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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 September 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 October 26, 2007: 186,356,981
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of September 30, 2007 and December 31, 2006.............................. 3
Consolidated Statement of Operations for the three and nine months ended
September 30, 2007 and 2006......................................................................... 5
Consolidated Statement of Shareholders' Equity for the nine months ended
September 30, 2007 and 2006......................................................................... 6
Consolidated Statement of Cash Flows for the nine months ended September 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............................................. 31
Overview ............................................................................................. 32
Critical Accounting Policies ......................................................................... 33
Results of Operations................................................................................. 36
Premium Collections................................................................................... 56
Liquidity and Capital Resources....................................................................... 61
Investments........................................................................................... 67
Investment in Variable Interest Entity................................................................ 73
New Accounting Standards ............................................................................. 74
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................................... 74
Item 4. Controls and Procedures............................................................................... 74
PART II - OTHER INFORMATION
Item 1. Legal Proceedings .................................................................................... 76
Item 1A. Risk Factors.......................................................................................... 76
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds........................................... 76
Item 5. Other Information..................................................................................... 76
Item 6. Exhibits ............................................................................................. 77
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
September 30, December 31,
2007 2006
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
September 30, 2007 - $21,073.6; December 31, 2006 - $22,946.9)....................... $20,511.7 $22,802.9
Investments to be transferred pursuant to an annuity coinsurance transaction at
fair value (amortized cost: September 30, 2007 - $2,564.1).......................... 2,564.1 -
Equity securities at fair value (cost: September 30, 2007 - $34.3;
December 31, 2006 - $23.9)........................................................... 35.5 24.8
Mortgage loans......................................................................... 1,914.3 1,642.2
Policy loans........................................................................... 389.5 412.5
Trading securities..................................................................... 691.2 675.2
Other invested assets ................................................................. 180.5 178.8
--------- ---------
Total investments.................................................................. 26,286.8 25,736.4
Cash and cash equivalents:
Unrestricted........................................................................... 392.3 385.9
Restricted............................................................................. 25.8 24.0
Accrued investment income................................................................. 346.3 344.5
Value of policies inforce at the Effective Date........................................... 1,740.2 2,137.2
Cost of policies produced................................................................. 1,359.4 1,106.7
Reinsurance receivables................................................................... 3,666.2 850.8
Income tax assets, net.................................................................... 1,992.3 1,786.9
Assets held in separate accounts.......................................................... 28.3 28.9
Other assets.............................................................................. 324.0 316.0
--------- ---------
Total assets....................................................................... $36,161.6 $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
September 30, December 31,
2007 2006
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $13,214.0 $13,018.0
Traditional products................................................................... 12,445.1 12,094.1
Claims payable and other policyholder funds............................................ 901.4 832.3
Liabilities related to separate accounts............................................... 28.3 28.9
Other liabilities........................................................................ 595.6 611.8
Liability for assets to be transferred pursuant to an annuity coinsurance transaction.... 2,564.1 -
Investment borrowings.................................................................... 913.7 418.3
Notes payable - direct corporate obligations............................................. 1,195.7 1,000.8
--------- ---------
Total liabilities.................................................................. 31,857.9 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: September 30, 2007 - 186,345,515; December 31, 2006 - 152,165,108).... 1.9 1.5
Additional paid-in capital............................................................... 4,094.6 3,473.2
Accumulated other comprehensive loss..................................................... (316.0) (72.6)
Retained earnings........................................................................ 523.2 643.2
--------- ---------
Total shareholders' equity......................................................... 4,303.7 4,713.1
--------- ---------
Total liabilities and shareholders' equity......................................... $36,161.6 $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 Nine months ended
September 30, September 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Revenues:
Insurance policy income................................. $ 822.0 $ 748.5 $2,352.6 $2,242.9
Net investment income:
General account assets................................ 392.6 360.6 1,152.7 1,069.2
Policyholder and reinsurer accounts and other
special-purpose portfolios.......................... 3.2 26.2 50.4 26.6
Net realized investment losses.......................... (51.1) (21.8) (114.3) (28.6)
Fee revenue and other income............................ 8.5 4.8 17.5 14.0
-------- -------- -------- --------
Total revenues...................................... 1,175.2 1,118.3 3,458.9 3,324.1
-------- -------- -------- --------
Benefits and expenses:
Insurance policy benefits............................... 888.8 772.6 2,621.0 2,204.6
Interest expense........................................ 33.3 17.8 84.8 51.3
Amortization............................................ 93.3 104.2 325.8 320.4
Costs related to a litigation settlement................ 16.4 - 64.4 174.7
Loss related to an annuity coinsurance transaction...... 76.5 - 76.5 -
Other operating costs and expenses...................... 153.7 147.0 449.7 430.2
-------- -------- -------- --------
Total benefits and expenses......................... 1,262.0 1,041.6 3,622.2 3,181.2
-------- -------- -------- --------
Income (loss) before income taxes................... (86.8) 76.7 (163.3) 142.9
Income tax expense (benefit) on period income.............. (33.1) 28.3 (60.1) 52.2
-------- -------- -------- --------
Net income (loss)................................... (53.7) 48.4 (103.2) 90.7
Preferred stock dividends.................................. - 9.5 14.1 28.5
-------- -------- -------- --------
Net income (loss) applicable to common stock........ $ (53.7) $ 38.9 $ (117.3) $ 62.2
======== ======== ======== ========
Earnings per common share:
Basic:
Weighted average shares outstanding................... 187,733,000 151,663,000 169,270,000 151,566,000
=========== =========== =========== ===========
Net income (loss)..................................... $(.29) $.26 $(.69) $.41
===== ==== ===== ====
Diluted:
Weighted average shares outstanding................... 187,733,000 152,529,000 169,270,000 152,547,000
=========== =========== =========== ===========
Net income (loss)..................................... $(.29) $.26 $(.69) $.41
===== ==== ===== ====
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........................................ (103.2) - - - (103.2)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $136.1)............................ (243.9) - - (243.9) -
--------
Total comprehensive loss.................... (347.1)
Cost of shares acquired........................... (64.3) - (64.3) - -
Stock option and restricted stock plans........... 12.3 - 12.3 - -
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, September 30, 2007.......................... $4,303.7 $ - $4,096.5 $(316.0) $ 523.2
======== ======= ======== ======= =======
Balance, January 1, 2006............................. $4,519.8 $ 667.8 $3,195.6 $ 71.7 $ 584.7
Comprehensive loss, net of tax:
Net income...................................... 90.7 - - - 90.7
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $80.5)............................. (143.5) - - (143.5) -
--------
Total comprehensive loss.................... (52.8)
Reduction of deferred income tax valuation
allowance....................................... 260.0 - 260.0 - -
Stock option and restricted stock plans........... 12.1 - 12.1 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date............................................ 2.1 - 2.1 - -
Dividends on preferred stock...................... (28.5) - - - (28.5)
-------- ------- -------- ------- -------
Balance, September 30, 2006.......................... $4,712.7 $ 667.8 $3,469.8 $ (71.8) $ 646.9
======== ======= ======== ======= =======
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Nine months ended
September 30,
----------------------
2007 2006
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 2,088.9 $ 1,975.4
Net investment income................................................................. 1,206.8 1,109.7
Fee revenue and other income.......................................................... 17.5 14.0
Net sales (purchases) of trading securities........................................... (135.5) 28.3
Insurance policy benefits............................................................. (1,682.7) (1,662.1)
Interest expense...................................................................... (80.2) (45.1)
Policy acquisition costs.............................................................. (368.0) (367.6)
Other operating costs................................................................. (495.5) (395.7)
Taxes................................................................................. (1.9) 1.8
--------- ---------
Net cash provided by operating activities........................................... 549.4 658.7
--------- ---------
Cash flows from investing activities:
Sales of investments.................................................................. 5,069.6 4,082.8
Maturities and redemptions of investments............................................. 817.6 840.5
Purchases of investments.............................................................. (6,843.2) (5,623.8)
Change in restricted cash............................................................. (1.8) 20.3
Other................................................................................. (15.0) (2.6)
--------- ---------
Net cash used by investing activities .............................................. (972.8) (682.8)
--------- ---------
Cash flows from financing activities:
Issuance of notes payable............................................................. 200.0 -
Issuance of common stock.............................................................. 3.4 1.0
Payments to repurchase common stock................................................... (64.3) -
Payments on notes payable............................................................. (5.6) (46.3)
Amounts received for deposit products................................................. 1,440.2 1,547.2
Withdrawals from deposit products..................................................... (1,620.3) (1,516.0)
Investment borrowings................................................................. 495.4 65.6
Dividends paid on preferred stock..................................................... (19.0) (28.5)
--------- ---------
Net cash provided by financing activities......................................... 429.8 23.0
--------- ---------
Net increase (decrease) in cash and cash equivalents.............................. 6.4 (1.1)
Cash and cash equivalents, beginning of period........................................... 385.9 237.8
--------- ---------
Cash and cash equivalents, end of period................................................. $ 392.3 $ 236.7
========= =========
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.
OUT-OF-PERIOD ADJUSTMENTS
During the three months ended September 30, 2007, we recorded the net
effects of certain out-of-period adjustments which decreased our net loss by
$1.2 million and diluted earnings per share by one cent.
During the nine months ended September 30, 2007, we recorded the net
effects of certain out-of-period adjustments which decreased our net loss by
$9.9 million and diluted earnings per share by six cents.
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.
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Certain of our trading securities are designed in an effort to offset the
portion of the income statement volatility caused by the effect of interest rate
fluctuations on the value of certain 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 policy benefits for these products. Our trading securities totaled
$691.2 million and $675.2 million at September 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 September 30, 2007 and December
31, 2006, were as follows (dollars in millions):
September 30, December 31,
2007 2006
---- ----
Net unrealized depreciation on investments............................................ $(553.3) $(136.3)
Adjustment to value of policies inforce at the Effective Date......................... 23.1 20.1
Adjustment to cost of policies produced............................................... 46.3 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........................... (9.2) -
Deferred income tax asset............................................................. 177.1 41.2
------- -------
Accumulated other comprehensive loss............................................. $(316.0) $ (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 Nine months ended
September 30, September 30,
-------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Net income (loss).............................................. $(53.7) $48.4 $(103.2) $ 90.7
Preferred stock dividends...................................... - (9.5) (14.1) (28.5)
------ ----- ------- ------
Net income (loss) applicable to common stock
for basic and diluted earnings per share................ $(53.7) $38.9 $(117.3) $ 62.2
====== ===== ======= ======
Shares:
Weighted average shares outstanding
for basic earnings per share.............................. 187,733 151,663 169,270 151,566
Effect of dilutive securities on weighted average shares:
Stock option and restricted stock plans................... - 866 - 981
------- ------- ------- -------
Weighted average shares outstanding for diluted
earnings per share........................................ 187,733 152,529 169,270 152,547
======= ======= ======= =======
There were no dilutive common stock equivalents during the three and nine
months ended September 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 (related to the period prior to their conversion) are not added
back to net income
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(loss) applicable to common stock. The potentially dilutive shares related to
the Class B mandatorily convertible preferred stock were not dilutive during the
three and nine months ended September 30, 2006, but the common stock equivalents
related to stock option and restricted stock plans were dilutive.
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and nine months ended September 30, 2007 and 2006, because doing so would
have been antidilutive in such periods (shares in thousands).
Three months ended Nine months ended
September 30, September 30,
------------------- ------------------
2007 2006 2007 2006
---- ---- ---- ----
Equivalent common shares that were antidilutive
during the period:
Class B mandatorily convertible preferred stock...... - 32,565 19,112 31,515
Stock option and restricted stock plans.............. 127 - 173 -
--- ------ ------ ------
Antidilutive equivalent common shares............. 127 32,565 19,285 31,515
=== ====== ====== ======
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 12.0
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 nine months ended September 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 nine months ended
September 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 Nine months ended
September 30, September 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities......................................... $ 16.4 $ 15.8 $ 48.7 $ 45.8
Supplemental health............................... 397.3 310.8 1,065.0 927.8
Life.............................................. 43.7 39.5 129.7 115.1
Other............................................. 16.2 24.0 66.2 69.0
Net investment income (a).............................. 144.2 134.4 440.2 380.3
Fee revenue and other income (a)....................... 3.8 1.4 7.7 4.8
Net realized investment losses (a)..................... (1.3) (5.5) (8.4) (8.9)
-------- -------- -------- --------
Total Bankers Life revenues................... 620.3 520.4 1,749.1 1,533.9
-------- -------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities......................................... 5.0 3.7 11.8 12.2
Supplemental health............................... 147.5 151.0 446.0 462.2
Life.............................................. 84.2 88.6 252.4 266.7
Other............................................. 2.0 2.6 6.8 8.6
Net investment income (a).............................. 181.2 189.3 559.1 532.6
Fee revenue and other income (a)....................... .1 .8 .4 1.1
Net realized investment losses (a)..................... (47.3) (4.4) (102.0) (13.5)
-------- -------- -------- --------
Total Conseco Insurance Group revenues........ 372.7 431.6 1,174.5 1,269.9
-------- -------- -------- --------
Colonial Penn:
Insurance policy income:
Supplemental health............................... 2.3 2.7 7.3 8.5
Life.............................................. 30.0 26.0 83.2 71.6
Other............................................. .2 .4 .7 1.0
Net investment income (a).............................. 9.4 9.2 28.3 28.0
Fee revenue and other income (a)....................... .2 .1 .5 .4
Net realized investment gains (losses) (a)............. .3 (.9) .4 .8
-------- -------- -------- --------
Total Colonial Penn revenues.................. 42.4 37.5 120.4 110.3
-------- -------- -------- --------
Other Business in Run-off:
Insurance policy income - supplemental health.......... 77.2 83.4 234.8 254.4
Net investment income (a).............................. 48.8 44.6 143.4 133.9
Fee revenue and other income (a)....................... .1 .1 .3 .3
Net realized investment gains (losses) (a)............. 1.9 (10.8) 1.6 (6.8)
-------- -------- -------- --------
Total Other Business in Run-off revenues...... 128.0 117.3 380.1 381.8
-------- -------- -------- --------
Corporate:
Net investment income.................................. 12.2 9.3 32.1 21.0
Fee and other income................................... 4.3 2.4 8.6 7.4
Net realized investment losses(a)...................... (4.7) (.2) (5.9) (.2)
-------- -------- -------- --------
Total corporate revenues...................... 11.8 11.5 34.8 28.2
-------- -------- -------- --------
Total revenues................................ 1,175.2 1,118.3 3,458.9 3,324.1
-------- -------- -------- --------
(continued on next page)
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits.............................. $ 459.5 $ 365.0 $1,252.2 $1,070.8
Amortization........................................... 49.9 52.2 201.0 165.4
Interest expense on investment borrowings.............. - - - .1
Other operating costs and expenses..................... 46.5 40.1 128.7 116.0
-------- -------- -------- --------
Total Bankers Life expenses....................... 555.9 457.3 1,581.9 1,352.3
-------- -------- -------- --------
Conseco Insurance Group:
Insurance policy benefits.............................. 296.7 268.6 824.5 769.5
Amortization........................................... 32.7 42.0 92.9 129.7
Interest expense on investment borrowings.............. 6.2 .1 11.5 .6
Costs related to a litigation settlement............... 8.2 - 32.2 165.8
Loss related to an annuity coinsurance transaction..... 76.5 - 76.5 -
Other operating costs and expenses..................... 76.3 66.5 212.7 204.9
-------- -------- -------- --------
Total Conseco Insurance Group expenses............ 496.6 377.2 1,250.3 1,270.5
-------- -------- -------- --------
Colonial Penn:
Insurance policy benefits.............................. 26.6 25.6 76.7 69.7
Amortization........................................... 5.1 4.4 14.8 12.7
Other operating costs and expenses..................... 3.4 3.8 10.2 10.9
-------- -------- -------- --------
Total Colonial Penn expenses...................... 35.1 33.8 101.7 93.3
-------- -------- -------- --------
Other Business in Run-off:
Insurance policy benefits.............................. 106.0 113.4 467.6 294.6
Amortization........................................... 5.6 5.6 17.1 12.6
Other operating costs and expenses..................... 17.4 22.1 60.8 66.0
-------- -------- -------- --------
Total Other Business in Run-off expenses.......... 129.0 141.1 545.5 373.2
-------- -------- -------- --------
Corporate:
Interest expense on corporate debt..................... 20.2 12.5 53.2 36.9
Interest expense on variable interest entity........... 6.9 5.2 20.1 13.7
Costs related to a litigation settlement............... 8.2 - 32.2 8.9
Other operating costs and expenses..................... 10.1 14.5 37.3 32.4
-------- -------- -------- --------
Total corporate expenses.......................... 45.4 32.2 142.8 91.9
-------- -------- -------- --------
Total expenses.................................... 1,262.0 1,041.6 3,622.2 3,181.2
-------- -------- -------- --------
Income (loss) before income taxes:
Bankers Life...................................... 64.4 63.1 167.2 181.6
Conseco Insurance Group........................... (123.9) 54.4 (75.8) (.6)
Colonial Penn..................................... 7.3 3.7 18.7 17.0
Other Business in Run-off......................... (1.0) (23.8) (165.4) 8.6
Corporate operations.............................. (33.6) (20.7) (108.0) (63.7)
-------- -------- -------- --------
Income (loss) before income taxes............. $ (86.8) $ 76.7 $ (163.3) $ 142.9
======== ======== ======== ========
<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 the amount of increase in the value 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 typically 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 $19.9 million and $6.7 million in the nine months
ended September 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 $94.7 million and $93.7 million at
September 30, 2007 and December 31, 2006, respectively. We classify these
instruments as other invested assets. Pursuant to the annuity coinsurance
agreement described below, we continue to hold $30 million of these options for
the benefit of the assuming company until such options expire. All future cash
flows (including any increases (decreases) in fair value) from these options are
transferred to the assuming company. Such options are included in other invested
assets, and we have established a liability for the amount due to the assuming
company upon their expiration, based on the September 30, 2007 estimated market
value of these options.
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 $350.8 million and $275.3
million at September 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
attributable to interest rate fluctuations will generally offset the portion of
the change in the value of the embedded derivative provided corporate spreads
remain constant.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At September 30, 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 $2.5 million and $9.6 million at September 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 attributable to
interest rate fluctuations will generally offset the change in value of the
embedded derivatives provided corporate spreads remain constant.
REINSURANCE
The cost of reinsurance ceded totaled $156.0 million and $165.0 million in
the first nine 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 $168.1
million and $176.0 million in the first nine months of 2007 and 2006,
respectively.
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 $220.0 million and $103.4 million in the first nine months of
2007 and 2006, respectively. Reinsurance premiums included amounts assumed
pursuant to quota-share reinsurance agreements with Coventry Health Care
("Coventry") of $181.4 million and $61.3 million in the first nine months of
2007 and 2006, respectively. The increase in premiums assumed under these
agreements in 2007 resulted from two new agreements: (i) we are assuming
approximately 50 percent of the Private-Fee-For-Service ("PFFS") business
marketed by our career agents pursuant to a marketing and distribution agreement
with Coventry effective January 1, 2007; and (ii) we are assuming 50 percent of
the PFFS business written by Coventry under one large group policy effective
July 1, 2007.
See the note entitled "Accounting for Derivatives" for a discussion of the
derivative embedded in the payable related to certain modified coinsurance
agreements.
COINSURANCE TRANSACTION
On October 12, 2007, we completed a transaction to coinsure 100 percent of
most of the older inforce equity-indexed annuity and fixed annuity business of
three of our insurance subsidiaries with Reassure America Life Insurance Company
("REALIC"), a subsidiary of Swiss Re Life & Health America Inc. The transaction
was recorded in our financial statements on September 28, 2007, the date the
parties were bound by the coinsurance agreement and all regulatory approvals had
been obtained. In the transaction, REALIC: (i) paid a ceding commission of $76.5
million; and (ii) assumed the investment and persistency risk of these policies.
Our insurance subsidiaries ceded approximately $2.8 billion of policy and other
reserves to REALIC, as well as transferred the invested assets backing these
policies on October 12, 2007. Our insurance subsidiaries remain primarily liable
to the policyholders in the event REALIC does not fulfill its obligations under
the agreements. The coinsurance transaction has an effective date of January 1,
2007.
Pursuant to the terms of the annuity coinsurance agreement, the ceding
commission was based on the January 1, 2007 value of the assets and liabilities
related to the ceded block. As previously disclosed, the loss on the annuity
coinsurance transaction (calculated based on the January 1, 2007 values) was
approximately $65 million after income taxes. The earnings (loss) after income
taxes on the business from January 1, 2007 through September 28, 2007, resulted
in increases (decreases) to the loss calculated as of January 1, 2007. Such
after-tax earnings (loss) include the market value declines on invested assets
transferred to the reinsurer occurring during the first three quarters of 2007.
The following summarizes the profits and losses recognized on this business
during the three and nine months ended September 30, 2007 (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
2007 2007
---- ----
Net earnings on the block before tax...................................... $ 1.2 $ 17.0
Realized investment losses, net of amortization of insurance intangibles.. (11.5) (40.6)
Loss related to an annuity coinsurance transaction........................ (76.5) (76.5)
------ ------
Net loss before income taxes.............................................. (86.8) (100.1)
Income tax benefit........................................................ 30.4 35.0
------ ------
Net loss related to coinsured business.................................... $(56.4) $(65.1) (a)
====== ======
<FN>
- ------------
(a) Amount represents the net after-tax loss recognized on the annuity
coinsurance transaction during the nine months ended September 30, 2007,
including the earnings and losses on the block during that period and the
loss recognized upon completion of the transaction. Since the loss on the
transaction was based on January 1, 2007 values, this amount is comparable
to the previously disclosed loss we estimated based on January 1, 2007
values.
</FN>
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
INCOME TAXES
The components of income tax expense (benefit) were as follows (dollars in
millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Current tax expense............................................ $ .8 $ - $ 2.5 $ -
Deferred tax provision (benefit)............................... (33.9) 28.3 (62.6) 52.2
------ ----- ------ -----
Income tax expense (benefit) on period income......... $(33.1) $28.3 $(60.1) $52.2
====== ===== ====== =====
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Nine months ended
September 30,
-----------------------
2007 2006
---- ----
U.S. statutory corporate rate............................................................ (35.0)% 35.0%
Other nondeductible expense (benefit).................................................... (.5) 1.3
State taxes.............................................................................. (1.3) .8
Provision for tax issues, tax credits and other.......................................... - (.6)
----- ----
Effective tax rate.............................................................. (36.8)% 36.5%
===== ====
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
September 30, December 31,
2007 2006
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries.................................................... $ 850.3 $ 800.3
Non-life companies............................................................. 849.1 780.0
Tax credits....................................................................... 14.2 14.2
Capital loss carryforwards........................................................ 407.6 391.7
Deductible temporary differences:
Insurance liabilities.......................................................... 1,027.0 1,320.0
Unrealized depreciation of investments......................................... 177.1 41.2
Reserve for loss on loan guarantees............................................ 70.3 145.8
Other.......................................................................... 86.0 -
-------- --------
Gross deferred tax assets.................................................... 3,481.6 3,493.2
-------- --------
Deferred tax liabilities:
Actively managed fixed maturities................................................. (4.1) (42.2)
Value of policies inforce at the Effective Date and cost of policies produced..... (710.7) (764.8)
Other............................................................................. - (117.6)
-------- --------
Gross deferred tax liabilities............................................... (714.8) (924.6)
-------- ---------
Net deferred tax assets before valuation allowance........................... 2,766.8 2,568.6
Valuation allowance................................................................... (776.5) (777.8)
-------- --------
Net deferred tax assets...................................................... 1,990.3 1,790.8
Current income taxes prepaid (accrued)................................................ 2.0 (3.9)
-------- --------
Income tax assets, net....................................................... $1,992.3 $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 addition, we update our previous
analysis of the adequacy of the valuation allowance in the fourth quarter of
each year, following the completion of the Company's annual operating plan. 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
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
valuation allowance of $776.5 million at September 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 deferred tax asset and assessing the effects of limitations or
interpretations on the value of such component to be fully recognized in the
future. During the third quarter of 2007, we reduced the valuation allowance by
$1.3 million to reflect our determination that certain tax loss carryforwards
will not be utilized.
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 $445 million (including $303 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 $2.0 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 September 30, 2007, we had $4.8 billion of NOLs and $1.2 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....... $ - $ - $ 450.7 $ 450.7 $ 450.7 $ -
2008 ...... - - 583.7 583.7 583.7 -
2009....... - 1.0 86.2 87.2 1.0 86.2
2010....... - 2.0 - 2.0 2.0 -
2011....... - .3 - .3 .3 -
2012....... - .4 44.1 44.5 .4 44.1
2016....... 17.0 - - 17.0 17.0 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6 (a) 9.0 - 2,179.6 53.1 2,126.5
2020....... - 2.5 - 2.5 2.5 -
2021....... 62.7 - - 62.7 - 62.7
2022....... 145.8 .6 - 146.4 - 146.4
2023....... - 2,114.7 (a) - 2,114.7 71.7 2,043.0
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 1.6 - 1.6 - 1.6
2027....... - 172.0 - 172.0 - 172.0
-------- -------- -------- -------- -------- --------
Total...... $2,429.3 $2,426.1 $1,164.7 $6,020.1 $1,215.6 $4,804.5
======== ======== ======== ======== ======== ========
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
<FN>
- -------------------
(a) The allocation of the NOLs summarized above assumes the IRS does not take
an adverse position in the future regarding the tax position we plan to
take in our tax returns with respect to the allocation of cancellation of
indebtedness income. If the IRS disagrees with the tax position we plan to
take with respect to the allocation of cancellation of indebtedness income,
and their position prevails, 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 September 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 nine months of 2007. The liability for accrued
interest and penalties was not significant at September 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 2004 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 $1.4 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital if realized.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of September 30, 2007 and December 31, 2006 (dollars in millions):
September 30, December 31,
2007 2006
---- ----
3.50% convertible debentures............................................................ $ 330.0 $ 330.0
Secured credit agreement................................................................ 867.7 673.3
Unamortized discount on convertible debentures.......................................... (2.0) (2.5)
-------- --------
Direct corporate obligations....................................................... $1,195.7 $1,000.8
======== ========
18
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 in an
aggregate amount of up to $300 million over the term of the facility
(of which only $200 million may be paid in the year commencing 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 nine months of 2007, we made scheduled principal payments
totaling $5.6 million on our Second Amended Credit Facility. There were $7.1
million and $6.2 million of unamortized issuance costs (classified as other
assets) related to our Second Amended Credit Facility at September 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 September 30, 2007, the
interest rate on our Second Amended Credit Facility was 7.1 percent.
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
Remainder of 2007............................. $ 2.2
2008.......................................... 8.7
2009.......................................... 8.7
2010.......................................... 338.8
2011.......................................... 8.7
Thereafter.................................... 830.6
--------
$1,197.7
========
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. As described in the
Second Amended Credit Facility, the Company may reinvest any portion of the
proceeds from asset sales in assets useful to its business, subject to certain
restrictions defined in the Second Amended Credit Facility. The Company intends
to use the majority of the ceding commission received from REALIC in the
coinsurance transaction, as further described in the note to the financial
statements
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
entitled "Coinsurance Transaction", to fund the recapture of a block of
traditional life insurance inforce, as further described in the note to the
consolidated financial statements entitled "Subsequent Event".
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 was 20.7 percent at September 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 September
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 September
30, 2007); and (iv) a combined statutory capital and surplus level of greater
than $1,270.0 million (combined statutory capital and surplus at September 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 September 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 year beginning June
12, 2007). As further discussed in the note to the consolidated financial
statements entitled "Changes in Common Stock", we repurchased 4.0 million shares
of our common stock for $64.3 million in the first nine months of 2007 (of
which, $34.7 million was paid in the year beginning June 12, 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 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 September 30, 2007, the carrying value of the FHLBI common stock
was $22.5 million. Advances from the FHLBI (the "Advances") totaled $450.0
million as of September 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 $517.7 million at September 30, 2007, which are maintained in a
custodial account for the benefit of the FHLBI. Conseco Life recognized interest
expense of $10.8 million in the first nine 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 September 30, 2007
-------- ---- ---------------------
$100.0 February 2012 Variable rate - 5.349%
100.0 March 2012 Variable rate - 5.350%
54.0 May 2012 Variable rate - 5.494%
146.0 November 2015 Fixed rate - 5.300%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 5.420%
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 $145.0 million at September 30, 2007, are matched with various
interest rate swaps, which are intended to convert the cash flows from 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. The change in value of the interest rate swaps was $(4.3)
million in the three month period ended September 30, 2007, and $(.7) million in
the nine month period ended September 30, 2007. The change in value of the
trading securities was $.4 million in the three month period ended September 30,
2007, and $(2.8) million in the nine month period ended September 30, 2007.
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 September 30, 2007, the
weighted average fixed rate being paid was 6.12 percent and the weighted average
variable rate being received was 6.18 percent.
At September 30, 2007, investment borrowings consisted of: (i) Advances of
$450.0 million; (ii) $452.4 million of securities issued to other entities by a
variable interest entity which is consolidated in our financial statements; and
(iii) other borrowings of $11.3 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............................... (3,975)
Conversion of preferred stock into common shares................... 37,809
Stock options exercised............................................ 208
Shares issued under employee benefit compensation plans............ 147 (a)
Other.............................................................. (8)
-------
Balance at September 30, 2007.......................................... 186,346
=======
<FN>
- -------------
(a) Such amount was reduced by 11 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 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
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 nine months of 2007, the Company repurchased an additional
2.8 million shares of its common stock for $39.6 million.
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 $40.1 million and $48.5 million during the nine
months ended September 30, 2007 and 2006, respectively. Amounts amortized
totaled $15.0 million and $14.1 million during the nine months ended September
30, 2007 and 2006, respectively. The unamortized balance of deferred sales
inducements at September 30, 2007 and December 31, 2006 was $140.1 million and
$115.0 million, respectively. The balance of insurance liabilities for
persistency bonus benefits was $266.3 million and $296.3 million at September
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, including insurance contracts, 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 have not yet determined whether we will elect the fair value option for
certain financial assets or liabilities; and therefore, we do not know the
impact, if any, 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 nine months ended
September 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 nine months of 2007. The liability for
accrued interest was not significant at September 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
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
remeasurement for any hybrid financial instrument that contains an embedded
derivative that otherwise would require bifurcation; (b) clarifies which
interest-only strips and principal-only strips are not subject to the
requirements of SFAS 133; (c) establishes a requirement to evaluate beneficial
interests in securitized financial assets to identify interests that are
freestanding derivatives or that are hybrid financial instruments that contain
an embedded derivative requiring bifurcation; (d) clarifies that concentrations
of credit risk in the form of subordination are not embedded derivatives; and,
(e) eliminates restrictions on a qualifying special-purpose entity's ability to
hold passive derivative financial instruments that pertain to beneficial
interests that are or contain a derivative financial instrument. The standard
also requires presentation within the financial statements that identifies those
hybrid financial instruments for which the fair value election has been applied
and information on the income statement impact of the changes in fair value of
those instruments. SFAS 155 was 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
were 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)
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
LITIGATION AND OTHER LEGAL PROCEEDINGS
Legal Proceedings
The Company and its subsidiaries are involved in various legal actions in
the normal course of business, in which claims for compensatory and punitive
damages are asserted, some for substantial amounts. Some of the pending matters
have been filed as purported class actions and some actions have been filed in
certain jurisdictions that permit punitive damage awards that are
disproportionate to the actual damages incurred. Although there can be no
assurances, at the present time the Company does not anticipate that the
ultimate liability from either pending or threatened legal actions, after
consideration of existing loss provisions, will have a material adverse effect
on the financial condition, operating results or cash flows of the Company. The
amounts sought in certain of these actions are often large or indeterminate and
the ultimate outcome of certain actions is difficult to predict. In the event of
an adverse outcome in one or more of these matters, the ultimate liability may
be in excess of the liabilities we have established and could have a material
adverse effect on our business, financial condition, results of operations and
cash flows. In addition, the resolution of pending or future litigation may
involve modifications to the terms of outstanding insurance policies, which
could adversely affect the future profitability of the related insurance
policies.
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. This motion was denied on
September 12, 2007. 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 $2.0 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
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 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. 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 began implementing the settlement with the
inforce and certain former policyholders in the third quarter of 2007.
We incurred total costs related to this litigation settlement of $267.2
million, including costs of $64.4 million and $174.7 million recognized in the
first nine months of 2007 and 2006, respectively (of which $16.4 million and nil
was recognized in the third quarters of 2007 and 2006, respectively). The costs
recognized in 2007 represent adjustments to our initial estimates based on the
ultimate cost of the settlement.
The implementation of the settlement includes enhanced benefits to the
inforce insurance policies, which eliminates the future estimated profits from
these policies in periods subsequent to the 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). This case was
settled in connection with the In Re Conseco Life Insurance Co. Cost of
Insurance Litigation, Cause No. MDL 1610 (Central District, California), as
further described above. 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
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
plaintiffs all of whom purport to have opted out of the In Re Conseco Life
Insurance Co. Cost of Insurance Litigation multi-district action. The complaint
alleges nondisclosure, breach of fiduciary duty, violations of HRS 480 (unfair
and/or deceptive business practices), declaratory and injunctive relief,
insurance bad faith, punitive damages, and seeks to impose alter ego liability.
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 States
District Court for the Northern District of Texas, transferred to California and
consolidated and coordinated with MDL 1610. This matter has been settled and the
case is expected to be 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.
The ultimate outcome of the cost of insurance lawsuits that have not been
settled 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 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 October 1, 2007, the court granted
the plaintiff's motion for class certification. On October 16, 2007, Bankers
Life and Casualty Company filed a petition for permission to appeal in the 7th
Circuit Court of Appeals. This matter has been placed on the June 2008 trial
calendar. 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
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
it was granted in part and denied in part. A motion to dismiss Conseco, Inc.,
Conseco Services, LLC, Conseco Marketing, LLC and 40|86 Advisors, Inc. was filed
on September 14, 2007, and we await a ruling on the motion. The court has not
yet made a determination whether the case should go forward as a class
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. The appellate briefing has been
concluded. 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.
On September 27, 2007, the court transferred this case to the State of
California for consolidation with the pending matter there. 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 parties have reached a tentative
settlement, subject to execution of detailed settlement documents. The amount
recognized as expense in 2007 related to the tentative settlement of this case
was not significant to our business, financial condition, results of operations
or cash flows.
On November 3, 2006, an action was filed in the U.S. District Court for the
Central District of California Ruth Ross v. Pioneer National Life Insurance
Company and Washington National Life Insurance Company, Case No. CV 06 7081. In
that case, the plaintiff alleges breach of contract, bad faith and violation of
California consumer protection laws in the handling of her claim for benefits
under a Washington National Life Insurance Company policy of long-term care
insurance. The Company paid out in excess of the $150,000 per occurrence maximum
benefit and declined to pay additional claims, but the plaintiff contends she
should receive the balance of a $250,000 lifetime maximum benefit. The parties
disagree as to whether the plaintiff's continuing confinement is caused by one
or more than one occurrence as defined under the policy. In her complaint, the
plaintiff claims loss of benefits of $.1 million, and compensatory damages for
mental anguish of $.9 million, together with punitive damages of $5 million plus
attorney fees, interest and costs of litigation. The parties were unable to
conclude the matter at a mediation which occurred June 22, 2007. The matter is
scheduled for jury trial February 5,
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
2008. The Company believes the claim is without merit and intends to defend it
vigorously. The outcome of the action cannot be predicted with certainty.
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.
The trial which was set for October 22, 2007, has been continued without date.
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 September 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 September 30, 2007, we estimated that
approximately $18.8 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, federal 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.
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
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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.
Conseco received a letter from Senator Grassley of the United States Senate
Finance Committee dated September 27, 2007 indicating his interest in learning
how long-term care insurance providers manage their policies, serve their
beneficiaries, and decide which claims to approve and which to deny. Senator
Grassley requested answers to questions regarding Conseco's policies and
practices and requested various documents. Representatives from Conseco
subsequently met with two of the Senator's staffers and reached an agreement on
the scope of the information requested. Conseco is in the process of providing
the information requested and intends to continue to fully cooperate with regard
to this inquiry.
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 35 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 litigation settlement described in
the section of this note entitled "Cost of Insurance Litigation".
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Nine months ended
September 30,
----------------------
2007 2006
---- ----
Cash flows from operating activities:
Net income (loss).................................................................... $(103.2) $ 90.7
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization and depreciation.................................................... 350.7 337.1
Income taxes..................................................................... (62.0) 54.0
Insurance liabilities............................................................ 674.6 275.0
Accrual and amortization of investment income.................................... 3.7 13.9
Deferral of policy acquisition costs............................................. (368.0) (367.6)
Net realized investment losses................................................... 114.3 28.6
Net sales (purchases) of trading securities...................................... (135.5) 28.3
Loss related to an annuity coinsurance transaction............................... 76.5 -
Other............................................................................ (1.7) 198.7
------- ------
Net cash provided by operating activities...................................... $ 549.4 $658.7
======= ======
Non-cash items not reflected in the investing and financing activities sections
of the consolidated statement of cash flows:
Stock option and restricted stock plans............................................ $ 8.9 $ 11.1
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 September 30, 2007 and December 31, 2006, restricted cash and cash
equivalents consisted of: (i) $20.8 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
Notes to Consolidated Financial Statements
-------------------
SUBSEQUENT EVENT
On October 31, 2007, we announced an agreement under which our subsidiary,
Colonial Penn Life Insurance Company ("Colonial Penn"), will recapture a block
of traditional life insurance in force that had been ceded in 2002 to REALIC.
In the transaction, Colonial Penn will pay REALIC a recapture fee of $63
million, recapture 100 percent of the liability for the future benefits
previously ceded, and recognize profits as they emerge over time. Colonial Penn
already administers the policies being recaptured. The transaction, which is to
have an effective date of October 1, 2007, will require insurance regulatory
filings in several states and is expected to close by year-end.
30
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at September 30, 2007, and the consolidated results of operations for the three
and nine months ended September 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;
31
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.
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,
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
32
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. We entered into a
national distribution agreement under which our career agents began distributing
Coventry's PFFS plan, Advantra Freedom, beginning January 1, 2007, and a
quota-share reinsurance agreement related to PFFS business written by Coventry
under one large group policy, beginning July 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
Prescription Drug Benefit
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.
33
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the pre-tax income of the PDP business (dollars in
millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Insurance policy income................................ $13.8 $21.5 $58.8 $61.3
Fee revenue and other.................................. .4 1.2 1.9 4.1
----- ----- ----- -----
Total revenues....................................... 14.2 22.7 60.7 65.4
----- ----- ----- -----
Insurance policy benefits.............................. 10.3 17.7 50.8 54.0
Commission expense..................................... 1.3 1.9 5.1 4.7
Other operating expenses............................... .2 2.4 .5 6.4
----- ----- ----- -----
Total expense........................................ 11.8 22.0 56.4 65.1
----- ----- ----- -----
Pre-tax income....................................... $ 2.4 $ .7 $ 4.3 $ .3
===== ===== ===== =====
Private-Fee-For-Service
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 approximately 50 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 an
approximately 50 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.
34
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the pre-tax income of the PFFS business in the
three and nine months ended September 30, 2007 (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
2007 2007
------------------ -----------------
Insurance policy income............................ $31.3 $70.9
Fee revenue and other.............................. 3.0 5.0
----- -----
Total revenues................................. 34.3 75.9
----- -----
Insurance policy benefits.......................... 25.2 58.0
Commission expense................................. 1.3 2.9
Other operating expenses........................... 2.9 5.6
----- -----
Total expense.................................. 29.4 66.5
----- -----
Pre-tax income..................................... $ 4.9 $ 9.4
===== =====
Large Group Private-Fee-For-Service Block
Effective July 1, 2007, Conseco entered into a quota-share reinsurance
agreement with Coventry related to the PFFS business written by Coventry under
one large group policy. Conseco receives 50 percent of the net premiums and
related profits associated with this business as long as the ceded revenue
margin is less than or equal to five percent. Conseco receives 25 percent of the
net premiums and related profits on the ceded margin in excess of five percent.
The following summarizes the pre-tax income of this business for 3Q07 (dollars
in millions):
Three months ended
September 30,
2007
------------------
Premium income.................................................. $51.7
-----
Policy benefits................................................. 47.0
Commission expense.............................................. 2.0
-----
Total expenses.............................................. 49.0
-----
Pre-tax income.................................................. $ 2.7
=====
35
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
The following tables and narratives summarize the operating results of our
segments for the periods presented (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- ---------------------
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................................................ $ 66.3 $ 68.4 $ 174.6 $189.3
Conseco Insurance Group..................................... (85.1) 58.5 (7.3) 8.1
Colonial Penn............................................... 7.0 4.6 18.3 16.2
Other Business in Run-off................................... (2.9) (13.0) (167.0) 15.4
Corporate operations........................................ (28.9) (20.5) (102.1) (63.5)
------- ------ ------- ------
(43.6) 98.0 (83.5) 165.5
------- ------ ------- ------
Net realized investment gains (losses),
net of related amortization:
Bankers Life................................................ (1.9) (5.3) (7.4) (7.7)
Conseco Insurance Group..................................... (38.8) (4.1) (68.5) (8.7)
Colonial Penn............................................... .3 (.9) .4 .8
Other Business in Run-off................................... 1.9 (10.8) 1.6 (6.8)
Corporate operations........................................ (4.7) (.2) (5.9) (.2)
------- ------ ------- ------
(43.2) (21.3) (79.8) (22.6)
------- ------ ------- ------
Income (loss) before income taxes:
Bankers Life................................................ 64.4 63.1 167.2 181.6
Conseco Insurance Group..................................... (123.9) 54.4 (75.8) (.6)
Colonial Penn............................................... 7.3 3.7 18.7 17.0
Other Business in Run-off................................... (1.0) (23.8) (165.4) 8.6
Corporate operations........................................ (33.6) (20.7) (108.0) (63.7)
------- ------ ------- ------
Income (loss) before income taxes........................ $ (86.8) $ 76.7 $(163.3) $142.9
======= ====== ======= ======
<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
</FN>
36
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.
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.
37
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -----------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Annuities................................................ $ 250.9 $ 278.2 $ 663.6 $ 749.9
Supplemental health...................................... 402.8 315.1 1,125.7 980.6
Life..................................................... 49.1 47.8 149.3 137.6
-------- -------- -------- --------
Total collections...................................... $ 702.8 $ 641.1 $1,938.6 $1,868.1
======== ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 284.8 $ 279.3 $ 282.9 $ 276.8
Equity-indexed....................................... 826.2 527.9 737.8 468.6
Deposit based........................................ 4,489.4 4,465.4 4,521.3 4,403.0
Health................................................. 3,615.3 3,325.6 3,544.9 3,270.2
Life:
Interest sensitive................................... 375.8 351.3 369.8 345.0
Non-interest sensitive............................... 306.7 254.0 291.7 240.8
-------- -------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded................. $9,898.2 $9,203.5 $9,748.4 $9,004.4
======== ======== ======== ========
Revenues:
Insurance policy income.................................. $ 473.6 $ 390.1 $1,309.6 $1,157.7
Net investment income:
General account invested assets........................ 145.8 130.8 428.7 378.8
Equity-indexed products based on the change
in value of options.................................. (2.1) 3.6 6.8 1.5
Other special-purpose portfolios....................... .5 - 4.7 -
Fee revenue and other income............................. 3.8 1.4 7.7 4.8
-------- -------- -------- --------
Total revenues....................................... 621.6 525.9 1,757.5 1,542.8
-------- -------- -------- --------
Expenses:
Insurance policy benefits................................ 404.6 313.3 1,091.6 932.8
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than equity-indexed products.......... 45.9 44.0 135.7 128.6
Equity-indexed products................................ 9.0 7.7 24.9 9.4
Amortization related to operations....................... 49.3 52.4 202.0 166.6
Interest expense on investment borrowings................ - - - .1
Other operating costs and expenses....................... 46.5 40.1 128.7 116.0
-------- -------- -------- --------
Total benefits and expenses.......................... 555.3 457.5 1,582.9 1,353.5
-------- -------- -------- --------
Income before net realized investment losses, net of
related amortization and income taxes...................... 66.3 68.4 174.6 189.3
-------- -------- -------- --------
Net realized investment losses........................... (1.3) (5.5) (8.4) (8.9)
Amortization related to net realized investment losses... (.6) .2 1.0 1.2
-------- -------- -------- --------
Net realized investment losses, net of
related amortization .............................. (1.9) (5.3) (7.4) (7.7)
-------- -------- -------- --------
Income before income taxes.................................... $ 64.4 $ 63.1 $ 167.2 $ 181.6
======== ======== ======== ========
(continued)
38
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................... $359.4 $272.5 $957.0 $813.4
Benefit ratio (a)....................................... 86.9% 81.4% 84.6% 81.6%
Medicare supplement:
Insurance policy benefits............................... $111.3 $106.4 $325.4 $330.7
Benefit ratio (a)....................................... 69.4% 65.6% 67.1% 67.1%
PDP and PFFS:
Insurance policy benefits............................... $82.5 $17.7 $155.8 $54.0
Benefit ratio (a)....................................... 85.4% 82.1% 85.9% 88.1%
Long-term care:
Insurance policy benefits............................... $165.6 $148.4 $475.8 $428.7
Benefit ratio (a)....................................... 105.8% 98.2% 102.3% 97.0%
Interest-adjusted benefit ratio (b)..................... 74.5% 68.8% 71.4% 67.5%
<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 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 $49.0 million and $44.5 million in the three months ended
September 30, 2007 and 2006, respectively, and $143.7 million and
$130.3 million in the nine months ended September 30, 2007 and 2006,
respectively.
</FN>
39
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections were $702.8 million in the third quarter of 2007,
up 9.6 percent from 2006 and were $1,938.6 million in the first nine months of
2007, up 3.8 percent from 2006. Premium collections include $92.9 million and
$20.8 million in the third quarters of 2007 and 2006, respectively, and $176.4
million and $58.9 million in the first nine 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
$9.9 billion in the third quarter of 2007, up 7.5 percent from 2006. Average
liabilities for insurance products, net of reinsurance ceded were $9.7 billion
in the first nine months of 2007, up 8.3 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 $96.8 million and $21.5 million
in the third quarters of 2007 and 2006, respectively, and $181.4 million and
$61.3 million in the first nine 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 $145.8 million in the third quarter of
2007, up 11 percent from 2006 and was $428.7 million in the first nine months of
2007, up 13 percent from 2006. The average balance of general account invested
assets was $10.1 billion and $9.3 billion in the third quarters of 2007 and
2006, respectively. The average yield on these assets was 5.78 percent and 5.62
percent in the third quarters of 2007 and 2006, respectively. The average
balance of general account invested assets was $9.9 billion and $9.1 billion in
the first nine months of 2007 and 2006, respectively. The average yield on these
assets was 5.77 percent and 5.57 percent in the first nine 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 investments in recent periods,
including securities with longer durations and increased allocations to
commercial mortgages and securities issued through private placements.
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 $(2.1) million and $3.6 million in the third
quarters of 2007 and 2006, respectively; and $6.8 million and $1.5 million in
the first nine 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 $.5 million and $2.0
million in the three and nine months ended September 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
40
CONSECO, INC. AND SUBSIDIARIES
-------------------
accounting principles. Since the insurance product liabilities we establish for
Medicare supplement business are subject to significant estimates, the ultimate
claim liability we incur for a particular period is likely to be different than
our initial estimate. Our insurance policy benefits reflected the release of
reserve redundancies from prior years of $3.4 million and $10.1 million in the
first nine months of 2007 and 2006, respectively. Excluding the effects of prior
period claim reserve redundancies, our benefit ratios would have been 67.8
percent and 69.1 percent in the first nine 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. Effective July 1, 2007, we entered
into a new PFFS quota-share reinsurance agreement to assume 50 percent of the
business written by Coventry under one large group policy. The benefit ratio
related to the PDP and PFFS business increased in the three months ended
September 30, 2007 due to the higher loss ratio on the group policy (which was
expected).
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 105.8 percent and 98.2 percent in the
third quarters of 2007 and 2006, respectively, and 102.3 percent and 97.0
percent in the first nine months of 2007 and 2006, respectively. The
interest-adjusted benefit ratio on this business was 74.5 percent and 68.8
percent in the third quarters of 2007 and 2006, respectively, and 71.4 percent
and 67.5 percent in the first nine months of 2007 and 2006, respectively. We
experienced an increase in the number of incurred claims in the third quarter of
2007.
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 in 2006 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. We have received all expected regulatory
approvals and have implemented the majority of these rate increases. We expect
the remainder of these premium rate increases will be implemented during the
next quarter. In addition, another round of increases was filed during the
second and third quarters of 2007 on newer long-term care, home health care, and
short-term care policies not included in the first round of rate increases. The
policies in this round represent approximately 25 percent of the inforce block.
As of September 30, 2007, approximately 80 percent of the filings had been
submitted for regulatory approval, and approximately 30 percent of the amounts
had been approved by regulators and implemented. Remaining approvals and
implementations are expected to occur over the next twelve months. Pursuant to
our policy of changing previous assumptions used to determine the earnings from
a block of insurance policies when there is a significant structural change in
the block (such as a significant change in premium from rate increases), the
effect of the rate increases will not be completely reflected in our benefit
ratios when implemented. The aforementioned rate increases reflect a change in
our previous rate increase assumptions. Accordingly, the new assumptions are
reflected prospectively in our reserves and deferred insurance acquisition costs
(including the value of policies inforce at the Effective Date and the cost of
policies produced) using the pivot method. The pivot method is a modification to
the valuation approach established when the policy was first issued, whereby our
reserves and deferred insurance costs are unchanged at the time of the rate
increase, but the future pattern of reserve changes is modified to reflect the
relationship of expected premiums to benefits based on the current best estimate
of future claim costs, morbidity, persistency and investment returns.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $45.9 million in the third quarter of
2007, up 4.3 percent from 2006 and were $135.7 million in the first nine months
of 2007, up 5.5 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 3.8 percent and 3.7 percent in
the third quarters of 2007 and 2006, respectively, and 3.7 percent and 3.6
percent in the first nine months of 2007 and 2006, respectively.
41
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 $49.3 million and
$52.4 million in the third quarters of 2007 and 2006, respectively, and $202.0
million and $166.6 million in the first nine months of 2007 and 2006,
respectively. The lapse experience on our Medicare supplement products in the
third quarter of 2007 was lower than our expectations resulting in lower
amortization as compared to the third quarter of 2006. During the first half 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 recognized additional amortization expense
of $25.4 million in the first half of 2007 and $7.9 million in the first half of
2006. We believe such increases were partially related to competition from
Medicare Advantage products. During the third quarter of 2007, amortization of
insurance acquisition costs related to our annuity products decreased by $3.4
million due to changes in the assumptions for the yield on investments
(reflecting the higher than expected yields we have been earning on the
investments backing our annuity 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 $46.5
million in the third quarter of 2007, up 16 percent from 2006 and were $128.7
million in the first nine months of 2007, up 11 percent from 2006. Other
operating costs and expenses include the following (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- ------------------
2007 2006 2007 2006
---- ---- ---- ----
Expenses related to the marketing and quota-share
agreements with Coventry........................... $ 7.7 $ 4.3 $ 16.1 $ 11.1
Commission expense.................................... 4.8 5.2 15.8 15.6
Other operating expenses.............................. 34.0 30.6 96.8 89.3
----- ----- ------ ------
Total.............................................. $46.5 $40.1 $128.7 $116.0
===== ===== ====== ======
Net realized investment losses fluctuate each period. During the first nine
months of 2007, net realized investment losses in this segment included $7.9
million of net losses from the sales of investments (primarily fixed
maturities), and a $.5 million writedown of an investment resulting from a
decline in fair value that we concluded was other than temporary. During the
first nine months of 2006, net realized investment losses in this segment
included $8.5 million of net losses from the sales of investments (primarily
fixed maturities), and $.4 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary.
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 an increase
(decrease) in the amortization of insurance acquisition costs of $.6 million and
$(.2) million in the third quarters of 2007 and 2006, respectively, and $(1.0)
million and $(1.2) million in the first nine months of 2007 and 2006,
respectively.
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -----------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Annuities................................................. $ 77.5 $ 182.8 $ 310.6 $ 311.4
Supplemental health....................................... 145.6 145.5 447.2 458.4
Life...................................................... 71.3 78.3 218.5 240.7
--------- --------- --------- ---------
Total collections....................................... $ 294.4 $ 406.6 $ 976.3 $ 1,010.5
========= ========= ========= =========
Average liabilities for insurance products:
Annuities:
Mortality based......................................... $ 229.0 $ 240.1 $ 231.3 $ 242.4
Equity-indexed.......................................... 1,253.9 1,386.1 1,482.8 1,338.9
Deposit based........................................... 1,815.1 3,099.4 2,533.9 3,192.3
Separate accounts....................................... 28.4 28.9 28.6 29.4
Health.................................................... 2,414.4 2,377.3 2,401.5 2,379.6
Life:
Interest sensitive...................................... 3,027.6 3,046.4 3,040.6 3,059.4
Non-interest sensitive.................................. 1,386.2 1,407.3 1,363.5 1,428.8
--------- --------- --------- ---------
Total average liabilities for insurance products, net
of reinsurance ceded................................ $10,154.6 $11,585.5 $11,082.2 $11,670.8
========= ========= ========= =========
Revenues:
Insurance policy income..................................... $ 238.7 $ 245.9 $ 717.0 $ 749.7
Net investment income:
General account invested assets........................... 185.9 174.9 547.8 525.6
Equity-indexed products................................... (2.7) 12.1 10.4 3.1
Trading account income related to policyholder and
reinsurer accounts...................................... 2.3 5.6 2.6 3.4
Change in value of embedded derivatives related to
modified coinsurance agreements......................... (.4) (3.3) 1.8 .5
Other special-purpose portfolios.......................... (3.9) - (3.5) -
Fee revenue and other income................................ .1 .8 .4 1.1
--------- --------- --------- ---------
Total revenues.......................................... 420.0 436.0 1,276.5 1,283.4
--------- --------- --------- ---------
Expenses:
Insurance policy benefits................................... 220.3 184.1 594.1 560.2
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products...................... 57.0 62.0 173.9 183.4
Equity-indexed products................................... 19.4 22.5 56.5 25.9
Amortization related to operations.......................... 41.2 42.3 126.4 134.5
Interest expense on investment borrowings................... 6.2 .1 11.5 .6
Costs related to a litigation settlement.................... 8.2 - 32.2 165.8
Loss related to an annuity coinsurance transaction.......... 76.5 - 76.5 -
Other operating costs and expenses.......................... 76.3 66.5 212.7 204.9
--------- --------- --------- ---------
Total benefits and expenses............................. 505.1 377.5 1,283.8 1,275.3
--------- --------- --------- ---------
Income (loss) before net realized investment losses, net of
related amortization, and income taxes...................... (85.1) 58.5 (7.3) 8.1
--------- --------- --------- ---------
Net realized investment losses.............................. (47.3) (4.4) (102.0) (13.5)
Amortization related to net realized investment losses...... 8.5 .3 33.5 4.8
--------- --------- --------- ---------
Net realized investment losses, net of related
amortization.......................................... (38.8) (4.1) (68.5) (8.7)
--------- --------- --------- ---------
Income (loss) before income taxes.............................. $ (123.9) $ 54.4 $ (75.8) $ (.6)
========= ========= ========= =========
(continued)
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Nine months ended
September 30, September 30,
------------------- ------------------
2007 2006 2007 2006
---- ---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................... $134.2 $109.9 $332.7 $332.7
Benefit ratio (a)....................................... 89.8% 71.5% 73.5% 70.7%
Medicare supplement:
Insurance policy benefits............................... $39.3 $41.2 $119.8 $119.0
Benefit ratio (a)....................................... 68.6% 66.8% 68.1% 61.3%
Specified disease:
Insurance policy benefits............................... $93.1 $65.7 $206.1 $206.3
Benefit ratio (a)....................................... 103.2% 73.6% 76.3% 77.0%
Interest-adjusted benefit ratio (b)..................... 70.3% 41.2% 43.5% 45.1%
Other:
Insurance policy benefits............................... $1.8 $3.0 $6.8 $7.4
Benefit ratio (a)....................................... 91.2% 108.9% 100.4% 85.1%
<FN>
- --------------------
(a) We calculate benefit ratios by dividing the related product's
insurance policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for 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
$29.6 million and $28.9 million in the three months ended September
30, 2007 and 2006, respectively, and $88.6 million and $85.4 million
in the nine months ended September 30, 2007 and 2006, respectively.
</FN>
Total premium collections were $294.4 million in the third quarter of 2007,
down 28 percent from the third quarter of 2006 and were $976.3 million in the
first nine months of 2007, down 3.4 percent from 2006. The decrease was
primarily due
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
to lower annuity sales as we changed the pricing of specific products and we no
longer emphasized the sale of certain products. See "Premium Collections" for
further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$10.2 billion in the third quarter of 2007, down 12 percent from 2006. Average
liabilities for insurance products, net of reinsurance ceded were $11.1 billion
in the first nine months of 2007, down 5.0 percent from 2006. The decrease in
such liabilities was due primarily to a coinsurance transaction completed in the
third quarter of 2007, as further discussed in the note to our consolidated
financial statements entitled "Coinsurance Transaction".
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 premiums from our life insurance block. The
lapses of these policies are exceeding new sales. In addition, we experienced
higher lapses than sales from Medicare supplement products in the first nine
months of 2007. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $185.9 million in the third
quarter of 2007, up 6.3 percent from 2006 and was $547.8 million in the first
nine months of 2007, up 4.2 percent from 2006. The average balance of general
account invested assets was $12.5 billion and $12.1 billion in the third
quarters of 2007 and 2006, respectively. The average yield on these assets was
5.96 percent and 5.77 percent in the third quarters of 2007 and 2006,
respectively. The average balance of general account invested assets was $12.4
billion and $12.2 billion in the first nine months of 2007 and 2006,
respectively. The average yield on these assets was 5.90 percent and 5.75
percent in the first nine months of 2007 and 2006, respectively. The increase in
yield is primarily due to the purchase of higher yielding investments in recent
periods including securities with longer durations and increased allocations to
commercial mortgages and securities issued through private placements. The yield
was also 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
nine months of 2007 and 2006 of $3.9 million ($.4 million in the third quarter
of 2007) and $8.0 million ($2.6 million in the third 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
$(2.9) million and $7.8 million in the third quarters of 2007 and 2006,
respectively; and $13.1 million and $5.2 million in the first nine 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 $.2 million
and $4.3 million in the third quarters of 2007 and 2006, respectively, and were
$(2.7) million and $(2.1) million in the first nine 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.
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
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. The change in value of the interest rate swaps was $(4.3)
million in the three month period ended September 30, 2007, and $(.7) million in
the nine month period ended September 30, 2007. The change in value of the
trading securities was $.4 million in the three month period ended September 30,
2007, and $(2.8) million in the nine month period ended September 30, 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.
Insurance margins (insurance policy income less insurance policy benefits)
related to life products declined approximately $24 million in the first nine
months of 2007 ($7 million of which was recognized in the third quarter of
2007), as compared to the same periods in 2006, primarily due to increased death
claims.
The benefit ratio in the first half 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 nine months of 2007 and 2006 reflected
claim reserve redundancies from prior years of $1.2 million and $5.4 million,
respectively. Excluding the effects of prior year claim reserve redundancies,
our benefit ratios in the first nine months of 2007 and 2006 for the Medicare
supplement block would have been 68.8 percent and 64.0 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 $19.2 million in the first nine months of 2007
(including a decrease of $2.5 million in the third quarter of 2007), as compared
to the same periods in 2006, due to a higher benefit ratio and a smaller inforce
block of business. We also experienced higher persistency in the third quarter
of 2007 as compared to the third quarter of 2006 which contributed to a higher
benefit ratio.
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 third quarter of 2007 reflects an $18.3 million
out-of-period increase in insurance policy benefits which was identified by our
material control weakness remediation procedures. We discovered that a key
factor used to determine specified disease insurance liabilities for certain
policies sold by a subsidiary prior to its acquisition by Conseco, was
incorrectly set to zero, which resulted in no reserve being established for
these policies. The benefit ratio excluding this increase in reserves was 82.9
percent in the third quarter of 2007. In addition to the out-of-period
adjustment in the third quarter of 2007 discussed above, the benefit ratio in
the first nine 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 the two items discussed above was 76.7 percent in the first nine
months of 2007. The benefit ratio for the first six months of 2006 was
unfavorably affected by higher persistency of older
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
policies which have higher benefit ratios than newer policies. Insurance margins
(insurance policy income less insurance policy benefits) on these products,
excluding the aforementioned reserve adjustments in the first and third quarters
of 2007, increased by $1.5 million in the first nine months of 2007 (net of a
decrease of $8.1 million in the third quarter of 2007), as compared to the same
periods in 2006.
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 $57.0 million in the third quarter of
2007, down 8.1 percent from 2006 and were $173.9 million in the first nine
months of 2007, down 5.2 percent from 2006. The decrease was primarily due to a
smaller block of annuity business inforce. The weighted average crediting rate
for these products was 4.0 percent in both the first nine months of 2007 and
2006.
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. Lapse rates on our Medicare
supplement products have impacted our estimates of future expected premium
income and, accordingly, we recognized increased (decreased) amortization
expense of $(1.6) million and $7.9 million in the first nine 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 first nine months of 2007, we were required to accelerate the
amortization of insurance acquisition costs related to our universal life
products 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.
Interest expense on investment borrowings includes $6.0 million and $10.8
million of interest expense on the Advances in the three and nine months ended
September 30, 2007, respectively, as further described in the note to the
consolidated financial statements entitled "Investment Borrowings and Interest
Rate Swaps".
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
Costs related to a litigation settlement include legal fees and estimated
amounts related to a settlement in the class action case referred to as In Re
Conseco Life Insurance Company Cost of Insurance Litigation. The costs related
to the litigation settlement recognized in 2007 represent changes to our initial
estimates based on the ultimate cost of the settlement, including the effect of
the recent sale of shares of our common stock distributed for the benefit of the
plaintiffs pursuant to the bankruptcy plan of our Predecessor at lower market
prices than previously reflected. 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.
Loss related to an annuity coinsurance transaction resulted from the
completion of a transaction to coinsure 100 percent of most of the older inforce
equity-indexed annuity and fixed annuity business of three of our insurance
subsidiaries with REALIC. Refer to the note entitled "Coinsurance Transaction"
in the accompanying notes to our consolidated financial statements for further
information about the transaction.
Other operating costs and expenses were $76.3 million in the third quarter
of 2007, up 15 percent from 2006 and were $212.7 million in the first nine
months of 2007, up 3.8 percent from 2006. Other operating costs and expenses
include commission expense of $20.2 million and $21.8 million in the third
quarters of 2007 and 2006, respectively, and $60.8 million and $65.9 million in
the first nine months of 2007 and 2006, respectively. During the third quarter
of 2007, the Company recognized expenses of $7.3 million related to the decision
to abandon certain software that will not be used consistent with our current
business plan and $3.7 million of costs related to other operational initiatives
and consolidation activities.
Net realized investment losses fluctuate each period. During the first nine
months of 2007, net realized investment losses in this segment included: (i)
$26.4 million from the sales of investments (primarily fixed maturities); (ii)
$1.9 million of writedowns of investments resulting from declines in fair values
that we concluded were other than temporary; and (iii) $73.7 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 "Coinsurance Transaction". The net
investment losses realized on sales of investments in the third quarter of 2007
were primarily recognized on securities collateralized by sub prime residential
mortgage loans. We decided to sell these securities given our concerns regarding
the effect future adverse developments in housing values could have on the value
of these securities. For further information on our sub prime holdings, refer to
the caption entitled "Structured Securities Collateralized by Sub Prime
Residential Mortgage Loans" in the "Investments" section of Management's
Discussion and Analysis of Financial Condition and Results of Operations. During
the first nine months of 2006, net realized investment losses included $10.3
million of net losses from the sales of investments (primarily fixed
maturities), and $3.2 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary.
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 $8.5 million and $.3 million in
the third quarters of 2007 and 2006, respectively, and $33.5 million and $4.8
million in the nine months ended September 30, 2007 and 2006, respectively.
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
Colonial Penn (dollars in millions)
Three months ended Nine months ended
September 30, September 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Life..................................................... $ 29.3 $ 25.4 $ 82.0 $ 70.4
Supplemental health...................................... 2.6 3.0 7.9 9.1
------ ------ ------ ------
Total collections...................................... $ 31.9 $ 28.4 $ 89.9 $ 79.5
====== ====== ====== ======
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 85.1 $ 86.6 $ 85.5 $ 87.1
Deposit based........................................ 4.6 3.8 4.1 4.0
Health................................................... 22.8 25.0 23.1 26.0
Life:
Interest sensitive................................... 25.5 27.5 26.2 27.8
Non-interest sensitive............................... 558.6 551.7 558.6 553.0
------ ------ ------ ------
Total average liabilities for insurance
products, net of reinsurance ceded.............. $696.6 $694.6 $697.5 $697.9
====== ====== ====== ======
Revenues:
Insurance policy income.................................. $ 32.5 $ 29.1 $ 91.2 $ 81.1
Net investment income:
General account invested assets........................ 9.4 9.2 28.3 28.0
Trading account income related to reinsurer
accounts............................................. 2.3 9.5 (3.2) (4.5)
Change in value of embedded derivatives related
to modified coinsurance agreements................... (2.3) (9.5) 3.2 4.5
Fee revenue and other income............................. .2 .1 .5 .4
------ ------ ------ ------
Total revenues....................................... 42.1 38.4 120.0 109.5
------ ------ ------ ------
Expenses:
Insurance policy benefits................................ 26.3 25.2 75.8 68.7
Amounts added to annuity and interest-sensitive
life product account balances........................ .3 .4 .9 1.0
Amortization related to operations....................... 5.1 4.4 14.8 12.7
Other operating costs and expenses....................... 3.4 3.8 10.2 10.9
------ ------ ------ ------
Total benefits and expenses.......................... 35.1 33.8 101.7 93.3
------ ------ ------ ------
Income before net realized investment gains (losses)
and income taxes......................................... 7.0 4.6 18.3 16.2
Net realized investment gains (losses)................. .3 (.9) .4 .8
------ ------ ------ ------
Income before income taxes.................................... $ 7.3 $ 3.7 $ 18.7 $ 17.0
====== ====== ====== ======
Total premium collections were $31.9 million in the third quarter of 2007,
up 12 percent from 2006 and were $89.9 million in the first nine months of 2007,
up 13 percent from 2006. See "Premium Collections" for further analysis of
Colonial Penn's premium collections.
49
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 third
quarter of 2007, up 2.2 percent from 2006 and was $28.3 million in the first
nine months of 2007, up 1.1 percent from 2006. The average balance of general
account invested assets was $.7 billion in both the third quarters of 2007 and
2006. The average yield on these assets was 5.71 percent and 5.40 percent in the
third quarters of 2007 and 2006, respectively. The average balance of general
account invested assets was $.7 billion in both the first nine months of 2007
and 2006. The average yield on these assets was 5.66 percent and 5.43 percent in
the first nine 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 (losses) fluctuate each period. We recognized
net realized investment gains (losses) in this segment of $.3 million and $(.9)
million from the sales of investments (primarily fixed maturities) in the third
quarters of 2007 and 2006, respectively, and $.4 million and $.8 million in the
first nine months of 2007 and 2006, respectively.
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-off (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Premium collections:
Long-term care........................................... $ 75.2 $ 79.6 $ 231.4 $ 247.1
Major medical........................................... .5 .8 1.7 4.1
-------- -------- -------- --------
Total collections................................... $ 75.7 $ 80.4 $ 233.1 $ 251.2
======== ======== ======== ========
Average liabilities for insurance products:
Long-term care........................................... $3,404.3 $3,212.2 $3,344.2 $3,225.9
Major medical............................................ 24.2 29.4 24.8 29.4
-------- -------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded........................ $3,428.5 $3,241.6 $3,369.0 $3,255.3
======== ======== ======== ========
Revenues:
Insurance policy income.................................. $ 77.2 $ 83.4 $ 234.8 $ 254.4
Net investment income on general account invested
assets................................................. 48.8 44.6 143.4 133.9
Fee revenue and other income............................. .1 .1 .3 .3
-------- -------- -------- --------
Total revenues....................................... 126.1 128.1 378.5 388.6
-------- -------- -------- --------
Expenses:
Insurance policy benefits................................ 106.0 113.4 467.6 294.6
Amortization related to operations....................... 5.6 5.6 17.1 12.6
Other operating costs and expenses....................... 17.4 22.1 60.8 66.0
-------- -------- -------- --------
Total benefits and expenses.......................... 129.0 141.1 545.5 373.2
-------- -------- -------- --------
Income (loss) before net realized investment gains
(losses) and income taxes................................ (2.9) (13.0) (167.0) 15.4
Net realized investment gains (losses)................... 1.9 (10.8) 1.6 (6.8)
-------- -------- -------- --------
Income (loss) before income taxes............................. $ (1.0) $ (23.8) $ (165.4) $ 8.6
======== ======== ======== ========
Health benefit ratios:
Insurance policy benefits.............................. $106.0 $113.4 $467.6 $294.6
Benefit ratio (a)...................................... 137.4% 136.0% 199.2% 115.8%
Interest-adjusted benefit ratio (b).................... 75.1% 83.1% 139.1% 63.8%
<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 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
</FN>
51
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 $48.0 million
and $44.1 million in the three months ended September 30, 2007 and
2006, respectively, and $141.1 million and $132.3 million in the nine
months ended September 30, 2007 and 2006, respectively.
Total premium collections were $75.7 million in the third quarter of 2007,
down 5.8 percent from 2006 and were $233.1 million in the first nine months of
2007, down 7.2 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 $48.8 million
in the third quarter of 2007, up 9.4 percent from 2006 and was $143.4 million in
the first nine months of 2007, up 7.1 percent from 2006. The average balance of
general account invested assets was $3.3 billion and $3.0 billion in the third
quarters of 2007 and 2006, respectively. The average yield on these assets was
5.91 percent in both the third quarters of 2007 and 2006. The average balance of
general account invested assets was $3.2 billion and $3.0 billion in the first
nine months of 2007 and 2006, respectively. The average yield on these assets
was 5.92 percent and 5.87 percent in the first nine 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, including securities with
longer durations.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below.
Insurance policy benefits in the third quarter of 2007 decreased 6.5
percent to $106.0 million compared to $113.4 million in the same period of 2006.
Insurance policy benefits in the nine months ended September 30, 2007 increased
59 percent to $467.6 million compared to $294.6 million in the same period of
2006. The benefit ratio on our Other Business in Run-off segment was 137.4
percent and 136.0 percent in the third quarters of 2007 and 2006, respectively,
and 199.2 percent and 115.8 percent in the first nine months of 2007 and 2006,
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 $129.7 million and $42.6
million in the first nine months of 2007 and 2006, respectively. Excluding the
effects of prior year claim reserve deficiencies, our benefit ratios would have
been 143.9 percent and 99.0 percent in the first nine months of 2007 and 2006,
respectively. In the third quarter of 2007, our insurance policy benefits
reflected reserve redundancies from prior periods of $3.4 million.
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
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
business was 75.1 percent and 83.1 percent in the third quarters of 2007 and
2006, respectively, and 139.1 percent and 63.8 percent in the first nine 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 the third quarter of 2007, the results of this segment were affected by
two partially offsetting adjustments. First, our material control weakness
remediation procedures identified issues whereby the release of active life
reserves for policies which had lapsed primarily due to death was not occurring
on a timely basis due to a weakness in the design of our internal controls. The
correction of this issue and the appropriate release of active life reserves
resulted in a decrease to insurance policy benefits of $20.1 million during the
third quarter of 2007. Second, we made changes to certain reserve estimates for
waiver of premium benefits and for policies with inflation benefits that have
elected a non-forfeiture benefit. These changes in estimates resulted in an
increase to insurance policy benefits of $13.5 million.
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. In the third quarter of 2007, there was no unusual development related to
claim liabilities.
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 relates 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.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 improved our methodologies to address this and other
shortcomings of the aggregate loss development methodology, which resulted in
the pre-tax adjustment.
The increase in insurance policy benefits in the third quarter of 2006
reflected:
(i) The lapse experience on this block of business has been less than
our expectations, resulting in approximately $9 million less reserve
releases for terminated policies than expected.
(ii) Prior period estimates of claim reserves proved to be deficient (net
of the positive impact of certain refinements to estimates of
approximately $6 million), resulting in an increase to insurance
policy benefits of approximately $11 million.
(iii) An increased number of initial claims were incurred in the third
quarter of 2006, resulting in an increase to insurance policy
benefits of approximately $2 million.
We have been aggressively seeking rate increases and pursuing other actions
on such long-term care policies. We have filed 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 86 percent
of our $35 million estimate. The effects of the approved rate increases have
been partially realized with the remaining impact 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 twelve months, and the full financial
effect of the first year of rate increases will take approximately two years to
be fully realized. Beginning in the second quarter of 2007, we have filed
requests for additional rate increases on many of the same policies. As of
September 30, 2007, approximately 70 percent of the filings had been submitted
for regulatory approval, and approximately 11 percent of the estimated total
amounts had been approved by regulators. 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.
Pursuant to our policy of changing previous assumptions used to determine
the earnings from a block of insurance policies when there is a significant
structural change in the block (such as a significant change in premium from
rate increases), the effect of the rate increases will not be completely
reflected in our benefit ratios when implemented. The aforementioned rate
increases reflect a change in our previous rate increase assumptions.
Accordingly, the new assumptions are reflected prospectively in our reserves and
deferred insurance acquisition costs using the pivot method. The pivot method is
a modification to the valuation approach established when the policy was first
issued, whereby our reserves and deferred
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
insurance costs are unchanged at the time of the rate increase, but the future
pattern of reserve changes is modified to reflect the relationship of expected
premiums to benefits based on the current best estimate of future claim costs,
morbidity, persistency and investment returns.
Amortization related to operations includes amortization of insurance
acquisition costs.
Other operating costs and expenses were $17.4 million in the third quarter
of 2007, down 21 percent from 2006 and were $60.8 million in the first nine
months of 2007, down 7.9 percent from 2006. Other operating costs and expenses
include commission expense of $7.8 million and $8.8 million in the third
quarters of 2007 and 2006, respectively, and $24.1 million and $27.6 million in
the first nine months of 2007 and 2006, respectively.
Net realized investment gains (losses) fluctuate each period. During the
first nine months of 2007 we recognized net realized investment gains of $1.6
million from the sales of investments (primarily fixed maturities). During the
first nine months of 2006, net realized investment gains included $.9 million of
net gains from the sales of investments (primarily fixed maturities), net of
$7.7 million of writedowns of investments resulting from declines in fair values
that we concluded were other than temporary. There were no such writedowns in
the first nine months of 2007.
Corporate Operations (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- ----------------------
2007 2006 2007 2006
---- ---- ---- ----
Corporate operations:
Interest expense on corporate debt......................... $(20.2) $(12.5) $ (53.2) $(36.9)
Net investment income ..................................... 2.8 1.1 4.7 2.9
Fee revenue and other income............................... 4.2 2.3 8.3 7.2
Net operating results of variable interest entity.......... 2.6 2.9 7.3 3.9
Costs related to a litigation settlement................... (8.2) - (32.2) (8.9)
Other operating costs and expenses......................... (10.1) (14.3) (37.0) (31.7)
------ ------ ------- ------
Loss before net realized investment losses
and income taxes....................................... (28.9) (20.5) (102.1) (63.5)
Net realized investment losses............................. (4.7) (.2) (5.9) (.2)
------ ------ ------- ------
Loss before income taxes................................. $(33.6) $(20.7) $(108.0) $(63.7)
====== ====== ======= ======
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 $1,082.9 million and $823.4 million during the first nine
months of 2007 and 2006, respectively. The average interest rate on our debt was
6.2 percent and 5.5 percent during the first nine 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. In the third quarter of 2007, our wholly owned
investment management subsidiary recognized performance-based fees of $2.4
million resulting from the liquidation of two portfolios that were managed by
the subsidiary. Excluding such performance-based fees, 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
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
and other permitted assets. Such consolidation requirements did not have a
material impact on our financial condition or results of operations.
Costs related to a 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. Refer to the captions entitled:
(i) "Costs related to a 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 nine months of 2007 included:
(i) $4.7 million from the sale of an investment; and (ii) a writedown of $1.2
million due to an other-than-temporary decline in the value of an investment.
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
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
allow their policies to lapse, this would reduce our premium income and
profitability in the future.
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- ---------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................. $128.4 $ 81.8 $ 305.3 $ 210.4
------ ------ -------- --------
Other fixed (first-year)................................ 122.1 195.5 356.2 536.7
Other fixed (renewal)................................... .4 .9 2.1 2.8
------ ------ -------- --------
Subtotal - other fixed annuities...................... 122.5 196.4 358.3 539.5
------ ------ -------- --------
Total annuities....................................... 250.9 278.2 663.6 749.9
------ ------ -------- --------
Supplemental health:
Medicare supplement (first-year)........................ 19.3 23.2 61.5 72.5
Medicare supplement (renewal)........................... 133.6 123.5 412.2 399.4
------ ------ -------- --------
Subtotal - Medicare supplement........................ 152.9 146.7 473.7 471.9
------ ------ -------- --------
Long-term care (first-year)............................. 11.7 12.0 35.5 39.3
Long-term care (renewal)................................ 142.8 133.0 432.6 402.9
------ ------ -------- --------
Subtotal - long-term care............................. 154.5 145.0 468.1 442.2
------ ------ -------- --------
PDP and PFFS (first year)............................... 78.5 20.8 120.4 58.9
PDP (renewal)........................................... 14.4 - 56.0 -
------ ------ -------- --------
Subtotal - PDP and PFFS............................... 92.9 20.8 176.4 58.9
------ ------ -------- --------
Other health (first-year)............................... .3 .4 .7 .8
Other health (renewal).................................. 2.2 2.2 6.8 6.8
------ ------ -------- --------
Subtotal - other health............................... 2.5 2.6 7.5 7.6
------ ------ -------- --------
Total supplemental health............................. 402.8 315.1 1,125.7 980.6
------ ------ -------- --------
Life insurance:
First-year.............................................. 21.2 24.4 67.9 68.4
Renewal................................................. 27.9 23.4 81.4 69.2
------ ------ -------- --------
Total life insurance.................................. 49.1 47.8 149.3 137.6
------ ------ -------- --------
Collections on insurance products:
Total first-year premium collections on
insurance products.................................... 381.5 358.1 947.5 987.0
Total renewal premium collections on
insurance products.................................... 321.3 283.0 991.1 881.1
------ ------ -------- --------
Total collections on insurance products............... $702.8 $641.1 $1,938.6 $1,868.1
====== ====== ======== ========
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 9.8 percent, to $250.9 million, in the third quarter of 2007,
and 12 percent, to $663.6 million, in the first nine 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
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
resulted in lower first-year fixed annuity sales as certain other competing
products, such as certificates of deposits, have become attractive.
Supplemental health products include Medicare supplement, Medicare Part D
contracts, PFFS contracts, 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 4.2 percent, to $152.9 million, in the third quarter of 2007,
and .4 percent, to $473.7 million, in the first nine months of 2007, as compared
to the same periods in 2006 primarily due to higher persistency, partially
offset by lower new sales.
Premiums collected on Bankers Life's long-term care policies increased 6.6
percent, to $154.5 million, in the third quarter of 2007, and 5.9 percent, to
$468.1 million, in the first nine 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.
Premiums collected on PDP and PFFS business relate to various quota-share
reinsurance agreements with Coventry. Effective July 1, 2007, we entered into a
new PFFS quota-share reinsurance agreement with Coventry pursuant to which we
received $43.3 million of first-year premiums in the third quarter of 2007.
These agreements are described in Critical Accounting Policies under the caption
"Accounting for marketing and quota-share agreements with Coventry".
Other health products 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 2.7
percent, to $49.1 million, in the third quarter of 2007, and 8.5 percent, to
$149.3 million, in the first nine months of 2007, compared to the same periods
in 2006, due to an increased focus on life products.
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................... $ 70.7 $166.3 $281.7 $ 264.2
Equity-indexed (renewal).................................. 2.5 1.9 7.2 7.2
------ ------ ------ --------
Subtotal - equity-indexed annuities..................... 73.2 168.2 288.9 271.4
------ ------ ------ --------
Other fixed (first-year).................................. 2.5 12.5 16.1 33.2
Other fixed (renewal)..................................... 1.8 2.1 5.6 6.8
------ ------ ------ --------
Subtotal - other fixed annuities........................ 4.3 14.6 21.7 40.0
------ ------ ------ --------
Total annuities......................................... 77.5 182.8 310.6 311.4
------ ------ ------ --------
Supplemental health:
Medicare supplement (first-year).......................... 4.2 6.5 16.0 22.7
Medicare supplement (renewal)............................. 50.6 48.1 154.7 159.7
------ ------ ------ --------
Subtotal - Medicare supplement.......................... 54.8 54.6 170.7 182.4
------ ------ ------ --------
Specified disease (first-year)............................ 7.7 6.8 22.7 21.0
Specified disease (renewal)............................... 81.0 81.3 247.2 247.3
------ ------ ------ --------
Subtotal - specified disease............................ 88.7 88.1 269.9 268.3
------ ------ ------ --------
Other health (renewal).................................... 2.1 2.8 6.6 7.7
------ ------ ------ --------
Total supplemental health............................... 145.6 145.5 447.2 458.4
------ ------ ------ --------
Life insurance:
First-year................................................ 1.3 1.7 3.6 5.1
Renewal................................................... 70.0 76.6 214.9 235.6
------ ------ ------ --------
Total life insurance.................................... 71.3 78.3 218.5 240.7
------ ------ ------ --------
Collections on insurance products:
Total first-year premium collections on
insurance products...................................... 86.4 193.8 340.1 346.2
Total renewal premium collections on
insurance products...................................... 208.0 212.8 636.2 664.3
------ ------ ------ --------
Total collections on insurance products................. $294.4 $406.6 $976.3 $1,010.5
====== ====== ====== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity premiums
collected in this segment decreased 58 percent, to $77.5 million, in the third
quarter of 2007, and .3 percent, to $310.6 million, in the first nine months of
2007, compared to the same periods in 2006.
Our equity-indexed annuities have guaranteed minimum cash surrender values,
but have potentially higher returns based on a percentage of the change in one
of several equity market indices during each year of their term. We purchase
options in an effort to hedge increases to policyholder benefits resulting from
increases in the indices. Total collected premiums for these products decreased
56 percent, to $73.2 million, in the third quarter of 2007, and increased 6.4
percent, to $288.9 million, in the first nine months of 2007, compared to the
same periods in 2006. During the third quarter of 2007, we changed the pricing
of specific products and we no longer emphasized the sale of certain products
resulting in a decrease in collected premiums. The increase in the first nine
months of 2007 is 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.
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. SPDA and FPDA policies typically have an interest
rate that is guaranteed for the first policy year, after which we have the
discretionary ability to change the crediting rate to any rate not below a
guaranteed minimum rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products decreased 71 percent, to $4.3
million, in the third quarter of 2007, and 46 percent, to $21.7 million, in the
first nine months of 2007, compared to the same periods in 2006. The increase in
short-term interest rates in recent periods resulted in lower first-year fixed
annuity sales as certain other competing products have become attractive.
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 increased .4 percent, to $54.8 million, in the third quarter of
2007, and decreased 6.4 percent, to $170.7 million, in the first nine months of
2007, as compared to the same periods in 2006. We have experienced lower sales
and 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 8.9
percent, to $71.3 million, in the third quarter of 2007, and 9.2 percent, to
$218.5 million, in the first nine months of 2007, compared to the same periods
in 2006.
Colonial Penn (dollars in millions)
Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Life insurance:
First-year............................................... $ 7.4 $ 5.8 $21.1 $17.0
Renewal.................................................. 21.9 19.6 60.9 53.4
----- ----- ----- -----
Total life insurance................................... 29.3 25.4 82.0 70.4
----- ----- ----- -----
Supplemental health:
Medicare supplement (renewal)............................ 2.3 2.7 7.1 8.2
Other health (renewal)................................... .3 .3 .8 .9
----- ----- ----- -----
Total supplemental health.............................. 2.6 3.0 7.9 9.1
----- ----- ----- -----
Collections on insurance products:
Total first-year premium collections on insurance
products............................................... 7.4 5.8 21.1 17.0
Total renewal premium collections on insurance
products............................................... 24.5 22.6 68.8 62.5
----- ----- ----- -----
Total collections on insurance products................ $31.9 $28.4 $89.9 $79.5
===== ===== ===== =====
Life products in this segment are sold primarily to the senior market. Life
premiums collected in this segment increased 15 percent, to $29.3 million, in
the third quarter of 2007, and increased 16 percent, to $82.0 million, in the
first nine months of 2007, compared to the same periods in 2006. Collected
premiums have been affected by increased advertising.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
Graded benefit life products sold through our direct response marketing channel
accounted for $28.3 million and $24.3 million of our total collected premiums in
the third quarters of 2007 and 2006, respectively, and $78.5 million and $66.7
million, in the first nine months of 2007 and 2006, respectively.
Supplemental health products include Medicare supplement and other
insurance products. Our profits on supplemental health policies depend on the
overall level of sales, the length of time the business remains inforce,
investment yields, claims experience and expense management. Premiums collected
on these products have decreased as we do not currently market these products
through this segment.
Other Business in Run-off (dollars in millions):
Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Premiums collected by product:
Long-term care (renewal).................................... $75.2 $79.6 $231.4 $247.1
Major medical (renewal)..................................... .5 .8 1.7 4.1
----- ----- ------ ------
Total renewal premium collections on insurance products... $75.7 $80.4 $233.1 $251.2
===== ===== ====== ======
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 5.5 percent, to
$75.2 million, in the third quarter of 2007, and 6.4 percent, to $231.4 million,
in the first nine 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 September 30, 2007 and
December 31, 2006, primarily reflect: (i) our net loss for the nine months ended
September 30, 2007; (ii) the effect of the coinsurance transaction which was
recorded in the third quarter of 2007 as further discussed in the note to the
financial statements entitled "Coinsurance Transaction"; and (iii) changes in
the fair value of actively managed fixed maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At September 30, 2007, we decreased the
carrying value of such investments by $553.3 million as a result of this fair
value adjustment.
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our capital structure as of September 30, 2007, and December 31, 2006,
was as follows (dollars in millions):
September 30, December 31,
2007 2006
---- ----
Total capital:
Corporate notes payable................................................ $1,195.7 $1,000.8
Shareholders' equity:
Preferred stock..................................................... - 667.8
Common stock........................................................ 1.9 1.5
Additional paid-in capital.......................................... 4,094.6 3,473.2
Accumulated other comprehensive loss................................ (316.0) (72.6)
Retained earnings................................................... 523.2 643.2
-------- --------
Total shareholders' equity....................................... 4,303.7 4,713.1
-------- --------
Total capital.................................................... $5,499.4 $5,713.9
======== ========
The following table summarizes certain financial ratios as of and for the
nine months ended September 30, 2007, and as of and for the year ended December
31, 2006:
September 30, December 31,
2007 2006
---- ----
Book value per common share................................................................... $23.10 $26.58
Book value per common share, excluding accumulated other comprehensive
income (loss) (a).......................................................................... $24.79 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............................................................ 22% 18%
Corporate debt to total capital, excluding accumulated other comprehensive
income (loss) (a)........................................................................ 21% 17%
Corporate debt and preferred stock to total capital........................................ 22% 29%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (loss) (a).......................................................... 21% 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 $163.3 million less than fixed charges.
(c) For such ratio, earnings were $185.6 million less than fixed charges.
</FN>
62
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 had reached a proposed
settlement in the class action case referred to as In Re Conseco Life Insurance
Company Cost of Insurance Litigation. The Court entered final judgment in the
case on July 5, 2007. Based on our estimates of the ultimate cash payments
required to implement the 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 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 September 30,
2007, the carrying value of the FHLBI common stock was $22.5 million. Advances
totaled $450.0 million in the first nine months of 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 $517.7 million at September 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 September 30, 2007
-------- ---- ---------------------
$100.0 February 2012 Variable rate - 5.349%
100.0 March 2012 Variable rate - 5.350%
54.0 May 2012 Variable rate - 5.494%
146.0 November 2015 Fixed rate - 5.300%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 5.420%
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.
63
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 September 7, 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 negative from stable.
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.
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 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. We do not expect the regulators to take
any actions against Conseco Senior or Conseco Life that would have a material
adverse effect on the financial position or results of operations of these
companies.
Conseco Senior has been aggressively seeking rate increases and pursuing
other actions on its long-term care policies. We have filed 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. Beginning in the second
quarter of 2007, we have filed requests for additional rate increases on many of
the same policies. 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 September 30, 2007, Conseco Inc. and CDOC held unrestricted cash of
$141.0 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 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
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 $160.0 million to our top tier
insurance subsidiary in the first nine months of 2007.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of (or in a few states, the lesser of): (i) statutory net gain
from operations or net income for the prior year; or (ii) 10 percent of
statutory capital and surplus as of the end of the preceding year. Any dividends
in excess of these levels require the approval of the director or commissioner
of the applicable state insurance department. During the first nine months of
2007, our top tier insurance subsidiary paid dividends of $50.0 million to CDOC.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
provide assurance that we will possess sufficient income and liquidity to meet
all of our liquidity requirements and other obligations.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted following the insurance law of its state of domicile with
such state's insurance regulator as the receiver for such insurer's property and
business. In the event of a default on our debt or our insolvency, liquidation
or other reorganization, our creditors and stockholders would have no right to
proceed against the assets of our insurance subsidiaries or to cause their
liquidation under federal and state bankruptcy laws.
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 in an
aggregate amount of up to $300 million over the term of the facility
(of which, only $200 million may be paid in the year commencing 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.
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
During the first nine months of 2007, we made scheduled principal payments
totaling $5.6 million on our Second Amended Credit Facility. The scheduled
repayment of our direct corporate obligations is as follows (dollars in
millions):
Remainder of 2007............................. $ 2.2
2008.......................................... 8.7
2009.......................................... 8.7
2010.......................................... 338.8
2011.......................................... 8.7
2012.......................................... 8.8
2013.......................................... 821.8
--------
$1,197.7
========
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 September 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. As described in the Second
Amended Credit Facility, the Company may reinvest any portion of the proceeds
from asset sales in assets useful to its business, subject to certain
restrictions defined in the Second Amended Credit Facility. The Company intends
to use the majority of the ceding commission received from REALIC in the
coinsurance transaction, as further described in the note to the financial
statements entitled "Coinsurance Transaction", to fund the recapture of a block
of traditional life insurance inforce, as further described in the note to the
consolidated financial statements entitled "Subsequent Event".
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 year beginning June 12, 2007). As further discussed in the note
to the consolidated financial statements entitled "Changes in Common Stock", we
repurchased 4.0 million shares of our common stock for $64.3 million in the
first nine months of 2007 (of which, $34.7 million was paid in the year
beginning June 12, 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.
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At September 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................................................ $13,029.6 $57.3 $(417.9) $12,669.0
United States Treasury securities and obligations of
United States government corporations and agencies................ 1,045.3 12.0 (6.4) 1,050.9
States and political subdivisions................................... 569.4 2.9 (11.6) 560.7
Debt securities issued by foreign governments....................... 53.0 .8 (.2) 53.6
Structured securities .............................................. 4,721.7 1.9 (128.6) 4,595.0
Below-investment grade (primarily corporate securities)................ 1,654.6 6.1 (78.2) 1,582.5
--------- ----- ------- ---------
Total actively managed fixed maturities............................. $21,073.6 $81.0 $(642.9) $20,511.7
========= ===== ======= =========
Equity securities...................................................... $34.3 $1.3 $(.1) $35.5
===== ==== ==== =====
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our actively managed
fixed maturity securities by category as of September 30, 2007 (dollars in
millions):
Percent of
Carrying value fixed maturities
-------------- ----------------
Structured securities................................................................ $ 4,655.7 22.7%
Manufacturing........................................................................ 3,333.4 16.3
Bank and finance..................................................................... 2,069.7 10.1
Utilities............................................................................ 1,681.8 8.2
Services............................................................................. 1,599.1 7.8
U.S. Government...................................................................... 1,050.9 5.1
Communications....................................................................... 993.2 4.8
Agriculture, forestry and mining..................................................... 897.9 4.4
Holding and other investment offices................................................. 789.3 3.9
Retail and wholesale................................................................. 727.0 3.5
Transportation....................................................................... 613.7 3.0
States and political subdivisions.................................................... 560.7 2.7
Asset-backed securities.............................................................. 488.6 2.4
Other................................................................................ 1,050.7 5.1
--------- -----
Total actively managed fixed maturities........................................... $20,511.7 100.0%
========= =====
Below-Investment Grade Securities
At September 30, 2007, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,654.6 million, or 7.9 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,582.5 million, or 96 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$484.8 million and an estimated fair value of $462.6 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
67
CONSECO, INC. AND SUBSIDIARIES
-------------------
securities and are not obligations of the Company. At September 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. Based on historical performance,
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
indebtedness of the issuer. Also, issuers of below-investment grade securities
usually have higher levels of debt and may be more financially leveraged, hence,
all other things being equal, more sensitive to adverse economic conditions,
such as recession or increasing interest rates. The Company attempts to reduce
the overall risk related to its investment in below-investment grade securities,
as in all investments, through careful credit analysis, strict investment policy
guidelines, and diversification by issuer and/or guarantor and by industry.
Net Realized Investment Gains (Losses)
During the first nine months of 2007, net realized investment losses
included: (i) $37.0 million of net losses from the sales of investments
(primarily fixed maturities) with proceeds of $5.1 billion; (ii) $3.6 million of
writedowns of investments for other than temporary declines in fair value; and
(iii) $73.7 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
"Coinsurance Transaction". During the first nine months of 2006, we recognized
net realized investment losses of $28.6 million, which were comprised of $17.3
million of net losses from the sales of investments (primarily fixed maturities)
with proceeds of $4.1 billion, and $11.3 million of writedowns of investments
for other than temporary declines in fair value. At September 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 nine months ended September 30, 2007, we sold $2.5 billion of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $94.3 million. We sell securities at a loss for a number of
reasons including, but not limited to: (i) changes in the investment
environment; (ii) expectation that the market value could deteriorate further;
(iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in
credit quality; 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.
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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 September
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................................................................. $ 76.5 $ 75.2
Due after one year through five years................................................... 960.8 941.2
Due after five years through ten years.................................................. 4,760.8 4,617.5
Due after ten years..................................................................... 6,555.7 6,214.6
--------- ---------
Subtotal............................................................................. 12,353.8 11,848.5
Structured securities................................................................... 4,453.5 4,315.9
--------- ---------
Total................................................................................ $16,807.3 $16,164.4
========= =========
At September 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.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position, at
September 30, 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...... $ 72.2 $ (1.3) $ 630.1 $ (5.1) $ 702.3 $ (6.4)
States and political subdivisions. 211.7 (4.6) 172.9 (7.0) 384.6 (11.6)
Debt securities issued by
foreign governments............ 29.1 (.2) - - 29.1 (.2)
Corporate securities.............. 7,780.1 (305.7) 2,952.3 (181.4) 10,732.4 (487.1)
Structured securities............. 2,247.1 (70.4) 2,068.9 (67.2) 4,316.0 (137.6)
--------- ------- -------- ------- --------- --------
Total actively managed
fixed maturities............... $10,340.2 $(382.2) $5,824.2 $(260.7) $16,164.4 $(642.9)
========= ======= ======== ======= ========= =======
Equity securities................. $.2 $(.1) $ - $ - $.2 $(.1)
=== ==== ===== ====== === ====
Based on management's current assessment of investments with unrealized
losses at September 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 September 30, 2007, fixed maturity investments included $4.7 billion of
structured securities (or 23 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
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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
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 nine 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 September 30, 2007 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 128.0 $ 127.7 $ 123.6
4 percent - 5 percent............................................................... 645.4 623.1 612.8
5 percent - 6 percent............................................................... 3,225.8 3,178.2 3,079.8
6 percent - 7 percent............................................................... 782.2 757.7 736.8
7 percent - 8 percent............................................................... 77.9 80.0 79.9
8 percent and above................................................................. 24.1 24.5 22.8
-------- -------- --------
Total structured securities (a).............................................. $4,883.4 $4,791.2 $4,655.7
======== ======== ========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $69.5 million and $60.7 million,
respectively.
</FN>
The amortized cost and estimated fair value of structured securities at
September 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, sequentials and equivalent securities..................... $2,170.2 $2,117.1 10%
Planned amortization class, target amortization class
and accretion-directed bonds.......................................... 1,552.4 1,510.9 8
Commercial mortgage-backed securities.................................... 994.7 963.2 5
Other.................................................................... 73.9 64.5 -
-------- -------- --
Total structured securities (a)................................... $4,791.2 $4,655.7 23%
======== ======== ==
<FN>
- --------------------
(a) Includes below-investment grade structured securities with an amortized
cost and estimated fair value of $69.5 million and $60.7 million,
respectively.
</FN>
Pass-through securities and sequentials 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.
Planned amortization classes, targeted amortization classes and
accretion-directed bonds adhere to fixed schedules of principal payments as long
as the underlying mortgage loans experience prepayments within certain estimated
ranges. Changes in prepayment rates are first absorbed by support or companion
classes, insulating the timing of receipt of cash flows from the consequences of
both faster prepayments (average life shortening) and slower prepayments
(average life extension).
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CONSECO, INC. AND SUBSIDIARIES
-------------------
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.
Structured Securities Collateralized by Sub Prime Residential Mortgage
Loans
Our investment portfolio includes structured securities collateralized by
sub prime residential mortgage loans with a market value of $149.3 million and a
book value of $181.2 million at September 30, 2007. We reduced our exposure to
sub prime residential mortgages by selling certain structured securities with a
book value of $54 million. We recognized a loss of $29 million on such sales. In
addition, the securities we transferred pursuant to the annuity coinsurance
agreement included structured securities collateralized by sub prime loans with
a book value of $61 million. These securities represent .6 percent of our
consolidated investment portfolio. Of these securities, $32.2 million (22
percent) were rated AAA, $44.9 million (30 percent) were rated AA, $62.7 million
(42 percent) were rated A, and $9.5 million (6 percent) were rated BBB or below.
Four of these securities were downgraded or put on watch as part of S&P's and
Moody's recent rating announcements. Sub prime structured securities issued in
2006 and 2007 have experienced higher delinquency and foreclosure rates than
originally expected. The Company's investment portfolio includes sub prime
structured securities collateralized by residential mortgage loans extended over
several years, primarily from 2003 to 2007. At September 30, 2007, we held no
securities collateralized by residential mortgage loans extended in 2006.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS IN VARIABLE INTEREST ENTITY
Fall Creek CLO Ltd. ("Fall Creek") is a collateralized loan trust that was
established to issue securities and use the proceeds to invest in loans and
other permitted investments. The assets held by the trust are legally isolated
and are not available to the Company. The liabilities of Fall Creek will be
satisfied from the cash flows generated by the underlying loans, not from the
assets of the Company, which has no legal obligation to satisfy those
liabilities. Repayment of the principal balance of the investment borrowings of
Fall Creek begin in 2012 based on available cash flows from the assets and such
borrowings mature in 2017. At September 30, 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):
September 30, December 31,
2007 2006
---- ----
Assets:
Actively managed fixed maturities.................................................. $470.2 $454.5
Cash and cash equivalents - restricted............................................. 20.8 15.7
Accrued investment income.......................................................... 5.2 3.9
Other assets....................................................................... 7.1 7.5
------ ------
Total assets................................................................... $503.3 $481.6
====== ======
Liabilities:
Other liabilities.................................................................. $ 19.4 $ 26.8
Investment borrowings due to others................................................ 447.2 401.7
Investment borrowings due to the Company........................................... 47.0 47.0
------ ------
Total liabilities.............................................................. 513.6 475.5
------ ------
Equity:
Capital provided by the Company.................................................... 1.7 1.8
Capital provided by others......................................................... 4.3 4.7
Accumulated other comprehensive income (loss)...................................... (22.6) (2.1)
Retained earnings.................................................................. 6.3 1.7
------ ------
Total equity (deficit)......................................................... (10.3) 6.1
------ ------
Total liabilities and equity (deficit)......................................... $503.3 $481.6
====== ======
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CONSECO, INC. AND SUBSIDIARIES
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Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2007 2006 2007 2006
---- ---- ---- ----
Revenues:
Net investment income - deposit accounts............. $9.4 $8.2 $27.4 $18.1
Fee revenue and other income......................... .1 .1 .3 .2
---- ---- ----- -----
Total revenues................................... 9.5 8.3 27.7 18.3
---- ---- ----- -----
Expenses:
Interest expense..................................... 6.9 5.2 20.1 13.7
Other operating expenses............................. - .2 .3 .7
---- ---- ----- -----
Total expenses................................... 6.9 5.4 20.4 14.4
---- ---- ----- -----
Income before net realized investment losses and
income taxes.......................................... 2.6 2.9 7.3 3.9
Net realized investment losses....................... - (.1) - (.1)
---- ---- ----- -----
Income before income taxes.............................. $2.6 $2.8 $ 7.3 $ 3.8
==== ==== ===== =====
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 nine 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 September 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, the
quarter ended March 31, 2007, and the quarter ended September 30, 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.
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CONSECO, INC. AND SUBSIDIARIES
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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 adjustments to insurance policy benefits and the
liabilities for insurance products in the quarter ended September 30, 2007 were
identified through our remediation procedures. We currently expect that our
remediation procedures will be completed prior to the end of 2007. However, we
may encounter issues that could require more extensive procedures. 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.
Accordingly, the material control weakness will not be fully remediated until
our redesigned and improved control procedures have been operating for several
quarters after the completion of the remediation procedures.
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 nine 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 nine months ended September 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
-------------------
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 nine 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)
July 1 through
July 31........... - $ - - $320.4
August 1 through
August 31......... 2,083,828 14.29 - 290.7
September 1 through
September 30...... 360,000 13.80 - 285.7
---------
Total................. 2,443,828 14.22 - 285.7
=========
<FN>
- ------------
(a) The Company purchased 1,492 shares of its common stock in August 2007,
in connection with employee benefit compensation plans. 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>
ITEM 5. OTHER INFORMATION.
Pursuant to our Sixth Amended Joint Plan of Reorganization (the "Plan"), we
issued 100 million shares of our common stock upon our emergence from bankruptcy
in September 2003. Of the 100 million shares issued, approximately 98 percent of
those shares of common stock were distributed in September 2003 under the Plan
to holders of allowed claims. The remainder of the 100 million shares was
reserved for distribution under the Plan upon resolution of disputed claims. All
such bankruptcy claims have now been resolved and all shares of common stock
that were reserved from the 100 million have now been distributed in connection
with the resolution of disputed claims under the Plan. Accordingly, there are no
shares remaining for distribution to the holders of bankruptcy claims including
those classes of creditors that were not paid in full upon emergence.
76
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 6. EXHIBITS.
10.11 Letter of agreement dated as of August 3, 2007 between Conseco
Services, LLC and John R. Kline.
10.12 Amendment to Amended and Restated Employment Agreement dated as of
September 25, 2007 between 40|86 Advisors, Inc. and Eric R. Johnson.
10.25 Amended and Restated Employment Agreement dated as of August 17, 2007
between Conseco Services, LLC and Susan L. Menzel.
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.
77
CONSECO, INC. AND SUBSIDIARIES
-------------------
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: November 8, 2007 By:/s/ Edward J. Bonach
--------------------
Edward J. Bonach
Executive Vice President and
Chief Financial Officer
(authorized officer and principal
financial officer)
78