
Equity-indexed products................................... 28.6 (1.9) 37.1 3.4
Amortization related to operations.......................... 47.0 36.7 85.2 92.2
Interest expense on investment borrowings................... 4.2 .3 5.3 .5
Costs related to the proposed litigation settlement......... 17.5 157.0 24.0 165.8
Other operating costs and expenses.......................... 68.5 68.4 136.4 138.4
--------- --------- --------- ---------
Total expenses.......................................... 412.6 500.9 778.7 897.8
--------- --------- --------- ---------
Income (loss) before net realized investment losses, net of
related amortization, and income taxes...................... 26.3 (92.3) 77.8 (50.4)
--------- --------- --------- ---------
Net realized investment losses.............................. (25.4) (4.0) (54.7) (9.1)
Amortization related to net realized investment losses...... 11.8 3.0 25.0 4.5
--------- --------- --------- ---------
Net realized investment losses, net of related
amortization.......................................... (13.6) (1.0) (29.7) (4.6)
--------- --------- --------- ---------
Income (loss) before income taxes.............................. $ 12.7 $ (93.3) $ 48.1 $ (55.0)
========= ========= ========= =========
(continued)
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................... $107.8 $109.1 $198.5 $222.8
Benefit ratio (a)....................................... 71.6% 69.8% 65.4% 70.3%
Medicare supplement:
Insurance policy benefits............................... $40.1 $36.5 $80.5 $77.8
Benefit ratio (a)....................................... 68.9% 56.9% 67.9% 58.7%
Specified disease:
Insurance policy benefits............................... $65.1 $71.2 $113.0 $140.6
Benefit ratio (a)....................................... 72.5% 79.9% 62.8% 78.7%
Interest-adjusted benefit ratio (b)..................... 39.7% 48.2% 30.0% 47.1%
Other:
Insurance policy benefits............................... $2.6 $1.4 $5.0 $4.4
Benefit ratio (a)....................................... 107.3% 47.0% 104.3% 74.5%
<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. These are
considered non-GAAP financial measures. A non-GAAP measure is a numerical
measure of a company's performance, financial position, or cash flows that
excludes or includes amounts that are normally excluded or included in the
most directly comparable measure calculated and presented in accordance
with GAAP.
These non-GAAP financial measures of "interest-adjusted benefit ratios"
differ from "benefit ratios" due to the deduction of interest income on the
accumulated assets backing the insurance liabilities from the product's
insurance policy benefits used to determine the ratio. Interest income is
an important factor in measuring the performance of health products that
are expected to be inforce for a longer duration of time, are not subject
to unilateral changes in provisions (such as non-cancelable or guaranteed
renewable contracts) and require the performance of various functions and
services (including insurance protection) for an extended period of time.
In addition, 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) that
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 that
includes the effect of interest income is useful in analyzing product
performance. We utilize the interest-adjusted benefit ratio in measuring
segment performance for purposes of SFAS 131 because we believe that this
performance measure is a better indicator of the ongoing businesses and
trends in the business. However, the "interest-adjusted benefit ratio" does
not replace the "benefit ratio" as a measure of current period benefits to
current period insurance policy income. Accordingly, management reviews
both "benefit ratios" and "interest-adjusted benefit ratios" when analyzing
the financial results attributable to these products. The investment income
earned on the accumulated assets backing the specified disease reserves was
$29.5 million and $28.2 million in the three months ended June 30, 2007 and
2006, respectively, and $59.0 million and $56.5 million in the six months
ended June 30, 2007 and 2006, respectively.
</FN>
Total premium collections were $330.4 million in the second quarter of
2007, up 2.0 percent from the second quarter of 2006 and were $681.9 million in
the first six months of 2007, up 13 percent from 2006. The increase was
primarily due to
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
the introduction of several new equity-indexed annuity products in recent
periods distributed through our new national partners. See "Premium Collections"
for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$11.5 billion in the second quarter of 2007, down 1.1 percent from 2006. Average
liabilities for insurance products, net of reinsurance ceded were $11.5 billion
in the first six months of 2007, down 1.4 percent from 2006. 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 partially due to lower income from Medicare supplement products due to
higher lapses exceeding new sales. See "Premium Collections" for further
analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $182.3 million in the second
quarter of 2007, up 3.6 percent from 2006 and was $361.9 million in the first
six months of 2007, up 3.2 percent from 2006. The average balance of general
account invested assets was $12.4 billion and $12.2 billion in the second
quarters of 2007 and 2006, respectively. The average yield on these assets was
5.89 percent and 5.79 percent in the second quarters of 2007 and 2006,
respectively. The average balance of general account invested assets was $12.3
billion and $12.2 billion in the first six months of 2007 and 2006,
respectively. The average yield on these assets was 5.86 percent and 5.74
percent in the first six months of 2007 and 2006, respectively. 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) in the first six months of
2007 and 2006 of $3.5 million ($.6 million in the second quarter of 2007) and
$5.4 million ($3.9 million in the second quarter of 2006), respectively.
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
$20.3 million and $(11.8) million in the second quarters of 2007 and 2006,
respectively; and $16.0 million and $(2.6) million in the first six months of
2007 and 2006, respectively. Such amounts also include income on trading
securities which are designed to act as hedges for embedded derivatives related
to equity-indexed products. Such trading account gains (losses) were $(3.4)
million and $(2.6) million in the second quarters of 2007 and 2006,
respectively, and were $(2.9) million and $(6.4) million in the first six months
of 2007 and 2006, respectively. Such amounts were partially offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products. Such income and related charges fluctuate based on
the value of options embedded in the segment's equity-indexed annuity
policyholder account balances subject to this benefit and to the performance of
the indices to which the returns on such products are linked.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading securities which are designed to act as hedges
for embedded derivatives related to certain modified coinsurance agreements. In
addition, such income includes the income on investments backing the market
strategies of certain annuity products which provide for different rates of cash
value growth based on the experience of a particular market strategy. The income
on our trading account securities is designed to substantially offset: (i) the
change in value of embedded derivatives related to modified coinsurance
agreements described below; and (ii) certain amounts included in insurance
policy benefits 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 "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.
Net investment income on other special-purpose portfolios includes: (i) the
change in the fair value of the trading securities purchased with a portion of
the proceeds from the Advances; and (ii) the change in fair value of interest
rate swaps which were purchased. Such fixed rate trading securities were matched
with an interest rate swap that converts the security from a fixed rate to a
floating rate basis. In the first six months of 2007, the change in the value of
the trading securities was
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
$(3.2) million ($(3.7) million of which was recognized in the second quarter of
2007) and the change in the value of the interest rate swaps was $3.6 million
($5.0 million of which was recognized in the second quarter of 2007). These
transactions are further discussed in the note to the consolidated financial
statements entitled "Investment Borrowings and Interest Rate Swaps".
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
Insurance policy benefits in the first quarter of 2006 were reduced for the
following items. We reduced insurance policy 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
policy 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 margins (insurance policy income less insurance policy benefits)
related to life products declined approximately $17 million in the first six
months of 2007 ($5 million of which was recognized in the second quarter of
2007), as compared to the same periods in 2006, primarily due to increased death
claims.
The benefit ratio in the first six months of 2006 on Conseco Insurance
Group's Medicare supplement products reflected higher policyholder lapses,
following our premium rate increase actions. 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 in the first half of 2007 and
2006 reflected claim reserve redundancies from prior years of $.4 million and
$5.6 million, respectively. Excluding the effects of prior year claim reserve
redundancies, our benefit ratios in the first six months of 2007 and 2006 for
the Medicare supplement block would have been 68.2 percent and 62.9 percent,
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. Insurance margins (insurance policy income less insurance policy
benefits) on these products decreased by $16.7 million in the first six months
of 2007 (including a decrease of $9.5 million in the second quarter of 2007), as
compared to the same periods in 2006, due to a higher benefit ratio and a
smaller inforce block of business.
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.
The benefit ratio in the first six months of 2007 reflects a release of
reserves totaling $19.3 million related to the return of premium benefit on
specified disease policies. During the first quarter of 2007, we determined that
the coding in our administrative system related to policies with the return of
premium rider was inaccurate resulting in an overstatement of reserves. The
benefit ratio excluding this release of reserves was 73.5 percent in the first
six months of 2007. The benefit ratio for the first half of 2006 was unfavorably
affected by higher persistency of older policies which have higher benefit
ratios than newer policies. The interest-adjusted benefit ratio for specified
disease products is calculated by dividing the
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
insurance product's insurance policy benefits less interest income on the
accumulated assets backing the insurance liabilities by insurance policy income.
Insurance margins (insurance policy income less insurance policy benefits) on
these products, excluding the aforementioned release of reserves in the first
quarter of 2007, increased by $9.6 million in the first six months of 2007
(including an increase of $6.9 million in the second quarter of 2007), as
compared to the same periods in 2006, due to a lower benefit ratio.
The benefit ratios on Conseco Insurance Group's other health 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 $58.4 million in the second quarter of
2007, down 3.0 percent from 2006 and were $116.9 million in the first six months
of 2007, down 3.7 percent from 2006. The decrease was primarily due to a smaller
block of annuity business inforce, partially offset by higher crediting rates.
The weighted average crediting rate for these products was 4.0 percent and 3.9
percent in the first six months of 2007 and 2006, 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 expectation of
future profits. For other products, we amortize insurance acquisition costs in
relation to actual and expected premium revenue, and amortization is only
adjusted if expected premium revenue changes or if we determine the balance of
these costs is not recoverable from future profits. Higher lapses on our
Medicare supplement products have reduced our estimates of future expected
premium income and, accordingly, we recognized additional amortization expense
of $.8 million and $8.4 million in the first six months of 2007 and 2006,
respectively. The assumptions we use to estimate our future gross profits and
premiums involve significant judgment. A revision to our current assumptions
could result in increases or decreases to amortization expense in future
periods.
During the second quarter of 2007, we were required to accelerate the
amortization of insurance acquisition costs related to our universal life
products by $7.7 million because the prior balance was not recoverable by the
value of future estimated gross profits on this block. This additional
amortization was necessary so that our insurance acquisition costs would not
exceed the value of future estimated gross profits and is expected to continue
to be recognized in subsequent periods. Because our insurance acquisition costs
are now equal to the value of future estimated gross profits, this block is
expected to generate break-even earnings in the future. In addition, results for
this block are expected to exhibit increased volatility in the future, because
the entire difference between our assumptions and actual experience is expected
to be reflected in earnings in the period such differences occur. During the
second quarter of 2006, we changed our estimates of the future gross profits of
certain universal life products, which under certain circumstances are eligible
for interest bonuses in addition to the declared base rate. These interest
bonuses are not required in the current crediting rate environment and our
estimates of future gross profits have been changed to reflect the
discontinuance of the bonus. We reduced amortization expense by $4.0 million
during the second quarter of 2006 as a result of this change. During the first
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 the first quarter of 2006
due to these changes. This increase to amortization expense was offset by a
reduction to insurance policy benefit expense of $11.5 million, to reflect the
effect of the changes in these assumptions on the calculation of certain
insurance liabilities, such as the liability to purchase future options
underlying our equity-indexed products.
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
Interest expense on investment borrowings includes $3.9 million and $4.8
million of interest expense on the Advances in the three and six months ended
June 30, 2007, respectively, as further described in the note to the
consolidated financial statements entitled "Investment Borrowings and Interest
Rate Swaps".
Costs related to the proposed litigation settlement include legal fees and
estimated amounts related to the proposed settlement in the class action case
referred to as In Re Conseco Life Insurance Company Cost of Insurance
Litigation. The settlement is subject to certain conditions. For further
information related to this case, refer to the caption entitled "Cost of
Insurance Litigation" included in the note to our consolidated financial
statements entitled "Litigation and Other Legal Proceedings". A portion of the
legal and other costs related to this litigation were incurred by the Corporate
Operations segment to defend the non-insurance company allegations made in such
lawsuits.
Other operating costs and expenses in the 2007 periods were comparable to
the 2006 periods. Other operating costs and expenses include commission expense
of $20.3 million and $21.4 million in the second quarters of 2007 and 2006,
respectively, and $40.6 million and $44.1 million in the first six months of
2007 and 2006, respectively.
Net realized investment losses fluctuate each period. During the first six
months of 2007, net realized investment losses in this segment included: (i)
$1.7 million of writedowns of investments resulting from declines in fair values
that we concluded were other than temporary; and (ii) $53.0 million of
writedowns of investments as a result of our intent not to hold investments for
a period of time sufficient to allow for any anticipated recovery as a result of
entering into a coinsurance agreement as further discussed in the note to the
consolidated financial statements entitled "Pending Coinsurance Transaction".
During the first six months of 2006, net realized investment losses included
$5.8 million of net losses from the sales of investments (primarily fixed
maturities), and $3.3 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary.
Amortization related to net realized investment losses is the increase or
decrease in the amortization of insurance acquisition costs which results from
realized investment gains or losses. When we sell securities which back our
universal life and investment-type products at a gain (loss) and reinvest the
proceeds at a different yield (or when we no longer have the intent to hold
impaired investments for a period of time sufficient to allow for any
anticipated recovery), we increase (reduce) the amortization of insurance
acquisition costs in order to reflect the change in estimated gross profits due
to the gains (losses) realized and the resulting effect on estimated future
yields. Sales of fixed maturity investments resulted in a decrease in the
amortization of insurance acquisition costs of $11.8 million and $3.0 million in
the second quarters of 2007 and 2006, respectively, and $25.0 million and $4.5
million in the six months ended June 30, 2007 and 2006, respectively.
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
Colonial Penn (dollars in millions)
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Life..................................................... $ 26.0 $ 21.6 $ 52.7 $ 45.0
Supplemental health...................................... 2.7 3.1 5.3 6.1
------ ------ ------ ------
Total collections...................................... $ 28.7 $ 24.7 $ 58.0 $ 51.1
====== ====== ====== ======
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 85.5 $ 87.1 $ 85.7 $ 87.4
Deposit based........................................ 4.1 4.0 3.9 4.0
Health................................................... 23.0 25.9 23.2 26.5
Life:
Interest sensitive................................... 26.3 27.8 26.5 28.0
Non-interest sensitive............................... 558.4 552.7 558.6 553.7
------ ------ ------ ------
Total average liabilities for insurance
products, net of reinsurance ceded.............. $697.3 $697.5 $697.9 $699.6
====== ====== ====== ======
Revenues:
Insurance policy income.................................. $ 29.4 $ 25.6 $ 58.7 $ 52.0
Net investment income:
General account invested assets........................ 9.4 9.1 18.9 18.8
Trading account income related to reinsurer
accounts............................................. (6.4) (6.2) (5.5) (14.0)
Change in value of embedded derivatives related
to modified coinsurance agreements................... 6.4 6.2 5.5 14.0
Fee revenue and other income............................. .1 .2 .3 .3
------ ------ ------ ------
Total revenues....................................... 38.9 34.9 77.9 71.1
------ ------ ------ ------
Expenses:
Insurance policy benefits................................ 23.9 20.7 49.5 43.5
Amounts added to annuity and interest-sensitive
life product account balances........................ .3 .3 .6 .6
Amortization related to operations....................... 4.9 4.1 9.7 8.3
Other operating costs and expenses....................... 3.1 3.3 6.8 7.1
------ ------ ------ ------
Total expenses....................................... 32.2 28.4 66.6 59.5
------ ------ ------ ------
Income before net realized investment gains
and income taxes......................................... 6.7 6.5 11.3 11.6
Net realized investment gains.......................... .3 1.2 .1 1.7
------ ------ ------ ------
Income before income taxes.................................... $ 7.0 $ 7.7 $ 11.4 $ 13.3
====== ====== ====== ======
Total premium collections were $28.7 million in the second quarter of 2007,
up 16 percent from 2006 and were $58.0 million in the first six months of 2007,
up 14 percent from 2006. See "Premium Collections" for further analysis of
Colonial Penn's premium collections.
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $9.4 million in the second
quarter of 2007, up 3.3 percent from 2006 and was $18.9 million in the first six
months of 2007, up .5 percent from 2006. The average balance of general account
invested assets was $.7 billion in both the second quarters of 2007 and 2006,
respectively. The average yield on these assets was 5.71 percent and 5.32
percent in the second quarters of 2007 and 2006, respectively. The average
balance of general account invested assets was $.7 billion in both the first six
months of 2007 and 2006, respectively. The average yield on these assets was
5.65 percent and 5.45 percent in the first six months of 2007 and 2006,
respectively.
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 "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 in the 2007
periods were comparable to the same periods in 2006.
Net realized investment gains fluctuate each period. We recognized net
realized investment gains in this segment of $.3 million and $1.2 million from
the sales of investments (primarily fixed maturities) in the second quarters of
2007 and 2006, respectively, and $.1 million and $1.7 million in the first six
months of 2007 and 2006, respectively.
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-off (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Long-term care........................................... $ 75.6 $ 80.2 $ 156.2 $ 167.5
Major medical........................................... .6 2.2 1.2 3.3
-------- -------- -------- --------
Total collections................................... $ 76.2 $ 82.4 $ 157.4 $ 170.8
======== ======== ======== ========
Average liabilities for insurance products:
Long-term care........................................... $3,348.2 $3,222.1 $3,314.1 $3,232.7
Major medical............................................ 24.3 29.3 25.1 29.5
-------- -------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded........................ $3,372.5 $3,251.4 $3,339.2 $3,262.2
======== ======== ======== ========
Revenues:
Insurance policy income.................................. $ 78.1 $ 82.1 $ 157.6 $ 171.0
Net investment income on general account invested
assets................................................. 47.6 44.6 94.6 89.3
Fee revenue and other income............................. .1 .1 .2 .2
-------- -------- -------- --------
Total revenues....................................... 125.8 126.8 252.4 260.5
-------- -------- -------- --------
Expenses:
Insurance policy benefits................................ 231.6 96.9 361.6 181.2
Amortization related to operations....................... 5.8 3.5 11.5 7.0
Other operating costs and expenses....................... 21.6 22.0 43.4 43.9
-------- -------- -------- --------
Total expenses....................................... 259.0 122.4 416.5 232.1
-------- -------- -------- --------
Income (loss) before net realized investment gains
(losses) and income taxes.......................... (133.2) 4.4 (164.1) 28.4
Net realized investment gains (losses)................... (.1) 1.0 (.3) 4.0
-------- -------- -------- --------
Income (loss) before income taxes.................... $ (133.3) $ 5.4 $ (164.4) $ 32.4
======== ======== ======== ========
Health benefit ratios:
Insurance policy benefits.............................. $231.6 $96.9 $361.6 $181.2
Benefit ratio (a)...................................... 296.7% 118.0% 229.5% 105.9%
Interest-adjusted benefit ratio (b).................... 236.7% 64.4% 170.4% 54.4%
<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 policy income. These are considered non-GAAP
financial measures. A non-GAAP measure is a numerical measure of a
company's performance, financial position, or cash flows that excludes or
includes amounts that are normally excluded or included in the most
directly comparable measure calculated and presented in accordance with
GAAP.
These non-GAAP financial measures of "interest-adjusted benefit ratios"
differ from "benefit ratios" due to the deduction of interest income on the
accumulated assets backing the insurance liabilities from the product's
insurance policy benefits used to determine the ratio. Interest income is
an important factor in measuring the performance of
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
health products that are expected to be inforce for a longer duration of
time, are not subject to unilateral changes in provisions (such as
non-cancelable or guaranteed renewable contracts) and require the
performance of various functions and services (including insurance
protection) for an extended period of time. 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) that 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 that includes the effect of
interest income is useful in analyzing product performance. We utilize the
interest-adjusted benefit ratio in measuring segment performance for
purposes of SFAS 131 because we believe that this performance measure is a
better indicator of the ongoing businesses and trends in the business.
However, the "interest-adjusted benefit ratio" does not replace the
"benefit ratio" as a measure of current period benefits to current period
insurance policy income. Accordingly, management reviews both "benefit
ratios" and "interest-adjusted benefit ratios" when analyzing the financial
results attributable to these products. The investment income earned on the
accumulated assets backing long-term care reserves in our Other Business in
Run-off segment was $46.9 million and $44.0 million in the three months
ended June 30, 2007 and 2006, respectively, and $93.1 million and $88.2
million in the six months ended June 30, 2007 and 2006, respectively.
</FN>
Total premium collections were $76.2 million in the second quarter of 2007,
down 7.5 percent from 2006 and were $157.4 million in the first six months of
2007, down 7.8 percent from 2006. We have ceased marketing the long-term care
business and major medical business of this segment. Accordingly, collected
premiums will decrease over time as policies lapse, partially offset by premium
rate increases. See "Premium Collections" for further analysis.
Insurance policy income is comprised of premiums earned on the segment's
long-term care and major medical policies. See "Premium Collections" for further
analysis.
Net investment income on general account invested assets was $47.6 million
in the second quarter of 2007, up 6.7 percent from 2006 and was $94.6 million in
the first six months of 2007, up 5.9 percent from 2006. The average balance of
general account invested assets was $3.2 billion and $3.0 billion in the second
quarters of 2007 and 2006, respectively. The average yield on these assets was
5.86 percent in both the second quarters of 2007 and 2006, respectively. The
average balance of general account invested assets was $3.2 billion and $3.1
billion in the first six months of 2007 and 2006, respectively. The average
yield on these assets was 5.92 percent and 5.85 percent in the first six months
of 2007 and 2006, respectively. The increase in yield is primarily due to the
purchase of higher yielding fixed maturity investments in recent periods.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below.
Insurance policy benefits in the second quarter of 2007 increased 139
percent to $231.6 million compared to $96.9 million in the same period of 2006.
Insurance policy benefits in the six months ended June 30, 2007 increased 100
percent to $361.6 million compared to $181.2 million in the same period of 2006.
The benefit ratio on our Other Business in Run-off segment was 296.7 percent and
118.0 percent in the second quarters of 2007 and 2006, respectively, and 229.5
percent and 105.9 percent in the first six months of 2007 and 206, 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 $132 million and $40 million in the
first six months of 2007 and 2006, respectively. Excluding the effects of prior
year claim reserve deficiencies, our benefit ratios would have been 145.7
percent and 82.6 percent in the first six months of 2007 and 2006, respectively.
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
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
business was 236.7 percent and 64.4 percent in the second quarters of 2007 and
2006, respectively, and 170.4 percent and 54.4 percent in the first six months
of 2007 and 2006, 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 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 and 2007.
In each quarterly period, we calculate our best estimate of claim reserves
based on all of the information available to us at that time, which necessarily
takes into account new experience emerging during the period. Our actuaries
estimate these claim reserves using various generally recognized actuarial
methodologies which are based on informed estimates and judgments that are
believed to be appropriate. Additionally, an external actuarial firm provides
consulting services which involve a review of the Company's judgments and
estimates for claim reserves on the long-term care block in the Other Business
in Run-off segment on a quarterly basis. As additional experience emerges and
other data become available, these estimates and judgments are reviewed and may
be revised. Significant assumptions made in estimating claim reserves for
long-term care policies include expectations about the: (i) future duration of
existing claims; (ii) cost of care and benefit utilization; (iii) interest rate
utilized to discount claim reserves; (iv) claims that have been incurred but not
yet reported; (v) claim status on the reporting date; (vi) claims that have been
closed but are expected to reopen; and (vii) correspondence that has been
received that will ultimately become claims that have payments associated with
them.
During the second quarter of 2007, we increased claim liabilities for the
long-term care insurance block in our Other Business in Run-off segment by $118
million as a result of changes in our estimates of claim reserves incurred in
prior periods. Approximately $20 million of this increase related to claims with
incurral dates in the first quarter of 2007 and $98 million related to claims
with incurral dates prior to 2007.
The $118 million increase in estimates of claims incurred in prior periods
included $110 million of adjustments related to updates to our reserve
assumptions and methodologies to reflect emerging trends in our claim
experience. The following assumption changes primarily contributed to the $110
million adjustment.
o We increased our reserves by $37 million for changes to our
assumptions regarding the future duration of existing claims. We
updated these assumptions to reflect our current expectation that
policyholders will receive benefits for a longer period based on
changing trends in the duration of our claims.
o We increased our reserves by $31 million related to a block of
long-term care policies originally sold by Transport Life Insurance
Company ("Transport") and acquired by our Predecessor. We estimate
claim reserves for this block of business using an aggregate paid loss
development method, which uses historical payment patterns to project
ultimate losses for all the claims in a given incurral period. We
refined our loss development assumptions by developing separate
assumption tables for claimants with and without lifetime benefit
periods and for claimants with and without inflationary benefits,
since this block's recent loss experience has been extremely sensitive
to the mix of its business. This adjustment further improves the
estimate that was made during the first quarter of 2007, which is
described in further detail below. This adjustment related to our
assumption of future duration of existing claims.
o We increased our claim reserves by $23 million to better reflect
fluctuations in claim inventories related to certain blocks of
business. This increase relates to our estimate of claim status on the
reporting date.
o We increased our claim reserves by $17 million for our estimate of
incurred but not reported claims, reflecting recent experience and the
impact of the other adjustments.
During the first quarter of 2007, we recorded a pre-tax adjustment that
increased policy benefits for the Transport block by $22 million. We found that
our previous claim estimates on this block were deficient because claims on
policies with lifetime benefits and inflation benefits had increased
significantly in recent periods. Since the policies with these benefits will
have longer average claim payout periods than similar policies without such
benefits, a shift in the mix of claimants can have a significant impact on
incurred claims that is not immediately reflected using a completion factor
methodology. We
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
improved our methodologies to address this and other shortcomings of the
aggregate loss development methodology, which resulted in the pre-tax
adjustment.
During the second quarter of 2006, we recognized a non-recurring benefit of
$9.4 million related to the release of certain other redundant reserve
liabilities. During the first quarter of 2006, we upgraded the prior version of
the valuation system used to determine reserves for the long-term care block of
business in run-off. The new version includes enhancements to more precisely
estimate insurance liabilities for policies with return of premium benefits. The
effect of this refinement and certain other reserve adjustments resulted in
decreases to our insurance liabilities of approximately $14 million in the first
quarter of 2006.
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 have
requested 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), others will choose to
allow their policies to lapse and certain policyholders will have the
opportunity to choose a non-forfeiture option which will provide a reduced
benefit with no future premiums). The impact of the second and third year rate
increases will be somewhat smaller as the block continues to run off. To date,
we have received approvals and implemented rate increases equivalent to
approximately 80 percent of our $35 million estimate. The effects of the
approved rate increases are expected to be realized over the next year. The
remaining first round rate increase filings are expected to be approved and
implemented 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. To date,
we have submitted filings for approval of approximately 6 percent of the second
round of 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 likely that we
will not be able to obtain approval for some of the 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 write off all or a portion of
the insurance acquisition costs and 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.
Amortization related to operations includes amortization of insurance
acquisition costs.
Other operating costs and expenses were $21.6 million in the second quarter
of 2007, down 1.8 percent from 2006 and were $43.4 million in the first six
months of 2007, down 1.1 percent from 2006. Other operating costs and expenses
include commission expense of $8.0 million and $9.0 million in the second
quarters of 2007 and 2006, respectively, and $16.3 million and $18.8 million in
the first six months of 2007 and 2006, respectively.
Net realized investment gains (losses) fluctuate each period. During the
first six months of 2007 we recognized net realized investment losses of $.3
million from the sales of investments (primarily fixed maturities). During the
first six months of 2006, net realized investment gains included $4.1 million of
net gains from the sales of investments (primarily fixed maturities), net of $.1
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary. There were no such writedowns in the
first six months of 2007.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
Corporate Operations (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ----------------------
2007 2006 2007 2006
---- ---- ---- ----
Corporate operations:
Interest expense on corporate debt......................... $(16.9) $(12.0) $(33.0) $(24.4)
Net investment income ..................................... .8 .8 1.9 1.8
Fee revenue and other income............................... 2.0 2.2 4.1 4.9
Net operating results of variable interest entity.......... 2.3 .3 4.7 1.0
Costs related to the proposed litigation settlement........ (17.5) - (24.0) (8.9)
Other operating costs and expenses......................... (13.1) (8.3) (26.9) (17.4)
------ ------ ------ ------
Loss before net realized investment losses
and income taxes....................................... (42.4) (17.0) (73.2) (43.0)
Net realized investment losses............................. (1.2) - (1.2) -
------ ------ ------ ------
Loss before income taxes................................. $(43.6) $(17.0) $(74.4) $(43.0)
====== ====== ====== ======
Interest expense on corporate debt was impacted by the amendments of the
Company's credit facility in June 2007 and October 2006. Our average corporate
debt outstanding was $1,023.4 million and $831.0 million during the first six
months of 2007 and 2006, respectively. The average interest rate on our debt was
6.1 percent and 5.4 percent during the first six months of 2007 and 2006,
respectively.
Net investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income and
fluctuated along with the change in the amount of invested assets in this
segment.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. Fee revenue and other income decreased primarily as
a result of a decrease in the market value of investments managed for others,
upon which these fees are based.
Net operating results of variable interest entity 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 ("FIN
46R"). Although we do not control this entity, we consolidate it because we are
the primary beneficiary. This entity was established to issue securities and use
the proceeds to invest in loans and other permitted assets. Such consolidation
requirements did not have a material impact on our financial condition or
results of operations.
Costs related to the proposed 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 had reached a proposed settlement of this case. Refer to
the captions entitled: (i) "Costs related to the proposed litigation settlement"
included in the results of operations section for the Conseco Insurance Group
segment; and (ii) "Cost of Insurance Litigation" included in the note to our
consolidated financial statements entitled "Litigation and Other Legal
Proceedings" for further information related to this case.
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.
Net realized investment losses in the first six months of 2007 include a
writedown of $1.2 million due to an other-than-temporary decline in value of an
investment.
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
PREMIUM COLLECTIONS
In accordance with GAAP, insurance policy income in our consolidated
statement of operations consists of premiums earned for traditional insurance
policies that have life contingencies or morbidity features. For annuity and
universal life contracts, premiums collected are not reported as revenues, but
as deposits to insurance liabilities. We recognize revenues for these products
over time in the form of investment income and surrender or other charges.
Our insurance segments sell products through three primary distribution
channels -- career agents (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, PFFS 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 Health Insurance Company, "Conseco Senior") from A.M. Best, S&P and
Moody's are "B+ (Good)", "BB+" and "Baa3", respectively. The current financial
strength ratings of Conseco Senior from A.M. Best, S&P and Moody's are "C++
(Marginal)", "CCC-" and "Caa1", respectively. For a description of these ratings
and additional information on our ratings, see "Liquidity for Insurance
Operations."
We set premium rates on our health insurance policies based on facts and
circumstances known at the time we issue the policies using assumptions about
numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. We also consider historical claims information,
industry statistics, the rates of our competitors and other factors. If our
actual claims experience is less favorable than we anticipated and we are unable
to raise our premium rates, our financial results may be adversely affected. We
generally cannot raise our health insurance premiums in any state until we
obtain the approval of the state insurance regulator. We review the adequacy of
our premium rates regularly and file rate increases on our products when we
believe such rates are too low. It is 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.
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................. $ 91.5 $ 65.7 $ 176.9 $ 128.6
------ ------ -------- --------
Other fixed (first-year)................................ 108.1 171.6 234.1 341.2
Other fixed (renewal)................................... .9 1.0 1.7 1.9
------ ------ -------- --------
Subtotal - other fixed annuities...................... 109.0 172.6 235.8 343.1
------ ------ -------- --------
Total annuities....................................... 200.5 238.3 412.7 471.7
------ ------ -------- --------
Supplemental health:
Medicare supplement (first-year)........................ 43.8 24.5 77.5 49.3
Medicare supplement (renewal)........................... 133.8 132.2 278.6 275.9
------ ------ -------- --------
Subtotal - Medicare supplement........................ 177.6 156.7 356.1 325.2
------ ------ -------- --------
Long-term care (first-year)............................. 12.2 13.1 23.8 27.3
Long-term care (renewal)................................ 143.2 138.4 289.8 269.9
------ ------ -------- --------
Subtotal - long-term care............................. 155.4 151.5 313.6 297.2
------ ------ -------- --------
Other health (first-year)............................... 2.3 32.2 7.0 38.5
Other health (renewal).................................. 21.3 2.2 46.2 4.6
------ ------ -------- --------
Subtotal - other health............................... 23.6 34.4 53.2 43.1
------ ------ -------- --------
Total supplemental health............................. 356.6 342.6 722.9 665.5
------ ------ -------- --------
Life insurance:
First-year.............................................. 25.3 23.3 46.7 44.0
Renewal................................................. 26.8 23.3 53.5 45.8
------ ------ -------- --------
Total life insurance.................................. 52.1 46.6 100.2 89.8
------ ------ -------- --------
Collections on insurance products:
Total first-year premium collections on
insurance products................................... 283.2 330.4 566.0 628.9
Total renewal premium collections on
insurance products.................................... 326.0 297.1 669.8 598.1
------ ------ -------- --------
Total collections on insurance products............... $609.2 $627.5 $1,235.8 $1,227.0
====== ====== ======== ========
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 decreased 16 percent, to $200.5 million, in the second quarter of 2007,
and 13 percent, to $412.7 million, in the first six months of 2007, as compared
to the same periods in 2006. Premium collections from our equity-indexed
products were favorably impacted in 2007 by 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.
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 increased 13 percent, to $177.6 million, in the second quarter of 2007,
and 9.5 percent, to $356.1 million, in the first six months of 2007, as compared
to the same periods in 2006. First year premiums collected in the three and six
months ended June 30, 2007 include $23.8 million and $35.3 million,
respectively, related to the PFFS quota-share reinsurance agreement with
Coventry.
Premiums collected on Bankers Life's long-term care policies increased 2.6
percent, to $155.4 million, in the second quarter of 2007, and 5.5 percent, to
$313.6 million, in the first six months of 2007, compared to the same periods in
2006 primarily due to higher premiums associated with the policies that were
impacted by the rate increases which became effective in 2006.
Other health products in the second quarter of 2007 include $2.1 million
and $19.0 million of first-year premiums and renewal premiums collected,
respectively, pursuant to the PDP quota-share reinsurance agreement with
Coventry. Other health products in the first six months of 2007 include $6.6
million and $41.6 million of first-year premiums and renewal premiums collected,
respectively, pursuant to the PDP quota-share reinsurance agreement with
Coventry. Other health products in the three and six months ended June 30, 2006
include $32.1 million and $38.1 million, respectively, of first-year premiums
collected pursuant to the PDP quota-share reinsurance agreement with Coventry.
These agreements are described in Critical Accounting Policies under the caption
"Accounting for marketing and quota-share agreements 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 12
percent, to $52.1 million, in the second quarter of 2007, and 12 percent, to
$100.2 million, in the first six months of 2007, compared to the same periods in
2006, due to an increased focus on life products.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................... $104.1 $ 77.2 $211.0 $ 97.9
Equity-indexed (renewal).................................. 2.6 2.9 4.7 5.3
------ ------ ------ ------
Subtotal - equity-indexed annuities..................... 106.7 80.1 215.7 103.2
------ ------ ------ ------
Other fixed (first-year).................................. 4.2 9.8 13.6 20.7
Other fixed (renewal)..................................... 2.1 2.5 3.8 4.7
------ ------ ------ ------
Subtotal - other fixed annuities........................ 6.3 12.3 17.4 25.4
------ ------ ------ ------
Total annuities......................................... 113.0 92.4 233.1 128.6
------ ------ ------ ------
Supplemental health:
Medicare supplement (first-year).......................... 5.2 7.9 11.8 16.2
Medicare supplement (renewal)............................. 50.9 54.0 104.1 111.6
------ ------ ------ ------
Subtotal - Medicare supplement.......................... 56.1 61.9 115.9 127.8
------ ------ ------ ------
Specified disease (first-year)............................ 7.7 7.0 15.0 14.2
Specified disease (renewal)............................... 81.4 81.8 166.2 166.0
------ ------ ------ ------
Subtotal - specified disease............................ 89.1 88.8 181.2 180.2
------ ------ ------ ------
Other health (renewal).................................... 2.2 2.6 4.5 4.9
------ ------ ------ ------
Total supplemental health............................... 147.4 153.3 301.6 312.9
------ ------ ------ ------
Life insurance:
First-year................................................ 1.1 1.7 2.3 3.4
Renewal................................................... 68.9 76.6 144.9 159.0
------ ------ ------ ------
Total life insurance.................................... 70.0 78.3 147.2 162.4
------ ------ ------ ------
Collections on insurance products:
Total first-year premium collections on
insurance products..................................... 122.3 103.6 253.7 152.4
Total renewal premium collections on
insurance products...................................... 208.1 220.4 428.2 451.5
------ ------ ------ ------
Total collections on insurance products................. $330.4 $324.0 $681.9 $603.9
====== ====== ====== ======
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity premiums
collected in this segment increased 22 percent, to $113.0 million, in the second
quarter of 2007, and 81 percent, to $233.1 million, in the first six months of
2007, compared to the same periods in 2006, due to an increase in sales of
equity-indexed annuities.
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 this product increased 33
percent, to $106.7 million, in the second quarter of 2007, and 109 percent, to
$215.7 million, in the first six months of 2007, compared to the same periods in
2006 due to the recent introduction of several new products distributed through
our new national partners. In addition, these products have become relatively
attractive due to general stock market conditions in recent periods.
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. SPDA and FPDA policies typically have an interest
rate that is guaranteed for the first policy year, after which we have the
discretionary ability to change the crediting rate to any rate not below a
guaranteed minimum rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products decreased 49 percent, to $6.3
million, in the second quarter of 2007, and 31 percent, to $17.4 million, in the
first six months of 2007, compared to the same periods in 2006, primarily due to
a decrease in new sales.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment decreased 9.4 percent, to $56.1 million, in the second quarter of
2007, and 9.3 percent, to $115.9 million, in the first six months of 2007, as
compared to the same periods in 2006. We have experienced higher lapses of these
products due to premium rate increases implemented in recent periods and
competition from companies offering Medicare Advantage products.
Premiums collected on specified disease products in the 2007 periods were
comparable to the same periods in 2006.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected decreased 11
percent, to $70.0 million, in the second quarter of 2007, and 9.4 percent, to
$147.2 million, in the first six months of 2007, compared to the same periods in
2006.
Colonial Penn (dollars in millions)
Three months ended Six months ended
June 30, June 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Life insurance:
First-year............................................... $ 7.0 $ 5.7 $13.7 $11.2
Renewal.................................................. 19.0 15.9 39.0 33.8
----- ----- ----- -----
Total life insurance................................... 26.0 21.6 52.7 45.0
----- ----- ----- -----
Supplemental health:
Medicare supplement (renewal)............................ 2.5 2.8 4.8 5.5
Other health (renewal)................................... .2 .3 .5 .6
----- ----- ----- -----
Total supplemental health.............................. 2.7 3.1 5.3 6.1
----- ----- ----- -----
Collections on insurance products:
Total first-year premium collections on insurance
products............................................... 7.0 5.7 13.7 11.2
Total renewal premium collections on insurance
products............................................... 21.7 19.0 44.3 39.9
----- ----- ----- -----
Total collections on insurance products................ $28.7 $24.7 $58.0 $51.1
===== ===== ===== =====
Life products in this segment are sold primarily to the senior market. Life
premiums collected in this segment increased 20 percent, to $26.0 million, in
the second quarter of 2007, and 17 percent, to $52.7 million, in the first six
months of 2007, compared to the same periods in 2006. Collected premiums have
been affected by increased advertising. Graded benefit life products sold
through our direct response marketing channel accounted for $24.8 million and
$20.3 million of our total collected premiums in the second quarters of 2007 and
2006, respectively, and $50.2 million and $42.4 million, in the first six months
of 2007 and 2006, respectively.
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 as we do not currently market these products
through this segment.
Other Business in Run-off (dollars in millions):
Three months ended Six months ended
June 30, June 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Long-term care (renewal).................................... $75.6 $80.2 $156.2 $167.5
Major medical (renewal)..................................... .6 2.2 1.2 3.3
----- ----- ------ ------
Total renewal premium collections on insurance products... $76.2 $82.4 $157.4 $170.8
===== ===== ====== ======
The Other Business in Run-off segment includes: (i) long-term care products
written in prior years through independent agents; and (ii) group and individual
major medical business in run-off.
Long-term care premiums collected in this segment decreased 5.7 percent, to
$75.6 million, in the second quarter of 2007, and 6.7 percent, to $156.2
million, in the first six months of 2007, compared to the same periods in 2006.
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.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between June 30, 2007 and
December 31, 2006, primarily reflect: (i) our net loss for the six months ended
June 30, 2007; and (ii) changes in the fair value of actively managed fixed
maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At June 30, 2007, we decreased the
carrying value of such investments by $581.4 million as a result of this fair
value adjustment.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our capital structure as of June 30, 2007, and December 31, 2006, was as
follows (dollars in millions):
June 30, December 31,
2007 2006
---- ----
Total capital:
Corporate notes payable................................................ $1,197.8 $1,000.8
Shareholders' equity:
Preferred stock..................................................... - 667.8
Common stock........................................................ 1.9 1.5
Additional paid-in capital.......................................... 4,126.4 3,473.2
Accumulated other comprehensive loss................................ (329.9) (72.6)
Retained earnings................................................... 576.9 643.2
-------- --------
Total shareholders' equity....................................... 4,375.3 4,713.1
-------- --------
Total capital.................................................... $5,573.1 $5,713.9
======== ========
The following table summarizes certain financial ratios as of and for the
six months ended June 30, 2007, and as of and for the year ended December 31,
2006:
June 30, December 31,
2007 2006
---- ----
Book value per common share................................................................... $23.19 $26.58
Book value per common share, excluding accumulated other comprehensive
income (loss) (a).......................................................................... 24.93 27.06
Ratio of earnings to fixed charges............................................................ (b) 1.30x
Ratio of earnings to fixed charges and preferred dividends.................................... (c) 1.16x
Debt to total capital ratios:
Corporate debt to total capital............................................................ 21% 18%
Corporate debt to total capital, excluding accumulated other comprehensive
income (loss) (a)........................................................................ 20% 17%
Corporate debt and preferred stock to total capital........................................ 21% 29%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (loss) (a).......................................................... 20% 29%
<FN>
- --------------------
(a) This non-GAAP measure differs from the corresponding GAAP measure presented
immediately above, because accumulated other comprehensive income (loss)
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 (loss). 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.
(b) For such ratio, earnings were $76.5 million less than fixed charges.
(c) For such ratio, earnings were $98.3 million less than fixed charges.
</FN>
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
Liquidity for insurance operations
Our insurance operating companies generally receive adequate cash flows
from premium collections and investment income to meet their obligations. Life
insurance and annuity liabilities are generally long-term in nature.
Policyholders may, however, withdraw funds or surrender their policies, subject
to any applicable penalty provisions. We seek to balance the duration of our
invested assets with the estimated duration of benefit payments arising from
contract liabilities.
The Company announced on August 1, 2006, that it has reached a proposed
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 proposed settlement, we believe there
are adequate sources of liquidity to satisfy such requirements. Such estimates
are subject to significant judgment, including the form of policy benefit
enhancement chosen by the inforce policyholders. For further information related
to this case, refer to the caption entitled "Cost of Insurance Litigation"
included in the note to our consolidated financial statements entitled
"Litigation and Other Legal Proceedings".
In the first quarter of 2007, Conseco Life became a member of the FHLBI. As
a member of the FHLBI, Conseco Life has the ability to borrow on a
collateralized basis from FHLBI. Conseco Life intends to use these advances to
earn incremental income and as a source of liquidity for its operations. Conseco
Life is required to hold a certain minimum amount of FHLBI common stock as a
requirement of membership in the FHLBI, and additional amounts based on the
amount of advances. At June 30, 2007, the carrying value of the FHLBI common
stock was $20.0 million. Advances totaled $400.0 million in the first six months
of 2007 and the proceeds were used to purchase primarily investment-grade fixed
maturity securities. Certain of these fixed rate securities, with a par value of
$147.5 million, are matched with an interest rate swap, which converts the
security from a fixed rate to a floating rate basis. The Advances are classified
as investment borrowings in the accompanying consolidated balance sheet. The
Advances are collateralized by investments with an estimated fair value of
$471.0 million at June 30, 2007, which are maintained in a custodial account for
the benefit of the FHLBI. The following summarizes the terms of the Advances
(dollars in millions):
Amount Maturity Interest rate
borrowed date at June 30, 2007
-------- ---- ----------------
$100.0 February 2012 Variable rate - 5.345%
100.0 March 2012 Variable rate - 5.350%
54.0 May 2012 Variable rate - 5.360%
146.0 November 2015 Fixed rate - 5.300%
On August 7, 2007, A.M. Best downgraded the financial strength ratings of
our primary insurance subsidiaries to "B+ (Good)" from "B++ (Good)", except
Conseco Senior, whose "B- (Fair)" rating was downgraded to "C++ (Marginal)".
A.M. Best also revised the outlook for the ratings of our primary insurance
subsidiaries, as well as Conseco Senior, to negative from stable. 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 "C++" rating is
assigned to companies which have a marginal ability, in A.M. Best's opinion, to
meet their ongoing 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 "C++"
rating from A.M. Best are the sixth and ninth highest, respectively, of sixteen
possible ratings.
On August 7, 2007, S&P affirmed the financial strength ratings of "BB+" of
our primary insurance subsidiaries, except Conseco Senior, whose "CCC" rating
was downgraded to "CCC-". S&P also revised the outlook for the ratings of our
primary insurance subsidiaries to negative from stable, except for Conseco
Senior, whose outlook of negative was affirmed. 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 nineteenth highest, respectively, of twenty-one
possible ratings.
62
CONSECO, INC. AND SUBSIDIARIES
-------------------
The current financial strength ratings of our primary insurance
subsidiaries (except Conseco Senior) from Moody's are "Baa3" and Conseco
Senior's rating is "Caal". On April 3, 2007, Moody's affirmed the financial
strength ratings of our core insurance subsidiaries and Conseco Senior and
revised its outlook on all our insurance subsidiaries to stable from positive.
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.
We have adopted several initiatives designed to reduce the expense levels
that exceed product pricing in our Conseco Insurance Group segment. 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 proposed 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 "Litigation and Other Legal Proceedings". 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 and
2007 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 its 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 effect of all
three years of rate increases will take as long as five years to be fully
realized. It is possible that it will take more time than we expect to prepare
rate increase filings and obtain approval from the state insurance regulators.
In addition, it is possible that we will not be able to obtain approval for rate
increases currently pending or for the additional rate increases we plan to
file. Most of our long-term care business is guaranteed renewable, and, if
necessary rate increases are not approved, we may be required to establish a
premium deficiency reserve. If, however, we are successful in obtaining
regulatory approval to raise premium rates, the increased premium rates may
cause existing policyholders to allow their policies to lapse. This could result
in a significantly higher ratio of claim costs to premiums if healthier
policyholders who get coverage elsewhere allow their policies to lapse, while
policies of less healthy policyholders continue inforce. We believe that the
series of smaller rate increases we are seeking could mitigate these effects.
Liquidity of the Holding Companies
At June 30, 2007, Conseco Inc. and CDOC held unrestricted cash of $230.7
million. Conseco Inc. and CDOC are holding companies with no business operations
of their own; they depend on their operating subsidiaries for cash to make
principal and interest payments on debt, and to pay administrative expenses and
income taxes. Conseco and CDOC receive cash from insurance subsidiaries,
consisting of dividends and distributions, principal and interest payments on
surplus debentures and tax-sharing payments, as well as cash from non-insurance
subsidiaries consisting of dividends, distributions, loans and advances. The
principal non-insurance subsidiaries that provide cash to Conseco and CDOC are
40|86 Advisors, Inc., which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives
63
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 $50.0
million to our top tier insurance subsidiary in the first six months of 2007 and
expect to make an additional capital contribution of $110.0 million in August
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.
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.
On June 12, 2007, Conseco amended its current credit facility. The
amendment of the credit facility provided for, among other things:
o an increase of $200.0 million in the principal amount of the facility;
o an increase in the general basket for restricted payments to $200
million for the fiscal year commencing June 12, 2007 and $300 million
thereafter (in each case less any amount thereof paid in any prior
fiscal year but following June 12, 2007); and
o the Company to be able to request the addition of up to two new
facilities or up to two increases in the credit facility of up to $330
million (but with the commitment increases made between June 12, 2007
and June 12, 2008 limited to $130 million), subject to compliance with
certain financial covenants and other conditions. Such increases would
be effective as of a date that is at least 90 days prior to the
scheduled maturity date.
No changes were made to the interest rate or the maturity schedule of the
amounts borrowed under the credit facility. We are required to make minimum
quarterly principal payments of $2.2 million through September 30, 2013. The
remaining unpaid principal balance is due on October 10, 2013. There were no
changes to the various financial ratios and balances that are required to be
maintained by the Company. We intend to use the additional borrowings for
general corporate purposes, including the repurchase of Conseco common stock and
the strengthening of the Company's insurance subsidiaries.
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
During the first six months of 2007, we made scheduled principal payments
totaling $3.4 million on our Second Amended Credit Facility. The scheduled
repayment of our direct corporate obligations is as follows (dollars in
millions):
Remainder of 2007............................. $ 4.4
2008.......................................... 8.7
2009.......................................... 8.7
2010.......................................... 338.8
2011.......................................... 8.7
2012.......................................... 8.8
2013.......................................... 821.8
--------
$1,199.9
========
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 June 30, 2007. 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 or 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
$300.0 million over the term of the facility (of which, only $200.0 million may
be paid in the fiscal year beginning June 12, 2007). As further discussed in the
note to the consolidated financial statements entitled "Changes in Common
Stock", we repurchased 1.5 million shares of our common stock for $29.6 million
in the first six months of 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 of the lenders. We have also agreed to meet or maintain various
financial ratios. These requirements represent significant restrictions on the
manner in which we may operate our business and our ability to meet these
financial covenants may be affected by events beyond our control. If we default
under any of these requirements (subject to certain remedies), the lenders could
declare all outstanding borrowings, accrued interest and fees to be immediately
due and payable. If that were to occur, we cannot provide assurance that we
would have sufficient liquidity to repay or refinance this indebtedness.
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At June 30, 2007, 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................................................ $13,887.4 $48.1 $(421.7) $13,513.8
United States Treasury securities and obligations of
United States government corporations and agencies................ 1,267.5 10.7 (25.0) 1,253.2
States and political subdivisions................................... 627.7 1.9 (19.7) 609.9
Debt securities issued by foreign governments....................... 109.2 2.4 (.8) 110.8
Structured securities .............................................. 5,782.5 1.7 (162.4) 5,621.8
Below-investment grade (primarily corporate securities)................ 1,740.1 12.3 (37.3) 1,715.1
--------- ----- ------- ---------
Total actively managed fixed maturities............................. $23,414.4 $77.1 $(666.9) $22,824.6
========= ===== ======= =========
Equity securities...................................................... $38.9 $1.4 $(.1) $40.2
===== ==== ==== =====
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 June 30, 2007 (dollars in millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 5,677.7 24.8%
Manufacturing........................................................................ 3,266.0 14.3
Bank and finance..................................................................... 2,201.4 9.6
Utilities............................................................................ 1,749.9 7.7
Services............................................................................. 1,728.0 7.6
U.S. Government...................................................................... 1,253.2 5.5
Communications....................................................................... 1,076.6 4.7
Holding and other investment offices................................................. 1,024.4 4.5
Agriculture, forestry and mining..................................................... 906.5 4.0
Retail and wholesale................................................................. 737.3 3.2
Asset-backed securities.............................................................. 687.7 3.0
Transportation....................................................................... 657.2 2.9
States and political subdivisions.................................................... 609.9 2.7
Other................................................................................ 1,248.8 5.5
--------- -----
Total actively managed fixed maturities........................................... $22,824.6 100.0%
========= =====
Below-Investment Grade Securities
At June 30, 2007, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,740.1 million, or 7.4 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,715.1 million, or 99 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$481.1 million and an estimated fair value of $481.2 million are held by a VIE
that we are required to consolidate. These fixed maturity securities are legally
isolated and are not available to the Company. The liabilities of such VIE will
be satisfied from the cash flows generated by these
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
securities and are not obligations of the Company. At June 30, 2007, our total
investment in the VIE was $48.7 million, and $47.0 million of such investment
was rated BBB.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of default by the borrower is
significantly greater for below-investment grade securities and in many cases,
severity of loss is relatively greater as such securities are generally
unsecured and often subordinated to other creditors of the issuer. Also, issuers
of below-investment grade securities usually have higher levels of debt and may
be more sensitive to adverse economic conditions, such as recession or
increasing interest rates. The Company attempts to reduce the overall risk
related to its investment in below-investment grade securities, as in all
investments, through careful credit analysis, strict investment policy
guidelines, and diversification by issuer and/or guarantor and by industry.
Net Realized Investment Gains (Losses)
During the first six months of 2007, net realized investment losses
included: (i) $7.3 million of net losses from the sales of investments
(primarily fixed maturities) with proceeds of $3.8 billion; (ii) $2.9 million of
writedowns of investments for other than temporary declines in fair value; and
(iii) $53.0 million of writedowns of investments as a result of our intent not
to hold investments for a period of time sufficient to allow for any anticipated
recovery as a result of entering into a coinsurance agreement as further
discussed in the note to the consolidated financial statements entitled "Pending
Coinsurance Transaction". During the first six months of 2006, we recognized net
realized investment losses of $6.8 million, which were comprised of $3.3 million
of net losses from the sales of investments (primarily fixed maturities) with
proceeds of $3.1 billion, and $3.5 million of writedowns of investments for
other than temporary declines in fair value. At June 30, 2007, investments in
default as to the payment of principal or interest had both an aggregate
amortized cost and carrying value of $7.0 million.
During the six months ended June 30, 2007, we sold $2.1 billion of fixed
maturity investments which resulted in gross investment losses (before income
taxes) of $51.0 million. We sell securities at a loss for a number of reasons
including, but not limited to: (i) changes in the investment environment; (ii)
expectation that the market value could deteriorate further; (iii) desire to
reduce our exposure to an issuer or an industry; (iv) changes in credit quality;
or (v) changes in expected liability cash flows.
We regularly evaluate our investments for possible impairment. When we
conclude that a decline in a security's net realizable value is other than
temporary, the decline is recognized as a realized loss and the cost basis of
the security is reduced to its estimated fair value.
Our assessment of whether unrealized losses are "other than temporary"
requires significant judgment. Factors considered include: (i) the extent to
which market value is less than the cost basis; (ii) the length of time that the
market value has been less than cost; (iii) whether the unrealized loss is event
driven, credit-driven or a result of changes in market interest rates; (iv) the
near-term prospects for improvement in the issuer and/or its industry; (v) our
view of the investment's rating and whether the investment is investment-grade
and/or has been downgraded since its purchase; (vi) whether the issuer is
current on all payments in accordance with the contractual terms of the
investment and is expected to meet all of its obligations under the terms of the
investment; (vii) our ability and intent to hold the investment for a period of
time sufficient to allow for any anticipated recovery; and (viii) the underlying
current and prospective asset and enterprise values of the issuer and the extent
to which our investment may be affected by changes in such values.
Future events may occur, or additional information may become available,
which may necessitate future realized losses of securities in our portfolio.
Significant losses in the carrying values of our investments could have a
material adverse effect on our earnings in future periods.
67
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at June 30,
2007, 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................................................................. $ 68.7 $ 67.9
Due after one year through five years................................................... 1,187.6 1,166.1
Due after five years through ten years.................................................. 5,049.4 4,903.4
Due after ten years..................................................................... 6,930.1 6,594.4
--------- ---------
Subtotal............................................................................. 13,235.8 12,731.8
Structured securities................................................................... 5,083.8 4,920.9
--------- ---------
Total................................................................................ $18,319.6 $17,652.7
========= =========
At June 30, 2007, 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 basis.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we have both the ability and intent to hold securities with
unrealized losses until they mature or recover in value, we may sell securities
at a loss in the future because of actual or expected changes in our view of the
particular investment, its industry, its type or the general investment
environment.
68
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position, at
June 30, 2007 (dollars in millions):
Less than 12 months 12 months or greater Total
----------------------- ------------------------ -------------------------
Estimated Estimated Estimated
fair Unrealized fair Unrealized fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 147.4 $ (3.5) $ 855.5 $ (21.5) $ 1,002.9 $ (25.0)
States and political subdivisions. 303.9 (9.4) 187.8 (10.3) 491.7 (19.7)
Debt securities issued by
foreign governments............ 37.4 (1.0) 3.9 (.1) 41.3 (1.1)
Corporate securities.............. 8,105.3 (268.6) 3,090.6 (189.6) 11,195.9 (458.2)
Structured securities............. 2,680.2 (66.1) 2,240.7 (96.8) 4,920.9 (162.9)
--------- ------- -------- ------- --------- -------
Total actively managed
fixed maturities............... $11,274.2 $(348.6) $6,378.5 $(318.3) $17,652.7 $(666.9)
========= ======= ======== ======= ========= =======
Equity securities................. $.8 $(.1) $ - $ - $.8 $(.1)
=== ==== ===== ===== === ====
Based on management's current assessment of investments with unrealized
losses at June 30, 2007, the Company believes the issuers of the securities will
continue to meet their obligations (or with respect to equity-type securities,
the investment value will recover to its cost basis). The Company has no current
plans to sell these securities and has the ability to hold them to maturity. If
the Company concludes in future periods that the unrealized loss is other than
temporary, a charge to earnings would be recognized.
Structured Securities
At June 30, 2007, fixed maturity investments included $5.7 billion of
structured securities (or 25 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; relative changes in home price values; 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
yields 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
69
CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
For structured and asset-backed securities included in actively managed
fixed maturities that were purchased at a discount or premium, we recognize
investment income using an effective yield based on anticipated future
prepayments and the estimated final maturity of the securities. Actual
prepayment experience is periodically reviewed and effective yields are
recalculated when differences arise between the prepayments originally
anticipated and the actual prepayments received and currently anticipated. For
credit-sensitive and certain prepayment-sensitive structured and asset-backed
securities (which, in the aggregate, represent approximately 20 percent of the
total estimated fair value of these securities), the effective yield is
recalculated when changes in assumptions are made, and reflected in our income
on a prospective basis. For all other structured and asset-backed securities,
the effective yield is recalculated when changes in assumptions are made, and
reflected in our income on a retrospective basis. Under this method, the
amortized cost basis of the investment in the securities is adjusted to the
amount that would have existed had the new effective yield been applied since
the acquisition of the securities. Such adjustments were not significant in the
first six months of 2007.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral, at June 30, 2007 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 153.8 $ 153.0 $ 148.5
4 percent - 5 percent............................................................... 824.7 792.1 769.6
5 percent - 6 percent............................................................... 3,935.3 3,871.1 3,754.8
6 percent - 7 percent............................................................... 897.5 888.0 870.5
7 percent - 8 percent............................................................... 107.2 109.6 108.9
8 percent and above................................................................. 24.6 25.1 25.4
-------- -------- --------
Total structured securities (a).............................................. $5,943.1 $5,838.9 $5,677.7
======== ======== ========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $56.4 million and $55.9 million,
respectively.
</FN>
The amortized cost and estimated fair value of structured securities at
June 30, 2007, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
------------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- --------- ------ ----------
Pass-throughs, sequential and targeted amortization classes............... $3,695.3 $3,587.9 16%
Planned amortization class and accretion-directed bonds................... 861.6 840.1 4
Commercial mortgage-backed securities..................................... 1,220.6 1,188.6 5
Other..................................................................... 61.4 61.1 -
-------- -------- --
Total structured securities (a).................................... $5,838.9 $5,677.7 25%
======== ======== ==
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $56.4 million and $55.9 million,
respectively.
</FN>
Pass-through securities, sequential and targeted amortization class
securities have unique 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
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CONSECO, INC. AND SUBSIDIARIES
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the underlying mortgage loans experience prepayments within certain estimated
ranges. Changes in prepayment rates are first absorbed by support or companion
classes, insulating 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.
Our investment portfolio includes mortgage-backed securities collateralized
by sub prime residential mortgage loans with a market value of $305 million and
a book value of $311 million at June 30, 2007. These securities represent 1.2
percent of our consolidated investment portfolio. Of these securities, $39
million (13 percent) were rated AAA, $66 million (21 percent) were rated AA,
$170 million (56 percent) were rated A, and $30 million (10 percent) were rated
BBB or below. None of these securities were downgraded or put on watch as part
of S&P's and Moody's recent rating announcements. Sub prime residential mortgage
securities issued in 2006 have experienced higher delinquency and foreclosure
rates than originally expected. The Company's investment portfolio includes sub
prime mortgage-backed securities issued over several years, primarily from 2003
to 2007. Securities issued in 2006 comprise $6.7 million (or less than .03
percent) of our consolidated investment portfolio.
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INVESTMENTS IN VARIABLE INTEREST ENTITY
Fall Creek CLO Ltd. ("Fall Creek") is a collateralized loan trust that was
established to issue securities and use the proceeds to invest in loans and
other permitted investments. The assets held by the trust are legally isolated
and are not available to the Company. The liabilities of Fall Creek will be
satisfied from the cash flows generated by the underlying loans, not from the
assets of the Company, which has no legal obligation to satisfy those
liabilities. Repayment of the principal balance of the investment borrowings of
Fall Creek begin in 2012 based on available cash flows from the assets and such
borrowings mature in 2017. At June 30, 2007 and December 31, 2006, our total
investment in Fall Creek was $48.7 million and $48.8 million, 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):
June 30, December 31,
2007 2006
---- ----
Assets:
Actively managed fixed maturities.................................................. $490.2 $454.5
Cash and cash equivalents - restricted............................................. 24.8 15.7
Accrued investment income.......................................................... 4.5 3.9
Other assets....................................................................... 7.2 7.5
------ ------
Total assets................................................................... $526.7 $481.6
====== ======
Liabilities:
Other liabilities.................................................................. $ 21.6 $ 26.8
Investment borrowings due to others................................................ 447.2 401.7
Investment borrowings due to the Company........................................... 47.0 47.0
------ ------
Total liabilities.............................................................. 515.8 475.5
------ ------
Equity:
Capital provided by the Company.................................................... 1.7 1.8
Capital provided by others......................................................... 4.4 4.7
Accumulated other comprehensive income (loss)...................................... .1 (2.1)
Retained earnings.................................................................. 4.7 1.7
------ ------
Total equity................................................................... 10.9 6.1
------ ------
Total liabilities and equity................................................... $526.7 $481.6
====== ======
Three months ended Six months ended
June 30, June 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Revenues:
Net investment income - deposit accounts............. $9.1 $5.4 $18.0 $ 9.9
Fee revenue and other income......................... .2 .1 .2 .1
---- ---- ----- -----
Total revenues................................... 9.3 5.5 18.2 10.0
---- ---- ----- -----
Expenses:
Interest expense..................................... 6.8 4.7 13.2 8.5
Other operating expenses............................. .2 .5 .3 .5
---- ---- ----- -----
Total expenses................................... 7.0 5.2 13.5 9.0
---- ---- ----- -----
Income before income taxes....................... $2.3 $ .3 $ 4.7 $ 1.0
==== ==== ===== =====
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CONSECO, INC. AND SUBSIDIARIES
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NEW ACCOUNTING STANDARDS
See "Recently Issued Accounting Standards" in the notes to consolidated
financial statements for a discussion of recently issued accounting standards.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our market risks, and the ways we manage them, are summarized in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", included in Conseco's Annual Report on Form 10-K for the year ended
December 31, 2006. There have been no material changes in the first six months
of 2007 to such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. Conseco's management,
under the supervision and with the participation of the Chief Executive Officer
and the Chief Financial Officer, evaluated the effectiveness of Conseco's
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended). Based on its evaluation,
and in light of the material weakness in internal control over financial
reporting identified as existing as of December 31, 2006, which is described in
our Annual Report on Form 10-K, Item 9A, the Chief Executive Officer and Chief
Financial Officer concluded that, as of June 30, 2007, Conseco's disclosure
controls and procedures were not effective.
As disclosed in our 2006 Annual Report on Form 10-K, 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 control over the actuarial reporting process related to the
design of controls to ensure the completeness and accuracy of certain inforce
policies in our Bankers Life segment, Conseco Insurance Group segment, and Other
Business in Run-off segment. This material weakness 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 and the
quarter ended March 31, 2007.
A material weakness is a deficiency, or a combination of deficiencies, in
internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of the Company's annual or interim
financial statements will not be prevented or detected on a timely basis.
The Company is actively engaged in the implementation of remediation
efforts to address the material weakness in internal control over financial
reporting. These remediation efforts are outlined in our 2006 Annual Report on
Form 10-K and further remediation developments will be described in future
filings with the SEC. 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.
Changes to Internal Controls and Procedures for Financial Reporting. We
have implemented several initiatives to streamline our administrative procedures
and improve our actuarial valuation systems at our insurance subsidiaries. Our
efforts include improvements to our policy administrative procedures and
significant system conversions. Although we did not implement any significant
new systems in the first six months of 2007, we expect to implement additional
system conversions in the future that we believe 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.
There were no other changes in the Company's internal control over
financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange
Act of 1934) during the six months ended June 30, 2007, that have materially
affected, or are reasonably likely to materially affect, Conseco's internal
controls over financial reporting.
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CONSECO, INC. AND SUBSIDIARIES
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Information required for Part II, Item 1 is incorporated by reference to
the discussion under the heading "Litigation and Other Legal Proceedings" in the
footnotes to our consolidated financial statements included in Part I, Item 1 of
this Form 10-Q.
ITEM 1A. RISK FACTORS.
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors could
have a material adverse effect on the business, financial condition or results
of operations of Conseco. Refer to "Risk Factors" in Conseco's Annual Report on
Form 10-K for the year ended December 31, 2006, for further discussion of such
risk factors. There have been no material changes in the first six months of
2007 to such risks.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
Issuer Purchases of Equity Securities
Total number of Maximum number (or
shares (or units) approximate dollar value)
Total Average price purchased as part of shares (or units) that
number of shares paid per share of publicly announced may yet be purchased
Period (or units)(a) (or unit) plans or programs under the plans or programs
------ ---------- --------- ----------------- ---------------------------
(dollars in millions)
April 1 through
April 30.......... - $ - - $320.4
May 1 through
May 31............ 9,019 18.20 - 320.4
June 1 through
June 30........... 3,032 20.96 - 320.4
------
Total................. 12,051 18.89 - 320.4
======
<FN>
- ------------
(a) The Company purchased 1,472 and 3,032 shares of its common stock in May and
June 2007, respectively, in connection with employee benefit compensation
plans. The Company also purchased 7,547 shares of its common stock in May
2007 in connection with a litigation settlement. Such purchases are not
included against the maximum number of shares that may be purchased as part
of our publicly announced share repurchase program.
</FN>
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
At the Company's annual meeting on May 22, 2007, the shareholders elected
ten directors to serve terms expiring at next year's annual meeting. The results
of the voting were as follows (there were no broker non-votes):
For Withheld
--- --------
Debra J. Perry................................ 137,021,171 842,233
Philip R. Roberts............................. 137,002,533 860,871
Michael T. Tokarz............................. 135,069,962 2,793,442
R. Glenn Hilliard............................. 137,000,084 863,320
Michael S. Shannon............................ 136,992,652 870,752
Neal C. Schneider............................. 136,222,103 1,641,301
John G. Turner................................ 136,986,192 877,212
C. James Prieur............................... 136,998,169 865,235
Donna A. James................................ 136,978,663 884,741
Doreen A. Wright.............................. 136,949,040 914,364
At the annual meeting, the shareholders also approved the following
proposal:
For Against Abstentions
--- ------- -----------
To ratify the appointment of
PricewaterhouseCoopers LLP
as the Company's independent
registered public accounting
firm for 2007.............................. 137,785,142 45,852 32,411
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CONSECO, INC. AND SUBSIDIARIES
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ITEM 6. EXHIBITS.
3.2 Amended and Restated Bylaws of Conseco, Inc. incorporated by
reference to Exhibit 3.2 of our Current Report on Form 8-K
filed April 27, 2007.
10.1 Amendment No. 1 to the Second Amended and Restated Credit
Agreement dated as of June 12, 2007 among Conseco, Inc.,
Bank of America, N.A., as agent, JP 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 June 15, 2007.
10.32 Employment Agreement dated as of April 23, 2007 between
Conseco, Inc. and Edward J. Bonach, incorporated by
reference to Exhibit 10.32 of our Current Report on Form 8-K
filed April 27, 2007.
10.33 Employment Agreement dated as of May 8, 2007 between Conseco
Services, LLC and Mark E. Alberts.
10.34 Coinsurance and Administration Agreement between Conseco
Insurance Company and Reassure America Life Insurance
Company.
12.1 Computation of Ratio of Earnings to Fixed Charges and
Preferred Dividends.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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CONSECO, INC. AND SUBSIDIARIES
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: August 9, 2007 By: /s/ Edward J. Bonach
--------------------
Edward J. Bonach
Executive Vice President and
Chief Financial Officer
(authorized officer and principal
financial officer)
77