===============================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2008
[ ] 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, a non-accelerated filer or a smaller reporting company.
See the definitions of "large accelerated filer", "accelerated filer" and
"smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated
filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting
company [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act): Yes [ ] No [ X ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court: Yes [ X ] No [ ]
Shares of common stock outstanding as of July 29, 2008: 184,725,949
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of June 30, 2008 and December 31, 2007.................................. 3
Consolidated Statement of Operations for the three and six months ended June 30, 2008 and 2007........ 5
Consolidated Statement of Shareholders' Equity for the six months ended June 30, 2008 and 2007........ 6
Consolidated Statement of Cash Flows for the six months ended June 30, 2008 and 2007.................. 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............................................. 42
Overview.............................................................................................. 43
Critical Accounting Policies.......................................................................... 44
Results of Operations................................................................................. 45
Premium Collections................................................................................... 65
Liquidity and Capital Resources....................................................................... 70
Investments........................................................................................... 76
Investment in Variable Interest Entity................................................................ 84
New Accounting Standards.............................................................................. 85
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................................... 85
Item 4. Controls and Procedures............................................................................... 85
PART II - OTHER INFORMATION
Item 1. Legal Proceedings..................................................................................... 86
Item 1A. Risk Factors.......................................................................................... 86
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds........................................... 87
Item 4. Submission of Matters to a Vote of Security Holders................................................... 88
Item 5. Other Information..................................................................................... 89
Item 6. Exhibits.............................................................................................. 89
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
ASSETS
June 30, December 31,
2008 2007
---- ----
(unaudited)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
June 30, 2008 - $21,336.8; December 31, 2007 - $20,992.7)............................ $20,148.4 $20,510.9
Equity securities at fair value (cost: June 30, 2008 - $34.0;
December 31, 2007 - $34.0)........................................................... 34.3 34.5
Mortgage loans......................................................................... 2,222.6 2,086.0
Policy loans........................................................................... 364.3 370.4
Trading securities..................................................................... 266.5 665.8
Other invested assets ................................................................. 88.7 134.3
--------- ---------
Total investments.................................................................. 23,124.8 23,801.9
Cash and cash equivalents - unrestricted.................................................. 295.3 407.5
Cash and cash equivalents - restricted.................................................... 21.5 21.1
Accrued investment income................................................................. 328.8 319.3
Value of policies inforce at the Effective Date........................................... 1,631.4 1,722.8
Cost of policies produced................................................................. 1,658.7 1,423.0
Reinsurance receivables................................................................... 3,445.5 3,592.8
Income tax assets, net.................................................................... 1,812.4 1,909.4
Assets held in separate accounts.......................................................... 24.6 27.4
Other assets.......................................................................... 338.0 289.6
--------- ---------
Total assets....................................................................... $32,681.0 $33,514.8
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
June 30, December 31,
2008 2007
---- ----
(unaudited)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $13,105.0 $13,169.4
Traditional products................................................................... 12,688.4 12,537.4
Claims payable and other policyholder funds............................................ 971.3 928.0
Liabilities related to separate accounts............................................... 24.6 27.4
Other liabilities........................................................................ 495.7 510.0
Investment borrowings.................................................................... 824.2 913.0
Notes payable - direct corporate obligations............................................. 1,189.7 1,193.7
--------- ---------
Total liabilities.................................................................. 29,298.9 29,278.9
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: June 30, 2008 - 184,725,949; December 31, 2007 - 184,652,017)......... 1.9 1.9
Additional paid-in capital............................................................... 4,073.6 4,068.6
Accumulated other comprehensive loss..................................................... (639.2) (273.3)
Retained earnings (accumulated deficit)................................................. (54.2) 438.7
--------- ---------
Total shareholders' equity......................................................... 3,382.1 4,235.9
--------- ---------
Total liabilities and shareholders' equity......................................... $32,681.0 $33,514.8
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended Six months ended
June 30, June 30,
---------------------- -------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Revenues:
Insurance policy income.............................. $ 896.1 $ 767.8 $1,747.3 $1,530.6
Net investment income (loss):
General account assets............................. 356.1 382.2 709.8 760.1
Policyholder and reinsurer accounts and other
special-purpose portfolios....................... (21.6) 42.3 (47.6) 47.2
Net realized investment losses....................... (235.3) (28.3) (278.9) (63.2)
Fee revenue and other income......................... 4.9 5.2 8.9 9.0
-------- -------- -------- --------
Total revenues................................... 1,000.2 1,169.2 2,139.5 2,283.7
-------- -------- -------- --------
Benefits and expenses:
Insurance policy benefits............................ 896.7 925.3 1,754.5 1,742.7
Interest expense..................................... 22.9 27.9 51.6 51.5
Amortization......................................... 106.9 114.5 222.0 231.6
Costs related to a litigation settlement............. - 35.0 - 48.0
Other operating costs and expenses................... 152.6 151.8 299.4 296.0
-------- -------- -------- --------
Total benefits and expenses...................... 1,179.1 1,254.5 2,327.5 2,369.8
-------- -------- -------- --------
Loss before income taxes......................... (178.9) (85.3) (188.0) (86.1)
Income tax expense (benefit):
Tax benefit on period income......................... (61.8) (30.1) (65.1) (30.4)
Valuation allowance for deferred tax assets.......... 370.0 - 370.0 -
-------- -------- -------- --------
Net loss......................................... (487.1) (55.2) (492.9) (55.7)
Preferred stock dividends............................... - 4.6 - 14.1
-------- -------- -------- --------
Net loss applicable to common stock.............. $ (487.1) $ (59.8) $ (492.9) $ (69.8)
======== ======== ======== ========
Loss per common share:
Basic:
Weighted average shares outstanding................ 184,684,000 169,139,000 184,669,000 160,038,000
=========== =========== =========== ===========
Net loss........................................... $(2.64) $(.35) $(2.67) $(.44)
====== ===== ====== =====
Diluted:
Weighted average shares outstanding................ 184,684,000 169,139,000 184,669,000 160,038,000
=========== =========== =========== ===========
Net loss........................................... $(2.64) $(.35) $(2.67) $(.44)
====== ===== ====== =====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Retained
Common stock Accumulated other earnings
Preferred and additional comprehensive (accumulated
Total stock paid-in capital income (loss) deficit)
----- ----- --------------- ------------- --------
Balance, January 1, 2008............................. $4,235.9 $ - $4,070.5 $(273.3) $ 438.7
Comprehensive loss, net of tax:
Net loss........................................ (492.9) - - - (492.9)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $207.2)............................ (365.9) - - (365.9) -
--------
Total comprehensive loss.................... (858.8)
Stock option and restricted stock plans........... 5.0 - 5.0 - -
-------- ------- -------- ------- -------
Balance, June 30, 2008............................... $3,382.1 $ - $4,075.5 $(639.2) $ (54.2)
======== ======= ======== ======= =======
Balance, January 1, 2007 (Restated).................. $4,700.1 $ 667.8 $3,469.5 $ (72.6) $ 635.4
Comprehensive loss, net of tax:
Net loss........................................ (55.7) - - - (55.7)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $143.9)............................ (257.6) - - (257.6) -
--------
Total comprehensive loss.................... (313.3)
Cost of shares acquired........................... (29.6) - (29.6) - -
Stock option and restricted stock plans........... 9.4 - 9.4 - -
Change in unrecognized net loss related to
deferred compensation plan (net of applicable
income tax expense of $.2 million).............. .3 - - .3 -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date in conjunction with adoption of FIN 48..... 6.0 - 6.0 - -
Cumulative effect of accounting change............ (2.7) - - - (2.7)
Conversion of preferred stock into common
shares.......................................... - (667.8) 667.8 - -
Dividends on preferred stock...................... (14.1) - - - (14.1)
-------- ------- -------- ------- -------
Balance, June 30, 2007 (Restated).................... $4,356.1 $ - $4,123.1 $(329.9) $ 562.9
======== ======= ======== ======= =======
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)
Six months ended
June 30,
----------------------
2008 2007
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 1,579.0 $ 1,355.9
Net investment income................................................................. 692.7 796.4
Fee revenue and other income.......................................................... 8.9 9.0
Net sales (purchases) of trading securities........................................... 391.6 (138.0)
Insurance policy benefits............................................................. (1,391.1) (1,120.6)
Interest expense...................................................................... (53.3) (51.3)
Policy acquisition costs.............................................................. (235.1) (244.4)
Other operating costs................................................................. (282.6) (278.3)
Taxes................................................................................. (.5) (1.6)
--------- ---------
Net cash provided by operating activities........................................... 709.6 327.1
--------- ---------
Cash flows from investing activities:
Sales of investments.................................................................. 4,288.1 3,810.3
Maturities and redemptions of investments............................................. 539.2 585.6
Purchases of investments.............................................................. (5,595.4) (5,072.0)
Change in restricted cash............................................................. (.4) (5.8)
Other................................................................................. (14.3) 6.4
--------- ---------
Net cash used by investing activities .............................................. (782.8) (675.5)
--------- ---------
Cash flows from financing activities:
Issuance of notes payable............................................................. - 200.0
Issuance of common stock.............................................................. - 3.4
Payments to repurchase common stock................................................... - (29.6)
Payments on notes payable............................................................. (4.3) (3.4)
Amounts received for deposit products................................................. 823.9 969.2
Withdrawals from deposit products..................................................... (769.8) (1,086.2)
Investment borrowings................................................................. (88.8) 450.6
Dividends paid on preferred stock..................................................... - (19.0)
--------- ---------
Net cash provided (used) by financing activities.................................. (39.0) 485.0
--------- ---------
Net increase (decrease) in cash and cash equivalents.............................. (112.2) 136.6
Cash and cash equivalents, beginning of period........................................... 407.5 385.9
--------- ---------
Cash and cash equivalents, end of period................................................. $ 295.3 $ 522.5
========= =========
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 2007 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 (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, our Predecessor 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.
PLAN TO TRANSFER CONSECO SENIOR HEALTH INSURANCE COMPANY TO AN INDEPENDENT
TRUST
We have entered into an agreement, pursuant to which Conseco Senior Health
Insurance Company ("Conseco Senior") will be transferred to an independent trust
subject to the approval of the Pennsylvania Insurance Department. We recognized
the following charges in the three months ended June 30, 2008 related to the
transaction: (i) pre-tax writedowns of $205.7 million ($133.7 million after
taxes) related to the investments of Conseco Senior that were in an unrealized
loss position because, as a result of the planned transaction, management no
longer has the positive intent to hold these securities until they recover in
value; (ii) an increase in the valuation allowance for deferred tax assets of
$298.0 million ($370.0 million, including the potential tax benefits of the
aforementioned investment writedowns) after considering the impact of our recent
results and the plan to transfer Conseco Senior to an independent trust.
Refer to the note to these consolidated financial statements entitled
"Subsequent Event" for more information on the transaction, including additional
charges expected to be incurred upon its completion.
OUT-OF-PERIOD ADJUSTMENTS
We recorded the net effects of certain out-of-period adjustments which
decreased our net income by: (i) $.9 million (or nil cents per diluted share) in
the second quarter of 2008; and (ii) $1.4 million (or one cent per diluted
share) in the first six months of 2008.
RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
As previously disclosed in our 2007 Form 10-K, we restated our financial
statements for the years ended December 31, 2006 and 2005, along with affected
Selected Consolidated Financial Data for 2004 and 2003, and quarterly financial
information for 2006 and the first three quarters of 2007. Such conclusion was
based on the significance of errors identified in 2007 during the procedures
performed in an effort to remediate the material weakness in internal controls
disclosed in our 2006 Form 10-K and subsequent quarterly filings with the U.S.
Securities and Exchange Commission (the "SEC").
The most significant errors related to adjustments to insurance policy
benefits and the liabilities for insurance products in the specified disease and
life blocks in the Conseco Insurance Group segment and in the long-term care
block of business in the Other Business in Run-off segment identified in 2007
during the aforementioned remediation procedures.
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
We reviewed certain actuarial valuation processes for approximately 2,400
types of policy forms, encompassing insurance products that accounted for more
than 80 percent of the total liabilities for the business subject to the
remediation procedures.
The errors we discovered through our remediation procedures had the effect
of reducing shareholders' equity at December 31, 2006 by $20.6 million, as
summarized below (dollars in millions):
Understatement
(overstatement) of
shareholders' equity
at December 31, 2006
--------------------
Coding errors in actuarial system related to specified disease
return of premium features..................................................... $ 25.6 (i)
Error related to certain specified disease policies for which return of
premium is payable upon first occurrence of claim.............................. (15.9) (ii)
Error in reserve factors for certain specified disease policies.................. (20.4) (iii)
Error related to certain specified disease policies for which return of
premium benefit is not reduced for claims...................................... (18.0) (iv)
Inconsistent performance of procedure to identify terminated long-term
care policies.................................................................. 10.7 (v)
Coding errors in actuarial system related to universal life policies............. 7.9 (vi)
Error related to certain universal life policies with bonus features............. (6.5) (vii)
Errors identified through outlier procedures..................................... (14.4) (viii)
Other errors..................................................................... (1.0) (ix)
------
Total errors before income tax effect........................................ (32.0)
Income tax effect................................................................ 11.4
------
Total errors after income tax................................................ $(20.6)
======
<FN>
- ---------------------
(i) The coding in our administrative system related to specified disease
policies with a return of premium feature that had been subject to an
exchange in the past was inaccurate. This resulted in an overstatement
of insurance policy liabilities. This error relates to business in our
Conseco Insurance Group segment. The $25.6 million total for this item
includes the $19.3 million adjustment previously disclosed in
Management's Discussion and Analysis of Financial Condition and
Results of Operations - Conseco Insurance Group in our Form 10-Q for
the quarterly period ended March 31, 2007.
(ii) Insurance policy liabilities for certain specified disease policies
with a return of premium feature that is payable upon the earlier of
the first occurrence of a covered claim or a specified date had not
considered the first occurrence provision. This error resulted in an
understatement of these reserves. This error relates to business in
our Conseco Insurance Group segment.
</FN>
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(iii) A key factor used to determine specified disease insurance liabilities
for certain policies sold by one of our insurance subsidiaries prior
to its acquisition by Conseco was incorrectly set to zero. This
resulted in no insurance policy liability being established for these
policies. This error relates to business in our Conseco Insurance
Group segment. The $20.4 million total for this item includes the
$18.3 million adjustment previously disclosed in Management's
Discussion and Analysis of Financial Condition and Results of
Operations - Conseco Insurance Group in our Form 10-Q for the
quarterly period ended September 30, 2007.
(iv) Insurance policy liabilities for certain specified disease policies
with a return of premium provision had been calculated as if the
benefit would be reduced by claims paid during the term of the policy,
when such offset provision was not applicable to the policies. This
error resulted in an understatement of insurance policy liabilities
and relates to business in our Conseco Insurance Group segment.
(v) The procedures we had established to identify terminations of
long-term care policies due to the death of the insured were not being
performed in a consistent manner. This error resulted in an
overstatement of insurance policy liabilities and relates to business
in our Other Business in Run-off segment.
(vi) Certain coding errors in the actuarial valuation system for universal
life policies had resulted in an overstatement of insurance policy
liabilities. This error relates to business in our Bankers Life
segment.
(vii) Provisions in certain universal life products that provided for future
bonus credits were not being reflected in the amortization of the
value of policies inforce. These errors resulted in an overstatement
of the value of policies inforce and relates to our Bankers Life
segment.
(viii) We perform various procedures in an effort to identify potential
errors in our insurance policy liabilities by reviewing amounts that
had unusual reserve or benefit balances. These procedures resulted in
the identification of certain specified disease, long-term care and
life policies with incorrect insurance policy liabilities. The errors
include an understatement of reserves of $9.1 million in our Conseco
Insurance Group segment and $5.3 million in our Other Business in
Run-off segment.
(ix) Other miscellaneous errors that resulted in an misstatement of certain
insurance policy liabilities and insurance intangible balances. No
single error resulted in adjustments exceeding $5.0 million. The
errors relate to our Bankers Life, Conseco Insurance Group and Other
Business in Run-off segments.
In addition, on February 28, 2008, the SEC's Office of the Chief Accountant
informed us that the use of a method which prospectively changes reserve
assumptions for long-term care policies when premium rate increases differ
significantly from original assumptions is not consistent with the guidance of
Statement of Financial Standards No. 60, "Accounting and Reporting by Insurance
Enterprises" ("SFAS 60").
As a result, if premium rate increases reflect a change in our previous
rate increase assumptions, the new assumptions are not reflected prospectively
in our reserves. Instead, the additional premium revenue resulting from the rate
increase is recognized as earned and original assumptions continue to be used to
determine changes to liabilities for insurance products unless a premium
deficiency exists.
Our restatement of previously issued financial statements for the year
ended December 31, 2006 and quarterly information for 2006 and the first three
quarters of 2007, included adjustments to eliminate the use of the prospective
revision methodology. After the elimination of the additional reserves we
established based on the prospective revision methodology, our liabilities for
insurance products for long-term care policies in the two business segments with
these blocks (Bankers Life and Other Business in Run-off) were not deficient in
the aggregate, but our estimates of future earnings indicated that profits would
be recognized in early periods and losses in later periods. In accordance with
paragraph 37 of SFAS 60, we increased the liabilities for insurance products
over the period of profits, by an amount necessary to offset losses that are
expected to be recognized in later periods.
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
During our process to restate our previously issued financial statements,
we also corrected previously identified errors, which had been recognized
through cumulative adjustments to previously issued financial statements. We
determined that these errors were immaterial, after considering the magnitude of
the adjustment in relationship to earnings in the period discovered, offsetting
adjustments and other factors. We described these adjustments in the
Management's Discussion and Analysis of Consolidated Financial Condition and
Results of Operations of our prior filings, including our 2006 Form 10-K. The
following is a summary of our prior disclosures:
o During 2006, we determined that we had been carrying insurance
liabilities for certain single premium annuities that were no longer in
force in the Bankers Life segment. The error resulted in an
overstatement of insurance policy liabilities of $7.4 million.
o During 2005, we determined the method that had been used to calculate
insurance policy liabilities for future long-term care benefits on
policies with inflation coverage was incorrect. The error resulted in an
overstatement of insurance policy liabilities of $6.4 million in the
Bankers Life segment.
o In 2005, we identified errors in the calculation of insurance
acquisition costs in the Bankers Life segment. The errors resulted in an
overstatement of insurance acquisition costs of $4.4 million.
o During 2006, we discovered that procedures to appropriately identify
deceased policyholders on a timely basis and release the related
insurance policy liabilities were not being performed in a consistent
manner. The error resulted in an overstatement of insurance policy
liabilities of $4.7 million in the Conseco Insurance Group segment.
o In 2006, we discovered that we had not been establishing insurance
policy liabilities for certain specified disease coverages and that
factors used to determine these liabilities were incorrect. The errors
resulted in an understatement of insurance policy liabilities of $13.3
million in the Conseco Insurance Group segment. This error was offset by
a $1.6 million understatement of insurance acquisition costs related to
the same policies.
o In 2006, we discovered that several errors had been made in estimating
claim reserve liabilities for our long-term care business in the Other
Business in Run-off segment. In the process of reviewing our claim
estimates, we discovered that some claim liabilities related to policies
with inflation riders had been estimated excluding inflation benefits.
We also discovered that some claim liabilities related to policies
providing lifetime benefits had been estimated based on the assumption
the benefit period was limited. We also discovered that some claim
liabilities for non-forfeiture benefits had been estimated based on the
original pool of money benefit, rather than pool amounts reduced by
benefits previously paid. These errors resulted in an understatement of
claim reserves of $7.1 million.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The effects of the restatement adjustments on our consolidated financial
statements are as follows:
Consolidated Statement of Operations
Three months ended June 30, 2007
---------------------------------------------------------------
Adjustments
------------------------------
Accounting for
As previously Remediation premium rate As
reported procedures increases restated
-------- ---------- --------- --------
(Dollars in millions, except per share data)
Total revenues........................ $1,169.2 $ - $ - $1,169.2
-------- ------ ------ --------
Benefits and expenses:
Insurance policy benefits.......... 930.9 (2.3) (3.3) 925.3
Interest expense................... 27.9 - - 27.9
Amortization....................... 116.3 .6 (2.4) 114.5
Costs related to a
litigation settlement........... 35.0 - - 35.0
Other operating costs and
expenses........................ 151.8 - - 151.8
-------- ------ ------ --------
Total benefits and expenses..... 1,261.9 (1.7) (5.7) 1,254.5
-------- ------ ------ --------
Income (loss) before income
taxes......................... (92.7) 1.7 5.7 (85.3)
Income tax expense (benefit).......... (32.8) .6 2.1 (30.1)
-------- ------ ------ --------
Net income (loss).................. $ (59.9) $ 1.1 $ 3.6 $ (55.2)
======== ====== ====== ========
Net loss per share - basic............ $(.38) $(.35)
===== =====
Net loss per share - diluted.......... $(.38) $(.35)
===== =====
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Six months ended June 30, 2007
-----------------------------------------------------------------------
Adjustments
--------------------------------------------
Accounting for Previously
As previously Remediation premium rate identified As
reported procedures increases errors restated
-------- ---------- --------- ------ --------
(Dollars in millions, except per share data)
Total revenues....................... $2,283.7 $ - $ - $ - $2,283.7
-------- ------- ------ ------ --------
Benefits and expenses:
Insurance policy benefits......... 1,732.2 17.3 (6.8) - 1,742.7
Interest expense.................. 51.5 - - - 51.5
Amortization...................... 232.5 1.2 (1.9) (.2) 231.6
Costs related to a
litigation settlement.......... 48.0 - - - 48.0
Other operating costs and
expenses....................... 296.0 - - - 296.0
-------- ------ ------ ------ --------
- -
Total benefits and expenses.... 2,360.2 18.5 (8.7) (.2) 2,369.8
-------- ------ ------ ------ --------
Income (loss) before income
taxes........................ (76.5) (18.5) 8.7 .2 (86.1)
Income tax expense (benefit)......... (27.0) (6.7) 3.2 .1 (30.4)
-------- ------ ------ ------ --------
Net income (loss)................. $ (49.5) $(11.8) $ 5.5 $ .1 $ (55.7)
======== ====== ====== ====== ========
Net loss per share - basic........... $(.40) $(.44)
===== =====
Net loss per share - diluted......... $(.40) $(.44)
===== =====
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Selected Consolidated Balance Sheet Accounts
June 30, 2007
------------------------------------------------------------------------
Adjustments
--------------------------------------------
Accounting for Previously
As previously Remediation premium rate identified As
reported procedures increases errors restated
-------- ---------- --------- ------ --------
(Dollars in millions, except per share data)
Additional paid-in capital........... $4,126.4 $ (4.8) $ - $ (.4) $4,121.2
Retained earnings.................... 576.9 (27.6) 14.6 (1.0) 562.9
Selected Consolidated Statement of Cash Flow Amounts
Six months ended June 30, 2007
------------------------------------------------------------------------
Adjustments
--------------------------------------------
Accounting for Previously
As previously Remediation premium rate identified As
reported procedures increases errors restated
-------- ---------- --------- ------ --------
(Dollars in millions, except per share data)
Cash flows from operating activities:
Net income (loss).................. $(49.5) $(11.8) $ 5.5 $ .1 $(55.7)
Amortization and depreciation...... 247.3 1.2 (1.9) (.2) 246.4
Income taxes....................... (28.6) (6.7) 3.2 .1 (32.0)
Insurance liabilities.............. 436.9 17.3 (6.8) - 447.4
Net cash provided by operating
activities......................... 327.1 - - - 327.1
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
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 accounting principles generally accepted in the
United States of America ("GAAP"). We have reclassified certain amounts from the
prior periods to conform to the 2008 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, 2007, 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 (including
derivatives), 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.
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into one of three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); or (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
Certain of our trading securities are held 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" 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 $266.5 million and
$665.8 million at June 30, 2008 and December 31, 2007, respectively.
Accumulated other comprehensive loss is primarily comprised of the net
effect of unrealized appreciation (depreciation) on our investments. These
amounts, included in shareholders' equity as of June 30, 2008 and December 31,
2007, were as follows (dollars in millions):
June 30, December 31,
2008 2007
---- ----
Net unrealized depreciation on investments............................................ $(1,185.7) $(481.3)
Adjustment to value of policies inforce at the Effective Date......................... 52.2 18.3
Adjustment to cost of policies produced............................................... 141.0 43.7
Unrecognized net loss related to deferred compensation plan........................... (7.2) (7.3)
Deferred income tax asset............................................................. 360.5 153.3
--------- -------
Accumulated other comprehensive loss............................................. $ (639.2) $(273.3)
========= =======
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
EARNINGS PER SHARE
A reconciliation of net loss and shares used to calculate basic and diluted
loss per share is as follows (dollars in millions and shares in thousands):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Net loss................................................ $(487.1) $(55.2) $(492.9) $(55.7)
Preferred stock dividends............................... - (4.6) - (14.1)
------- ------ ------- ------
Net loss applicable to common stock
for basic and diluted earnings per share......... $(487.1) $(59.8) $(492.9) $(69.8)
======= ====== ======= ======
Shares:
Weighted average shares outstanding
for basic and diluted earnings per share........... 184,684 169,139 184,669 160,038
======= ======= ======= =======
There were no dilutive common stock equivalents during the 2008 and 2007
periods 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 (loss)
applicable to common stock.
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share during the
three and six months ended June 30, 2008 and 2007, because doing so would have
been antidilutive in such periods (shares in thousands).
Three months ended Six months ended
June 30, June 30,
------------------- ------------------
2008 2007 2008 2007
---- ---- ---- ----
Equivalent common shares that were antidilutive
during the period:
Class B mandatorily convertible preferred stock... - 19,528 - 28,669
Stock option and restricted stock plans........... 67 263 46 196
-- ------ -- ------
67 19,791 46 28,865
== ====== == ======
In August 2005, we completed the private offering of $330.0 million of
3.50% Convertible Debentures due September 30, 2035 (the "Debentures"). In
future periods, our diluted shares outstanding may include incremental shares
issuable upon conversion of all or part of such Debentures. Since the $330.0
million principal amount can only be redeemed for cash, it has no impact on the
diluted earnings per share calculation. In accordance with the conversion
feature of these Debentures, we may be required to pay a stock premium along
with redeeming the accreted principal amount for cash, if our common stock
reaches a certain market price. In accordance with the consensus from EITF No.
04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings
per Share", we will include the dilutive effect of our Debentures in the
calculation of diluted earnings per share when the impact is dilutive. During
the three and six months ended June 30, 2008 and 2007, 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 (loss) per share for the three or six months
ended June 30, 2008 and 2007.
Basic earnings (loss) per common share is computed by dividing net income
(loss) applicable to common stock by the weighted average number of common
shares outstanding for the period. Restricted shares (including our performance
shares) are not included in basic earnings (loss) per share until vested.
Diluted earnings (loss) per share reflect the potential dilution
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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).
BUSINESS SEGMENTS
We manage our business through the following: three primary operating
segments, Bankers Life, Colonial Penn and Conseco Insurance Group, 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.
We measure segment performance for purposes of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information", excluding realized investment gains (losses) because we believe
that this performance measure is a better indicator of the ongoing business 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. We may experience 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.
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Operating information by segment was as follows (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------------- ----------------------------
2008 2007 2008 2007
---- ---------------------- ---- ----------------------
(Restated) (As reported) (Restated) (As reported)
Revenues:
Bankers Life:
Insurance policy income:
Annuities..................................... $ 10.3 $ 15.6 $ 15.6 $ 27.3 $ 32.3 $ 32.3
Supplemental health........................... 463.0 340.5 340.5 875.4 667.7 667.7
Life.......................................... 47.6 44.8 44.8 91.2 86.0 86.0
Other......................................... 22.5 23.1 23.1 46.5 50.0 50.0
Net investment income (a).......................... 135.2 155.1 155.1 264.5 296.0 296.0
Fee revenue and other income (a)................... 2.1 2.7 2.7 3.7 3.9 3.9
-------- -------- -------- -------- -------- --------
Total Bankers Life revenues............... 680.7 581.8 581.8 1,308.6 1,135.9 1,135.9
-------- -------- -------- -------- -------- --------
Colonial Penn:
Insurance policy income:
Supplemental health........................... 2.1 2.5 2.5 4.3 5.0 5.0
Life.......................................... 45.1 26.7 26.7 87.0 53.2 53.2
Other......................................... .3 .2 .2 .6 .5 .5
Net investment income (a).......................... 10.1 9.4 9.4 19.3 18.9 18.9
Fee revenue and other income (a)................... .5 .1 .1 .8 .3 .3
-------- -------- -------- -------- -------- --------
Total Colonial Penn revenues.............. 58.1 38.9 38.9 112.0 77.9 77.9
-------- -------- -------- -------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities..................................... 3.4 3.9 3.9 6.1 6.8 6.8
Supplemental health........................... 142.1 148.1 148.1 287.2 298.5 298.5
Life.......................................... 81.2 81.9 81.9 165.0 168.2 168.2
Other......................................... 3.0 2.4 2.4 5.7 4.8 4.8
Net investment income (a).......................... 131.3 202.5 202.5 260.6 377.9 377.9
Fee revenue and other income (a)................... .4 .1 .1 1.1 .3 .3
-------- -------- -------- -------- -------- --------
Total Conseco Insurance Group revenues.... 361.4 438.9 438.9 725.7 856.5 856.5
-------- -------- -------- -------- -------- --------
Other Business in Run-off:
Insurance policy income - supplemental health...... 75.5 78.1 78.1 151.0 157.6 157.6
Net investment income (a).......................... 51.6 47.6 47.6 102.1 94.6 94.6
Fee revenue and other income (a)................... .1 .1 .1 .2 .2 .2
-------- -------- -------- -------- -------- --------
Total Other Business in Run-off revenues.. 127.2 125.8 125.8 253.3 252.4 252.4
-------- -------- -------- -------- -------- --------
Corporate:
Net investment income.............................. 6.3 9.9 9.9 15.7 19.9 19.9
Fee and other income............................... 1.8 2.2 2.2 3.1 4.3 4.3
-------- -------- -------- -------- -------- --------
Total corporate revenues.................. 8.1 12.1 12.1 18.8 24.2 24.2
-------- -------- -------- -------- -------- --------
Total revenues............................ 1,235.5 1,197.5 1,197.5 2,418.4 2,346.9 2,346.9
-------- -------- -------- -------- -------- --------
(continued on next page)
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
----------------------------- ----------------------------
2008 2007 2008 2007
---- ---------------------- ---- ----------------------
(Restated) (As reported) (Restated) (As reported)
Expenses:
Bankers Life:
Insurance policy benefits....................... $ 534.4 $ 396.8 $ 399.7 $1,014.1 $ 786.5 $ 792.7
Amortization.................................... 66.6 69.2 71.3 141.6 151.2 152.7
Other operating costs and expenses.............. 45.1 45.3 45.3 89.2 82.2 82.2
-------- -------- -------- -------- -------- --------
Total Bankers Life expenses................ 646.1 511.3 516.3 1,244.9 1,019.9 1,027.6
-------- -------- -------- -------- -------- --------
Colonial Penn:
Insurance policy benefits....................... 35.8 24.2 24.2 71.1 50.1 50.1
Amortization.................................... 7.4 4.9 4.9 14.8 9.7 9.7
Other operating costs and expenses.............. 6.6 3.1 3.1 14.1 6.8 6.8
-------- -------- -------- -------- -------- --------
Total Colonial Penn expenses............... 49.8 32.2 32.2 100.0 66.6 66.6
-------- -------- -------- -------- -------- --------
Conseco Insurance Group:
Insurance policy benefits....................... 232.9 275.9 275.4 473.1 552.8 527.8
Amortization.................................... 31.0 47.0 47.0 61.1 85.2 85.2
Interest expense on investment borrowings....... 5.5 4.2 4.2 11.3 5.3 5.3
Costs related to a litigation settlement........ - 17.5 17.5 - 24.0 24.0
Other operating costs and expenses.............. 62.0 68.5 68.5 126.9 136.4 136.4
-------- -------- -------- -------- -------- --------
Total Conseco Insurance Group expenses..... 331.4 413.1 412.6 672.4 803.7 778.7
-------- -------- -------- -------- -------- --------
Other Business in Run-off:
Insurance policy benefits....................... 93.6 228.4 231.6 196.2 353.3 361.6
Amortization.................................... 5.6 6.1 5.8 11.0 12.1 11.5
Other operating costs and expenses.............. 15.8 21.6 21.6 35.2 43.4 43.4
-------- -------- -------- -------- -------- --------
Total Other Business in Run-off expenses... 115.0 256.1 259.0 242.4 408.8 416.5
-------- -------- -------- -------- -------- --------
Corporate:
Interest expense on corporate debt.............. 13.9 16.9 16.9 30.3 33.0 33.0
Interest expense on variable interest entity.... 3.5 6.8 6.8 10.0 13.2 13.2
Costs related to a litigation settlement........ - 17.5 17.5 - 24.0 24.0
Other operating costs and expenses.............. 23.1 13.3 13.3 34.0 27.2 27.2
-------- -------- -------- -------- -------- --------
Total corporate expenses................... 40.5 54.5 54.5 74.3 97.4 97.4
-------- -------- -------- -------- -------- --------
Total expenses............................. 1,182.8 1,267.2 1,274.6 2,334.0 2,396.4 2,386.8
-------- -------- -------- -------- -------- --------
Income (loss) before income taxes:
Bankers Life............................... 34.6 70.5 65.5 63.7 116.0 108.3
Colonial Penn.............................. 8.3 6.7 6.7 12.0 11.3 11.3
Conseco Insurance Group.................... 30.0 25.8 26.3 53.3 52.8 77.8
Other Business in Run-off.................. 12.2 (130.3) (133.2) 10.9 (156.4) (164.1)
Corporate operations....................... (32.4) (42.4) (42.4) (55.5) (73.2) (73.2)
-------- -------- -------- -------- -------- --------
Income (loss) before income taxes...... $ 52.7 $ (69.7) $ (77.1) $ 84.4 $ (49.5) $ (39.9)
======== ======== ======== ======== ======== ========
<FN>
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
A reconciliation of segment revenues and expenses to consolidated revenues
and expenses is as follows (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------------- ----------------------------
2008 2007 2008 2007
---- ---------------------- ---- ----------------------
(Restated) (As reported) (Restated) (As reported)
Total segment revenues.................................. $1,235.5 $1,197.5 $1,197.5 $2,418.4 $2,346.9 $2,346.9
Net realized investment losses.......................... (235.3) (28.3) (28.3) (278.9) (63.2) (63.2)
-------- --------- -------- -------- -------- --------
Consolidated revenues............................... $1,000.2 $1,169.2 $1,169.2 $2,139.5 $2,283.7 $2,283.7
======== ======== ======== ======== ======== ========
Total segment expenses.................................. $1,182.8 $1,267.2 $1,274.6 $2,334.0 $2,396.4 $2,386.8
Amortization related to net realized investment losses.. (3.7) (12.7) (12.7) (6.5) (26.6) (26.6)
-------- -------- -------- -------- -------- --------
Consolidated expenses............................... $1,179.1 $1,254.5 $1,261.9 $2,327.5 $2,369.8 $2,360.2
======== ======== ======== ======== ======== ========
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 anniversary date, a new index period
begins. We are typically able to change the participation rate at the beginning
of each index period during a policy year, subject to contractual minimums. We
typically buy call options referenced to 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 will fluctuate in relation to changes in a
particular index, which are related to the call options we purchase. 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 $(55.8) million and $24.9 million in the six months
ended June 30, 2008 and 2007, respectively. These amounts were substantially
offset by the corresponding charge to insurance policy benefits. The estimated
fair value of these options was $12.2 million and $51.2 million at June 30, 2008
and December 31, 2007, respectively. We classify these instruments as other
invested assets. Pursuant to an annuity coinsurance agreement described below
under the caption "Reinsurance", we held $11.9 million of these options at
December 31, 2007, for the benefit of the assuming company until such options
expired. All cash flows (including any increases (decreases) in fair value) from
these options were transferred to the assuming company in the first six months
of 2008.
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"). In accordance with these requirements, the expected
future cost of options on equity-indexed annuity products is used to determine
the value of embedded derivatives. The Company does not purchase call options to
hedge liabilities which may arise after the next policy anniversary date. The
Company must value both the call options and the related forward embedded
options in the policies at fair value. These accounting requirements often
create volatility in the earnings from these products. We record the changes in
the fair values of the embedded derivatives in current earnings as a component
of policyholder benefits. Effective January 1, 2008, we adopted Statement of
Financial Accounting Standards No. 157 "Fair Value Measurements" ("SFAS 157")
which required us to value the embedded derivatives reflecting a hypothetical
market perspective for fair value measurement. We recorded a charge of $1.8
million to net income (after the effects of the 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") and
income taxes), attributable to changes in the fair value of the embedded
derivatives as a result of adopting SFAS 157. The fair value of these
derivatives, which are classified as "liabilities for interest-sensitive
products", was $358.9 million at June 30, 2008 and $353.2 million at December
31, 2007. We maintain a specific block of investments in our trading securities
account, which we carry at estimated fair value with changes in such value
recognized as investment income (classified as
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
investment income from policyholder and reinsurer accounts and other
special-purpose portfolios). The change in value of these trading securities
attributable to interest fluctuations is intended to offset a portion of the
change in the value of the embedded derivative.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At June 30, 2008, 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 $(4.2) million and $(1.0) million at June 30, 2008 and
December 31, 2007, respectively. The adoption of SFAS 157 had no impact on the
valuation of these embedded derivatives. 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 fluctuations is intended to offset the
change in value of the embedded derivatives. However, differences will occur as
corporate spreads change.
REINSURANCE
The cost of reinsurance ceded totaled $81.8 million and $108.7 million in
the first six months of 2008 and 2007, 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 $215.4
million and $116.7 million in the first six months of 2008 and 2007,
respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced. Reinsurance premiums
assumed totaled $314.7 million and $110.8 million in the first six months of
2008 and 2007, respectively. Reinsurance premiums included amounts assumed
pursuant to marketing and quota-share agreements with Coventry Health Care
("Coventry") of $290.2 million and $84.6 million in the first six months of 2008
and 2007, respectively. The increase in premiums assumed under these agreements
in 2008 resulted from agreements whereby we are assuming: (i) 50 percent of the
Private-Fee-For-Service ("PFFS") business written by Coventry under a large
group policy effective July 1, 2007; and (ii) 40 percent of the PFFS business
written by Coventry under another large group policy effective May 1, 2008.
See the note entitled "Accounting for Derivatives" for a discussion of the
derivative embedded in the payable related to certain modified coinsurance
agreements.
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. Accordingly, our insurance liabilities continue to include the
amounts ceded for these policies, which is offset by a corresponding amount in
reinsurance receivables. The coinsurance transaction had an effective date of
January 1, 2007.
21
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 Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Current tax expense........................................ $ .4 $ 1.2 $ 1.0 $ 1.7
Deferred tax provision..................................... (62.2) (31.3) (66.1) (32.1)
------ ------ ------ ------
Income tax benefit on period income.................... (61.8) (30.1) (65.1) (30.4)
Valuation allowance........................................ 370.0 - 370.0 -
------ ------ ------ ------
Total income tax expense (benefit)..................... $308.2 $(30.1) $304.9 $(30.4)
====== ====== ====== ======
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Six months ended
June 30,
-----------------------
2008 2007
---- ----
(Restated)
U.S. statutory corporate rate............................................................ (35.0)% (35.0)%
Valuation allowance...................................................................... 196.8 -
Other nondeductible expense (benefit).................................................... 1.0 (1.0)
State taxes.............................................................................. (.6) (.6)
Provision for tax issues, tax credits and other.......................................... - 1.3
----- -----
Effective tax rate.............................................................. 162.2% (35.3)%
===== =====
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
June 30, December 31,
2008 2007
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries.................................................... $ 909.9 $ 892.1
Non-life companies............................................................. 841.4 843.8
Net state operating loss carryforwards............................................ 32.2 32.1
Tax credits....................................................................... 13.7 13.7
Capital loss carryforwards........................................................ 268.0 259.7
Deductible temporary differences:
Actively managed fixed maturities.............................................. 55.3 -
Insurance liabilities.......................................................... 1,013.2 1,074.6
Unrealized depreciation of investments......................................... 360.5 153.3
Reserve for loss on loan guarantees............................................ 68.5 71.9
Other.......................................................................... 24.2 4.4
--------- --------
Gross deferred tax assets.................................................... 3,586.9 3,345.6
--------- --------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. - (32.8)
Value of policies inforce at the Effective Date and cost of policies produced.. (734.0) (732.9)
--------- --------
Gross deferred tax liabilities............................................... (734.0) (765.7)
--------- --------
Net deferred tax assets before valuation allowance........................... 2,852.9 2,579.9
Valuation allowance................................................................... (1,042.9) (672.9)
--------- --------
Net deferred tax assets...................................................... 1,810.0 1,907.0
Current income taxes prepaid.......................................................... 2.4 2.4
--------- --------
Income tax assets, net....................................................... $ 1,812.4 $1,909.4
========= ========
We account for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes, ("SFAS 109"). 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. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply in the years
in which temporary differences are expected to be recovered or paid. The effect
of a change in tax rates on deferred tax assets and liabilities is recognized in
earnings in the period when the changes are enacted.
SFAS 109 requires a reduction of the carrying amount of deferred tax assets
by establishing a valuation allowance if, based on the available evidence, it is
more likely than not that such assets will not be realized. We evaluate the need
to establish a valuation allowance for our deferred income tax assets on an
ongoing basis. In evaluating our deferred income tax assets, we consider whether
the deferred income tax assets will be realized, based on the SFAS 109
more-likely-than-not realization threshold criterion. 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. In assessing the need for a valuation
allowance, appropriate consideration is given to all positive and negative
evidence related to the realization of the deferred tax assets. This assessment
considers, among other matters, the nature, frequency and severity of current
and cumulative losses, forecasts of future profitability, excess appreciated
asset value over the tax basis of net assets, the duration of carryforward
periods, our experience with operating loss and tax credit carryforwards
expiring unused, and tax planning alternatives.
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Pursuant to SFAS 109, concluding that a valuation allowance is not required
is difficult when there has been significant negative evidence, such as
cumulative losses in recent years. We utilize a three year rolling calculation
of actual income before income taxes as our primary measure of cumulative losses
in recent years. Our analysis of whether there needs to be further increases to
the deferred tax valuation allowance recognizes that as of June 30, 2008, we
have incurred a cumulative loss over the evaluation period, resulting from the
substantial loss during the three month period ending June 30, 2008 primarily
related to the plan to transfer Conseco Senior to an independent trust as
described in the note to these consolidated financial statements entitled
"Subsequent Event". As a result of the cumulative losses recognized in recent
years, our evaluation of the need to increase the valuation allowance for
deferred tax assets was primarily based on our historical earnings. However,
because a substantial portion of the cumulative losses for the three-year period
ended June 30, 2008, relates to transactions to dispose of blocks of businesses,
we have adjusted the three-year cumulative results for the income and losses
from the blocks of business disposed of in the past and the business we plan to
dispose of as further described in the note to these financial statements
entitled "Subsequent Event." In addition, we have adjusted the three-year
cumulative results for a significant litigation settlement, which we consider to
be a non-recurring matter and have reflected our best estimates of how temporary
differences will reverse over the carryforward periods.
In the second quarter of 2008, we increased our valuation allowance against
our net deferred tax assets by $370 million, to $1,042.9 million, as 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
and/or interpretations on the value of such component to be fully recognized in
the future. We have also evaluated the likelihood that we will have sufficient
taxable income to offset the available deferred tax assets based on evidence
which we consider to be objective and verifiable. Based upon our analysis
completed at June 30, 2008, we believe that we will more likely than not recover
$1.8 billion of our deferred tax assets through reductions of our tax
liabilities in future periods.
Recovery of our deferred tax assets is dependent on achieving the
projections of future taxable income embedded in our analysis 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 may 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.
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 may only be utilized by
the Company up to approximately $142 million per year with any unused amounts
carried forward to the following year. Absent an additional ownership change,
our Section 382 limitation for 2008 will be approximately $559 million
(including $417 million of unused amounts carried forward from prior years).
Future transactions and the timing of such transactions could cause an
additional ownership change for Section 382 income tax purposes. Such
transactions may include, but are not limited to, additional repurchases or
issuances of common stock (including upon conversion of our outstanding 3.50%
convertible debentures), or acquisitions or sales of shares of Conseco stock by
certain holders of our shares, including persons who have held, currently hold
or may accumulate in the future five percent or more of our outstanding common
stock for their own account. Many of these transactions are beyond our control.
If an additional ownership change were to occur for purposes of Section 382, we
would be required to calculate a new annual restriction (which would supersede
the current $142 million annual limit if lower) on the use of our net operating
loss carryforwards to offset future taxable income. The new annual restriction
would be calculated based upon the value of Conseco's equity at the time of such
ownership change, multiplied by a federal long-term tax exempt rate (currently
approximately 4.7 percent), and the new annual restriction could effectively
eliminate our ability to use a substantial portion
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
of our net operating loss carryforwards to offset future taxable income. We
regularly monitor ownership change (as calculated for purposes of Section 382)
and, as of June 30, 2008, we were below the 50 percent ownership change level
that would trigger further impairment of our ability to utilize our net
operating loss carryforwards.
As of June 30, 2008, we had $5.0 billion of NOLs and $.8 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
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
2008 ...... $ - $ - $583.7 $ 583.7 $ 583.7 $ -
2009....... - .9 86.2 87.1 .9 86.2
2010....... - 1.0 - 1.0 1.0 -
2011....... - .1 - .1 .1 -
2012....... - .1 72.2 72.3 .1 72.2
2013....... - - 23.5 23.5 - 23.5
2016....... 16.9 - - 16.9 16.9 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6 (a) 3.2 - 2,173.8 47.3 2,126.5
2020....... - 2.5 - 2.5 2.5 -
2021....... 61.8 - - 61.8 - 61.8
2022....... 266.2 .6 - 266.8 - 266.8
2023....... 51.1 2,092.9 (a) - 2,144.0 71.7 2,072.3
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 1.6 - 1.6 - 1.6
2027....... - 178.8 - 178.8 - 178.8
2028....... - .2 - .2 - .2
-------- -------- ------ -------- -------- --------
Total...... $2,599.8 $2,403.9 $765.6 $5,769.3 $ 757.4 $5,011.9
======== ======== ====== ======== ======== ========
<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>
We had deferred tax assets related to NOLs for state income taxes of $32.2
million and $32.1 million at June 30, 2008 and December 31, 2007, respectively.
The related state NOLs are available to offset future state taxable income in
certain states through 2015.
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.
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of June 30, 2008 and December 31, 2007 (dollars in millions):
June 30, December 31,
2008 2007
---- ----
3.50% convertible debentures............................................................ $ 330.0 $ 330.0
Secured credit agreement................................................................ 861.2 865.5
Unamortized discount on convertible debentures.......................................... (1.5) (1.8)
-------- --------
Direct corporate obligations....................................................... $1,189.7 $1,193.7
======== ========
During the first six months of 2008, we made scheduled principal payments
totaling $4.3 million on our secured credit agreement ("Second Amended Credit
Facility"). There were $6.3 million and $6.8 million of unamortized issuance
costs (classified as other assets) related to our Second Amended Credit Facility
at June 30, 2008 and December 31, 2007, respectively.
The amounts outstanding under the Second Amended Credit Facility bear
interest, payable at least quarterly, based on either a Eurodollar rate or a
base rate. The Eurodollar rate is equal to LIBOR plus 2 percent. The base rate
is equal to 1 percent plus the greater of: (i) the Federal funds rate plus .50
percent; or (ii) Bank of America's prime rate. Under the terms of the Second
Amended Credit Facility, if the Company's senior secured long-term debt is rated
at least "Ba2" by Moody's Investors Service, Inc. ("Moody's") and "BB" by S&P,
in each case with a stable outlook, the margins on the Eurodollar rate or the
base rate would each be reduced by .25 percent. At June 30, 2008, the interest
rate on our Second Amended Credit Facility was 4.5 percent.
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
Remainder of 2008............................. $ 4.4
2009.......................................... 8.7
2010.......................................... 338.8
2011.......................................... 8.7
2012.......................................... 8.8
2013.......................................... 821.8
--------
$1,191.2
========
Pursuant to the Second Amended Credit Facility, as long as the debt to
total capitalization ratio (as defined in the Second Amended Credit Facility) is
greater than 20 percent and certain insurance subsidiaries (as defined in the
Second Amended Credit Facility) have financial strength ratings of less than A-
from A.M. Best Company ("A.M. Best"), the Company is required to make mandatory
prepayments with all or a portion of the proceeds from the following
transactions or events including: (i) the issuance of certain indebtedness; (ii)
equity issuances; (iii) certain asset sales or casualty events; and (iv) excess
cash flows as defined in the Second Amended Credit Facility (the first such
payment, if applicable, would not be paid prior to the first quarter of 2009).
The Company may make optional prepayments at any time in minimum amounts of $3.0
million or any multiple of $1.0 million in excess thereof.
The Second Amended Credit Facility requires the Company to maintain various
financial ratios and balances, as defined in the agreement, including: (i) a
debt to total capitalization ratio of not more than 30 percent at all times
(such ratio was 23 percent at June 30, 2008); (ii) an interest coverage ratio
greater than or equal to 2.0 to 1 for each rolling four quarters (such ratio
exceeded the minimum requirement for the four quarters ending June 30, 2008);
(iii) an aggregate risk-based capital ratio, as defined in the Second Amended
Credit Facility, greater than or equal to 250 percent for each quarter (such
ratio exceeded the minimum risk-based capital requirements at June 30, 2008);
and (iv) a combined statutory capital and surplus level of greater than $1,270.0
million (combined statutory capital and surplus at June 30, 2008 exceeded such
requirement).
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The Second Amended Credit Facility includes an $80.0 million revolving
credit facility that can be used for general corporate purposes and that would
mature on June 22, 2009. There were no amounts outstanding under the revolving
credit facility at June 30, 2008 and December 31, 2007. 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 ("CLTX"). 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. We have repurchased $87.2 million of our common stock. No repurchases
were made in the first six months of 2008.
INVESTMENT BORROWINGS
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 the
borrowings. At June 30, 2008, the carrying value of the FHLBI common stock was
$22.5 million. Collateralized borrowings from the FHLBI totaled $450.0 million
as of June 30, 2008, and the proceeds were used to purchase fixed maturity
securities. The borrowings are classified as investment borrowings in the
accompanying consolidated balance sheet. The borrowings are collateralized by
investments with an estimated fair value of $508.0 million at June 30, 2008,
which are maintained in a custodial account for the benefit of the FHLBI.
Conseco Life recognized interest expense of $11.0 million and $4.8 million in
the first six months of 2008 and 2007, respectively, related to the borrowings.
The following summarizes the terms of the borrowings (dollars in millions):
Amount Maturity Interest rate
borrowed date at June 30, 2008
-------- ---- ----------------
$ 54.0 May 2012 Variable rate - 2.638%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 2.770%
146.0 November 2015 Fixed rate - 5.300%
100.0 November 2015 Fixed rate - 4.890%
100.0 December 2015 Fixed rate - 4.710%
At June 30, 2008, investment borrowings consisted of: (i) collateralized
borrowings from the FHLBI of $450.0 million; (ii) $364.3 million of securities
issued to other entities by a variable interest entity ("VIE") which is
consolidated in our financial statements; and (iii) other borrowings of $9.9
million.
At December 31, 2007, investment borrowings consisted of: (i)
collateralized borrowings of $450.0 million; (ii) $452.3 million of securities
issued to other entities by a VIE which is consolidated in our financial
statements; and (iii) other borrowings of $10.7 million.
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CHANGES IN COMMON STOCK
Changes in the number of shares of common stock outstanding were as follows
(shares in thousands):
Balance at December 31, 2007................................................. 184,652
Shares issued under employee benefit compensation plans.................. 74 (a)
-------
Balance at June 30, 2008..................................................... 184,726
=======
<FN>
- ---------
(a) Such amount was reduced by four thousand shares which were tendered
for the payment of federal and state taxes owed on the issuance of
restricted stock.
</FN>
SALES INDUCEMENTS
Certain of our annuity products offer sales inducements to contract holders
in the form of enhanced crediting rates or bonus payments in the initial period
of the contract. Certain of our life insurance products offer persistency
bonuses credited to the contract holders balance after the policy has been
outstanding for a specified period of time. These enhanced rates and persistency
bonuses are considered sales inducements under Statement of Position 03-01
"Accounting and Reporting by Insurance Enterprises for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts". Such amounts are deferred
and amortized in the same manner as the cost of policies produced. Sales
inducements deferred totaled $21.3 million and $28.5 million during the six
months ended June 30, 2008 and 2007, respectively. Amounts amortized totaled
$8.5 million and $10.5 million during the six months ended June 30, 2008 and
2007, respectively. The unamortized balance of deferred sales inducements at
June 30, 2008 and December 31, 2007 was $161.8 million and $149.0 million,
respectively. The balance of insurance liabilities for persistency bonus
benefits was $224.1 million and $252.8 million at June 30, 2008 and December 31,
2007, respectively.
RECENTLY ISSUED ACCOUNTING STANDARDS
Pending Accounting Standards
In June 2008, the FASB issued Emerging Issues Task Force No. 07-5
"Determining Whether an Instrument (or Embedded Feature) is Indexed to an
Entity's Own Stock" ("EITF 07-5"). Statement of Financial Accounting Standards
No. 133 "Accounting for Derivative Instruments and Hedging Activities," ("SFAS
133") specifies that a contract (that would otherwise meet the definition of a
derivative under SFAS 133) issued or held by the reporting entity that is both
indexed to its own stock and classified in stockholders' equity in its statement
of financial position should not be considered a derivative financial instrument
for purposes of applying SFAS 133. EITF 07-5 provides guidance for determining
whether an equity-linked financial instrument (or an embedded feature) is
indexed to an entity's own stock, using a two-step approach. First, the
instrument's contingent exercise provisions, if any, must be evaluated, followed
by an evaluation of the instrument's settlement provisions. The guidance in EITF
07-5 is effective for financial statements issued for fiscal years beginning
after December 15, 2008, and interim periods within those fiscal years. EITF
07-5 is not expected to have a material impact on our consolidated financial
statements.
In May 2008, the FASB issued FSP No. APB 14-1, "Accounting for Convertible
Debt Instruments That May Be Settled In Cash Upon Conversion (Including Partial
Cash Settlement)" ("FSP APB 14-1"). FSP APB 14-1 specifies that issuers of such
instruments should separately account for the liability and equity components in
a manner that will reflect the entity's nonconvertible debt borrowing rate when
interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years. Early adoption is not permitted.
FSP APB 14-1 shall be applied retrospectively to all periods presented unless
instruments were not outstanding during any period included in the financial
statements. The Company is evaluating the impact of adopting FSP APB 14-1 on its
consolidated financial statements.
In May 2008, the FASB issued Statement of Financial Accounting Standards
No. 163, "Accounting for Financial Guarantee Insurance Contracts - an
interpretation of FASB Statement No. 60" ("SFAS 163"). The scope of SFAS 163 is
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
limited to financial guarantee insurance (and reinsurance) contracts issued by
enterprises that are included within the scope of SFAS 60 and that are not
accounted for as derivative instruments. SFAS 163 excludes from its scope
insurance contracts that are similar to financial guarantee insurance such as
mortgage guaranty insurance and credit insurance on trade receivables. SFAS 163
is effective for financial statements issued for fiscal years beginning after
December 15, 2008, and all interim periods within those fiscal years, except for
certain disclosures about the insurance enterprise's risk-management activities,
which are effective for the first period (including interim periods) beginning
after May 2008. Except for certain disclosures, earlier application is not
permitted. The Company does not have financial guarantee insurance products,
and, accordingly does not expect the issuance of SFAS 163 to have an effect on
the Company's consolidated financial condition and results of operations.
In May 2008, the FASB issued Statement of Financial Accounting Standards
No. 162, "The Hierarchy of Generally Accepted Accounting Principles" ("SFAS
162"). Under SFAS 162, the GAAP hierarchy will now reside in the accounting
literature established by the FASB. SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements in conformity with GAAP. SFAS 162 is
effective 60 days following the SEC's approval of the Public Company Accounting
Oversight Board Auditing amendments to AU Section 411, "The Meaning of Present
Fairly in Conformity with Generally Accepted Accounting Principles." SFAS 162 is
not expected to have a material impact on our consolidated financial statements.
In March 2008, the FASB issued Statement of Financial Accounting Standards
No. 161, "Disclosure about Derivative Instruments and Hedging Activities, an
Amendment of FASB Statement No. 133" ("SFAS 161"). SFAS 161 requires enhanced
disclosures about an entities derivative and hedging activities. SFAS 161 is
effective for financial statements issued for fiscal years and interim periods
beginning after November 15, 2008.
In December 2007, the FASB issued Statement of Financial Accounting
Standards No. 160, "Noncontrolling Interests in Consolidated Financial
Statements, an amendment of ARB No. 51" ("SFAS 160"), which establishes new
standards governing the accounting for and reporting of noncontrolling interests
(previously referred to as minority interests). SFAS 160 establishes reporting
requirements which include, among other things, that noncontrolling interests be
reflected as a separate component of equity, not as a liability. It also
requires that the interests of the parent and the noncontrolling interest be
clearly identifiable. Additionally, increases and decreases in a parent's
ownership interest that leave control intact shall be reflected as equity
transactions, rather than step acquisitions or dilution gains or losses. SFAS
160 is effective for fiscal years beginning on or after December 15, 2008 and
early adoption is prohibited. We do not expect the initial adoption of SFAS 160
to be material to our financial position or results of operations.
In December 2007, the FASB issued Statement of Financial Accounting
Standards No. 141 (revised 2007), "Business Combinations" ("SFAS 141R"). SFAS
141R requires the acquiring entity in a business combination to recognize all
assets acquired and liabilities assumed in a transaction at the acquisition date
fair value, with certain exceptions. Additionally, SFAS 141R requires changes to
the accounting treatment of acquisition related items, including, among other
items, transaction costs, contingent consideration, restructuring costs,
indemnification assets and tax benefits. SFAS 141R also provides for a
substantial number of new disclosure requirements. SFAS 141R is effective for
business combinations initiated on or after the first annual reporting period
beginning after December 15, 2008 and early adoption is prohibited. We expect
that SFAS 141R will have an impact on our accounting for future business
combinations once the statement is adopted but the effect is dependent upon
acquisitions, if any, that are made in the future. In addition, SFAS 141R
changes the previous requirement that reductions in a valuation allowance for
deferred tax assets established in conjunction with the implementation of
fresh-start accounting be recognized as a direct increase to additional paid-in
capital. Instead, the revised standard requires that any such reduction be
reported as a decrease to income tax expense through the consolidated statement
of operations. Accordingly, reductions to our valuation allowance for deferred
tax assets will be reported as a decrease to income tax expense, after the
effective date of SFAS 141R.
Adopted Accounting Standards
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
29
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. We adopted SFAS 159 on January 1, 2008. We
did not elect the fair value option for any of our financial assets or
liabilities.
In September 2006, the FASB issued SFAS 157. SFAS 157 defines fair value,
establishes a framework for measuring fair value and expands disclosures of fair
value measurements. We adopted SFAS 157 on January 1, 2008, except as further
described below. SFAS 157 required us to value the embedded derivatives
associated with our equity-indexed annuity products reflecting a hypothetical
market perspective for fair value measurement. We recorded a charge of $1.8
million to net income (after the effects of the amortization of insurance
acquisition costs and income taxes) attributable to changes in the fair value of
the embedded derivative as a result of adopting SFAS 157. In February 2008, the
FASB issued FASB Staff Position FAS 157-2, "Effective Date of FASB Statement No.
157" ("FSP 157-2"). FSP 157-2 delays the effective date (to fiscal years
beginning after November 15, 2008) of SFAS 157 for nonfinancial assets and
nonfinancial liabilities, except for items that are recognized or disclosed at
fair value in the financial statements on a recurring basis (at least annually).
The Company does not expect it to have a material effect on its consolidated
financial position, results of operations or cash flows.
In April 2007, FASB issued Interpretation 39-1 "Amendment of FASB
Interpretation No. 39" ("FIN 39-1"). FIN 39-1 amends FIN 39, "Offsetting of
Amounts Related to Certain Contracts", to allow fair value amounts recognized
for collateral to be offset against fair value amounts recognized for derivative
instruments that are executed with the same counterparty under certain
circumstances. FIN 39-1 also requires an entity to disclose the accounting
policy decision to offset, or not to offset, fair value amounts in accordance
with FIN 39-1, as amended. We do not, and have not previously, offset the fair
value amounts recognized for derivatives with the amounts recognized as
collateral. All collateral is maintained in a tri-party custodial account. At
June 30, 2008, $4.9 million of derivative liabilities have been offset against
derivative assets executed with the same counterparty under master netting
arrangements. We adopted FIN 39-1 on January 1, 2008.
In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN
48"). FIN 48 creates a comprehensive model which addresses how a company should
recognize, measure, present and disclose in its financial statements uncertain
tax positions that the company has taken or expects to take on a tax return.
This guidance was 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 first three months of 2007. The Company classifies interest
and, if applicable, penalties as income tax expense in the consolidated
statement of operations. No such amounts were recognized in the first six months
of 2008 and 2007. The liability for accrued interest was not significant at June
30, 2008 or December 31, 2007.
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
30
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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 our Predecessor 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. Our current estimate of the maximum loss that we could reasonably incur on
this case is approximately $2.0 million. 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. Plaintiffs filed their motion for class
certification on May 2, 2008. The matter is scheduled for a jury trial on May
10, 2010. We believe this lawsuit is without merit and intend to defend it
vigorously; however, the ultimate outcome cannot be predicted with certainty. We
do not believe that the potential loss related to the individual defendant who
served as an officer on the Effective Date is material.
Cost of Insurance Litigation
The Company and certain subsidiaries, including principally Conseco Life,
have been named in numerous purported class action and individual lawsuits
alleging, among other things, breach of contract, fraud and misrepresentation
with regard to a change made in 2003 and 2004 in the way cost of insurance
charges are calculated for life insurance policies sold primarily under the
names "Lifestyle" and "Lifetime". Approximately 86,500 of these policies were
subject to the change, which resulted in increased monthly charges to the
policyholders' accounts. Many of the purported class action lawsuits were filed
in Federal courts across the United States. In June 2004, the Judicial Panel on
Multidistrict Litigation consolidated these lawsuits into the action now
referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation,
Cause No. MDL 1610 (Central District, California). In September 2004, plaintiffs
in the multi-district action filed an amended consolidated complaint and, at
that time, added Conseco, Inc. as a defendant. The amended complaint alleged,
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 last half of 2007. We previously recognized
costs related to this litigation totaling $267.2 million (none of which was
recognized in the first six months of 2008).
31
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Three other cases remain pending with respect to life insurance policies
sold primarily under the names "Lifestyle" and "Lifetime". 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. The Harte matter was settled in June, 2008 and will be dismissed by the
court on motion by the parties. Also, a lawsuit was filed on September 14, 2005
in Hawaii captioned AE Ventures for Archie Murakami, et al. v. Conseco, Inc.,
Conseco Life Insurance Company; And Doe Defendants 1-100, Case No. CV05-00594
(United States District Court, District of Hawaii). This suit involves
approximately 800 plaintiffs all of whom purport to have opted out of the In Re
Conseco Life Insurance Co. Cost of Insurance Litigation multi-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. In the recently settled matter Cost of Insurance Cases, Judicial
Counsel Coordination Proceeding No. 4384 (Judicial Counsel of California) one
plaintiff's claims remain, those of Marvin Barenblat, and he will be filing an
amended complaint within this proceeding in the near future.
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. Bankers Life and Casualty
Company subsequently appealed to the 7th Circuit Court of Appeals, which denied
the appeal. Bankers Life and Casualty Company subsequently filed a motion to
decertify the class with the district court, which entered an order decertifying
the class action on July 28, 2008. This matter is set for trial, with Ms. Walker
as the sole plaintiff, on August 25, 2008. We believe the action is without
merit and we intend to defend the case vigorously. The ultimate outcome of the
action cannot be predicted with certainty.
On January 16, 2008, a purported class action was filed in the Superior
Court of the State of California for the County of Alameda, Robin Fletcher
individually, and on behalf of all others similarly situated vs. Bankers Life
and Casualty Company, and Does 1 through 100, Case No. RG08366328. In her
complaint, plaintiff alleged nonpayment by Bankers Life and Casualty Company of
overtime wages, failure to provide meal and rest periods, failure to reimburse
expenses, and failure to provide accurate wage statements to its sales
representatives in the State of California for the time period January 16, 2004
to present. Additionally, the complaint alleges failure to pay wages on
termination and unfair business practices. 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
32
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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; 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 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 in an
unspecified amount 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 appealed the certification order to the 5th Circuit
Court of Appeals, and by order entered May 28, 2008, the 5th Circuit Court of
Appeals affirmed class certification but made modifications to the class
definitions. Our subsequent petition for rehearing was denied by order dated
June 27, 2008. We believe the action is without merit, and we intend to defend
the case vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On November 3, 2006, an action was filed in the United States District
Court for the Central District of California Ruth Ross v. Pioneer National Life
Insurance Company and Washington National Insurance Company, Case No. CV 06
7081. In that case, the plaintiff alleged breach of contract, bad faith and
violation of California consumer protection laws in the handling of her claim
for benefits under a Washington National 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
contended that she should have received the balance of a $250,000 lifetime
maximum benefit. The parties disagreed as to whether the plaintiff's continuing
confinement was caused by one or more than one occurrence as defined under the
policy. In her complaint, the plaintiff claimed 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 matter was scheduled for jury trial May 27, 2008. At a mediation
conducted on April 23, 2008, the matter was resolved on a confidential basis and
the court dismissed the action with prejudice by order entered June 20, 2008.
The amount recognized as expense in 2008 related to the settlement of this case
was not significant to our business, financial condition, results of operations
or cash flows.
On August 7, 2006, an action was filed in the United States District Court
for the Southern District of New York, Sheldon H. Solow v. Conseco, Inc. and
Carmel Fifth, LLC, Case No. 06-CV-5988 (BSJ). The plaintiff alleges breach of
duty to hold a fair auction, fraud, promissory estoppel, unjust enrichment and a
declaratory judgment with respect to the sale by defendants of the GM Building
in New York City in 2003. Plaintiff was a losing bidder on the building. In the
complaint, plaintiff seeks damages of $35 million on the unjust enrichment count
and damages in an amount to be determined at trial on the remaining counts.
Defendants filed a motion to dismiss the complaint on September 18, 2006. On
January 11, 2008, the court ruled on the motion to dismiss, granting the motion
with respect to the unjust enrichment and declaratory judgment counts, and
denying the motion with respect to the remaining three counts. Discovery will
now be proceeding in the matter.
33
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The plaintiff filed a motion for summary judgment on July 16, 2008. The Company
believes the action is without merit and intends to defend it vigorously. The
ultimate outcome of the action cannot be predicted with certainty.
On March 19, 2008 a purported class action was filed in the United States
District Court for the Western District of Washington, Susan W. Taylor and
Curtis L. Welch, on behalf of themselves and all others similarly situated v.
Bankers Life and Casualty Co., Case No. C08-0447JCC. The case was filed on
behalf of all persons in the state of Washington who since 1988 purchased long
or short-term convalescent care (commonly referred to as long-term care)
insurance policies from Bankers Life and Casualty Co. The complaint alleges
damages from increases in premiums for such policies in causes of action
alleging unfair or deceptive practices under Washington's Consumer Protection
Act, breach of contract and bad faith. We filed a motion to dismiss the
complaint on May 19, 2008. We believe the action is without merit and we intend
to defend the case vigorously. The ultimate outcome of the action cannot be
predicted with certainty.
On March 4, 2008, a Complaint was filed in the United Stated District Court
for the Central District of California, Celedonia X. Yue, M. D. on behalf of the
class of all others similarly situated, and on behalf of the General Public v.
Conseco Life Insurance Company, successor to Philadelphia Life Insurance Company
and formerly known as Massachusetts General Life Insurance Company, Cause No.
CV08-01506 CAS. Plaintiff in this putative class action owns a Valulife
universal life policy insuring the life of Ruth S. Yue originally issued by
Massachusetts General Life Insurance Company on September 26, 1995. Plaintiff is
claiming breach of contract on behalf of the proposed national class and seeks
injunctive and restitutionary relief pursuant to Business & Professions Code
Section 17200 and Declaratory Relief. The putative class consists of "All owners
of Valulife and Valuterm `universal life' insurance policies issued by either
Massachusetts General or Philadelphia Life and that were later acquired and
serviced by Conseco Life. The class does not include officers or actuaries (or
their immediate families) of Massachusetts General, Philadelphia Life, Conseco
Life or any of their parent companies, including Conseco, Inc." Plaintiff
alleges that members of the class will be damaged by increases in the cost of
insurance that are set to take place in the twenty first policy year of Valulife
and Valuterm policies. No such increases have yet been applied to the subject
policies, and none is scheduled to take effect until around 2011. We filed a
motion to dismiss the complaint on June 25, 2008, which is set for hearing on
August 25, 2008. Plaintiff has not yet filed a motion for certification of the
class, and we intend to oppose any form of class 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 June 4, 2008, a purported class action complaint was filed in the United
Stated District Court for the Northern District of Illinois, Ruby Sandock,
individually and on behalf of herself and all others similarly situated v.
Bankers Life & Casualty Company Case No. 08-CV-3218. Plaintiff is claiming
breach of contract, consumer fraud and deceptive business practices, and unjust
enrichment on behalf of the proposed national class and seeks compensatory and
punitive damages, injunctive and restitutionary relief. Plaintiff alleges that
Bankers Life & Casualty systematically and intentionally failed to comply with
standard contractual waiver of premium provisions that are included in its
long-term care insurance policy contracts that it offers and sells to consumers.
Plaintiffs allege that Bankers Life & Casualty has a policy or practice of
continuing to charge and/or bill its insureds for policy premiums after the
insured has received 90 days of benefits. Our answer was filed on July 3, 2008,
denying liability and denying that the action is properly maintainable as a
class action. We also filed a motion to dismiss the complaint. We believe the
action is without merit, and intend to defend it vigorously. The ultimate
outcome of the action cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other 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,
34
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
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. On January 22, 2008,
the Indiana Court of Appeals, in Massey v. Conseco Services, LLC Case No.
29A05-0610-CV-565, affirmed the judgment entered in the Hamilton County case in
favor of the Company and the dismissal of Massey's counterclaims. Mr. Massey has
filed a petition for rehearing with the Court of Appeals. The Murray U.S.
District Court case is currently set for trial on February 2, 2009.
The Company and Conseco Services believe that all amounts due under the
director and officer loan programs, including all applicable interest, are valid
obligations owed to the companies. As part of our Predecessor's plan of
reorganization, we have agreed to pay 45 percent of any net proceeds recovered
in connection with these lawsuits, in an aggregate amount not to exceed $30
million, to former holders of our Predecessor's trust preferred securities that
did not opt out of a settlement reached with the committee representing holders
of these securities. As of June 30, 2008, we have paid $13.7 million to the
former holders of trust preferred securities under this arrangement. We intend
to prosecute these claims to obtain the maximum recovery possible. Further, with
regard to the various claims brought against the Company and Conseco Services by
certain former directors and officers, we believe that these claims are without
merit and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty. At June 30, 2008, we estimated that
approximately $10.1 million, net of collection costs, of the remaining amounts
due under the loan program will be collected (including amounts that remain to
be collected from borrowers with whom we have settled) and that $10.3 million
will be paid to the former holders of our Predecessor's trust preferred
securities (of which $5.7 million is held in a segregated cash account related
to amounts already collected).
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.
The states of Pennsylvania, Illinois, Texas, Florida and Indiana led a
multistate examination of the long-term care claims administration and complaint
handling practices of Conseco Senior 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 and on May 7, 2008, Conseco announced a
settlement among the state insurance regulators and Conseco Senior and Bankers
Life and Casualty Company. This examination covered the years 2005, 2006 and
2007. More than 40 states are parties to the settlement, under which Conseco
will pay a fine of up to $2.3 million, with an additional $10 million payable in
the event Conseco fails to meet the process improvement benchmarks over the next
two-and-a-half years. Conseco will review certain claims from 2005-2007 and
provide up to $4 million of remediation. The fine and remediation cost were
accrued in 2007. In addition, the settlement requires Conseco to implement a
detailed process improvement plan designed to achieve performance standards for
the timely processing of claims and complaints and other processes as part of an
improvement program undertaken by the Company in 2007. Under that program,
Conseco is moving several long-term care back-office functions to the Long-Term
Care Group, Inc. to better manage the Conseco Senior business and improve
customer service, and Conseco is investing $26 million on system enhancements
and business process improvements over the next two-and-a-half years. The
process improvement plan will be monitored by the lead states.
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".
35
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Six months ended
June 30,
----------------------
2008 2007
---- ----
(Restated)
Cash flows from operating activities:
Net loss............................................................................. $(492.9) $ (55.7)
Adjustments to reconcile the net loss to net cash provided
by operating activities:
Amortization and depreciation.................................................... 235.9 246.4
Income taxes..................................................................... 304.4 (32.0)
Insurance liabilities............................................................ 195.0 447.4
Accrual and amortization of investment income.................................... 30.6 (10.9)
Deferral of policy acquisition costs............................................. (235.1) (244.4)
Net realized investment losses................................................... 278.9 63.2
Net sales (purchases) of trading securities...................................... 391.6 (138.0)
Other............................................................................ 1.2 51.1
------- --------
Net cash provided by operating activities...................................... $ 709.6 $ 327.1
======= ========
Non-cash items not reflected in the investing and financing activities sections
of the consolidated statement of cash flows:
Stock option and restricted stock plans............................................ $5.0 $ 6.0
Conversion of preferred stock into common shares................................... - 667.8
Reduction of tax liabilities related to various contingencies recognized
at the fresh-start date in conjunction with adoption of FIN 48................... - 6.0
At June 30, 2008 and December 31, 2007, restricted cash and cash
equivalents consisted of: (i) $12.7 million and $16.1 million, respectively,
held by a VIE; (ii) $5.7 million and $1.9 million, respectively, of segregated
cash held for the benefit of the former holders of TOPrS; and (iii) $3.1 million
and $3.1 million, respectively, held in an escrow account pursuant to a
litigation settlement.
INVESTMENT IN A VARIABLE INTEREST ENTITY
The Company has an investment in a special purpose entity, that is a VIE
under Financial Accounting Standards Board Interpretation No. 46 "Consolidation
of Variable Interest Entities, revised December 2003" ("FIN 46R"). The following
is description of our significant investment in a VIE:
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. 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. The carrying value of our investment
in Fall Creek was $51.9 million and $47.0 million at June 30, 2008 and December
31, 2007, respectively.
The investment borrowings of Fall Creek may become due and payable if
certain threshold ratios (based on the entity's leverage and the market value of
its assets) are not met for a specified period of time. During the first quarter
of 2008, such threshold ratio was not met and was amended. Subsequent to the
amendment, Fall Creek sold assets of $90 million (which resulted in net realized
investment losses of $11.2 million), and paid down investment borrowings of
$83.5 million in the first quarter of 2008. Pursuant to the amendment, we
committed to provide additional capital to Fall Creek for up to $25 million
36
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
(under defined circumstances), $5 million of which was contributed through June
30, 2008 (none of which was contributed in the second quarter of 2008).
FAIR VALUE MEASUREMENTS
Effective January 1, 2008, we adopted SFAS 157 which clarifies a number of
considerations with respect to fair value measurement objectives for financial
reporting and expands disclosures about the use of fair value measurements. SFAS
157 is intended to increase consistency and comparability among fair value
estimates used in financial reporting. The disclosure requirements of SFAS 157
are intended to provide users of financial statements with the ability to assess
the reliability of an entity's fair value measurements. The initial adoption of
SFAS 157 resulted in a charge of $1.8 million to net income (after the effects
of the amortization of insurance acquisition costs and income taxes) in the
first quarter of 2008, attributable to changes in the liability for the embedded
derivatives associated with our equity-indexed annuity products. The change
resulted from the incorporation of risk margins into the estimated fair value
calculation for this liability.
Definition of Fair Value
As defined in SFAS 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date and, therefore, represents an exit
price, not an entry price. We hold fixed maturities, equity securities,
derivatives, separate account assets and embedded derivatives, which are carried
at fair value.
The degree of judgment utilized in measuring the fair value of financial
instruments is largely dependent on the level to which pricing is based on
observable inputs. Observable inputs reflect market data obtained from
independent sources, while unobservable inputs reflect our view of market
assumptions in the absence of observable market information. Financial
instruments with readily available active quoted prices would be considered to
have fair values based on the highest level of observable inputs, and little
judgment would be utilized in measuring fair value. Financial instruments that
rarely trade would be considered to have fair value based on a lower level of
observable inputs, and more judgment would be utilized in measuring fair value.
Valuation Hierarchy
SFAS 157 establishes a three-level hierarchy for valuing assets or
liabilities at fair value based on whether inputs are observable or
unobservable.
o Level 1 - includes assets and liabilities valued using inputs that are
quoted prices in active markets for identical assets or liabilities. Our
Level 1 assets include exchange traded securities and U.S. Treasury
securities.
o Level 2 - includes assets and liabilities valued using inputs that are
quoted prices for similar assets in an active market, quoted prices for
identical or similar assets in a market that is not active, observable
inputs, or observable inputs that can be corroborated by market data.
Level 2 assets and liabilities include those financial instruments that
are valued by independent pricing services using models or other
valuation methodologies. These models are primarily industry-standard
models that consider various inputs such as interest rate, credit
spread, reported trades, broker/dealer quotes, issuer spreads and other
inputs that are observable or derived from observable information in the
marketplace or are supported by observable levels at which transactions
are executed in the marketplace. Financial instruments in this category
primarily include: certain public and private corporate fixed maturity
securities; certain government or agency securities; certain mortgage
and asset-backed securities; and non-exchange-traded derivatives such as
call options to hedge liabilities related to our equity-indexed annuity
products.
o Level 3 - includes assets and liabilities valued using unobservable
inputs that are used in model-based valuations that contain management
assumptions. Level 3 assets and liabilities include those financial
instruments whose fair value is estimated based on non-binding broker
prices or internally developed models or methodologies utilizing
significant inputs not based on, or corroborated by, readily available
market information. Financial instruments in this category include
certain corporate securities (primarily private placements), certain
mortgage and asset-backed securities, and other less liquid securities.
Additionally, the Company's liabilities for embedded derivatives
(including embedded derivates related to our equity-indexed annuity
products and to a modified coinsurance arrangement)
37
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
are classified in Level 3 since their values include significant
unobservable inputs including actuarial assumptions.
At each reporting date, we classify assets and liabilities into the three
input levels based on the lowest level of input that is significant to the
measurement of fair value for each asset and liability reported at fair value.
This classification is impacted by a number of factors, including the type of
financial instrument, whether the financial instrument is new to the market and
not yet established, the characteristics specific to the transaction and overall
market conditions. Our assessment of the significance of a particular input to
the fair value measurement and the ultimate classification of each asset and
liability requires judgment.
The vast majority of our fixed maturity securities and separate account
assets use Level 2 inputs for the determination of fair value. These fair values
are obtained primarily from independent pricing services, which use Level 2
inputs for the determination of fair value. Third party pricing services
normally derive the security prices through recently reported trades for
identical or similar securities making adjustments through the reporting date
based upon available market observable information. If there are no recently
reported trades, the third party pricing services may use matrix or model
processes to develop a security price where future cash flow expectations are
developed and discounted at an estimated risk-adjusted market rate. As the
Company is responsible for the determination of fair value, we perform monthly
quantitative and qualitative analysis on the prices received from third parties
to determine whether the prices are reasonable estimates of fair value. The
Company's analysis includes: (i) a review of the methodology used by third party
pricing services; (ii) a comparison of pricing services' valuation to other
pricing services' valuations for the same security; (iii) a review of month to
month price fluctuations; (iv) a review to ensure valuations are not
unreasonably stale; and (v) back testing to compare actual purchase and sale
transactions with valuations received from third parties.
For securities that are not priced by pricing services and may not be
reliably priced using pricing models, we obtain broker quotes. These broker
quotes represent an exit price, but assumptions used to establish the fair value
may not be observable and therefore represent Level 3 inputs.
Certain of our investments do not have readily determinable market prices
and/or observable inputs. For these securities, we use internally developed
valuations. Key assumptions used to determine fair value for these securities
may include risk-free rates, risk premiums, performance of underlying collateral
and other factors involving significant assumptions which may not be reflective
of an active market. For certain investments, we use a matrix or model process
to develop a security price where future cash flow expectations are developed
and discounted at an estimated market rate. The pricing matrix utilizes a spread
level to determine the market price for a security. The credit spread generally
incorporates the issuer's credit rating and other factors relating to the
issuer's industry and the security's maturity. In some instances issuer-specific
spread adjustments, which can be positive or negative, are made based upon
internal analysis of security specifics such as liquidity, deal size, and time
to maturity.
The classification of fair value measurements for derivative instruments,
including embedded derivatives requiring bifurcation, is determined based on the
consideration of several inputs including closing exchange or over-the-counter
market price quotations; time value and volatility factors underlying options;
market interest rates; and non-performance risk. For certain embedded
derivatives, we may use actuarial assumptions in the determination of fair
value.
38
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
The categorization of fair value measurements, by input level, for our
fixed maturity securities, equity securities, trading securities, certain other
invested assets, assets held in separate accounts and embedded derivative
instruments included in liabilities for insurance products at June 30, 2008 is
as follows (dollars in millions):
Quoted prices
in active markets Significant other Significant
for identical assets observable unobservable
or liabilities inputs inputs
(Level 1) (Level 2) (Level 3) Total
--------- --------- --------- -----
Assets:
Actively managed fixed maturities........ $90.2 $18,104.2 $1,954.0 $20,148.4
Equity securities........................ - - 34.3 34.3
Trading securities....................... 14.9 246.7 4.9 266.5
Other invested assets.................... - 45.2 (a) 5.2 (b) 50.4
Assets held in separate accounts......... - 24.6 - 24.6
Liabilities:
Liabilities for insurance products:
Embedded derivative instruments........ $ - $ - $361.9 (c) $361.9
<FN>
- -------------
(a) Includes corporate-owned life insurance and derivatives.
(b) Includes equity-like holdings in special-purpose entities.
(c) Includes $358.9 million of embedded derivatives associated with our
equity-indexed annuity products and $3.0 million of embedded
derivatives associated with a modified coinsurance agreement.
</FN>
The following tables present additional information about assets and
liabilities measured at fair value on a recurring basis and for which we have
utilized significant unobservable (Level 3) inputs to determine fair value for
the three and six months ended June 30, 2008 (dollars in millions):
Embedded derivative
Actively Other instruments included
managed fixed Equity Trading invested in liabilities for
maturities securities securities assets insurance products
---------- ---------- ---------- ------ ------------------
Assets:
Beginning balance as of
March 31, 2008....................... $2,106.1 $34.4 $ 9.4 $ 4.3 $(365.9)
Purchases, sales, issuances and
settlements, net..................... (35.9) - (3.9) (1.4) 8.1
Total realized and unrealized gains (losses):
Included in net loss................. (14.4) - (.1) .9 (4.1)
Included in other comprehensive
income (loss)...................... (75.3) (.1) - 1.4 -
Transfers in and/or (out) of Level 3 (a) (26.5) - (.5) - -
-------- ----- ----- ----- -------
Ending balance as of June 30, 2008....... $1,954.0 $34.3 $ 4.9 $ 5.2 $(361.9)
======== ===== ===== ===== =======
Amount of total gains (losses) for the three
months ended June 30, 2008
included in our net loss relating to assets
and liabilities still held as Of the
reporting date......................... $(12.9) $ - $(.1) $ - $(4.1)
====== ===== ==== ===== =====
39
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
Embedded derivative
Actively Other instruments included
managed fixed Equity Trading invested in liabilities for
maturities securities securities assets insurance products
---------- ---------- ---------- ------ ------------------
Assets:
Beginning balance as of
December 31, 2007.................... $1,924.3 $34.5 $11.8 $ 4.3 $(354.6)
Purchases, sales, issuances and
settlements, net..................... 153.3 - (5.5) (1.4) 22.1
Total realized and unrealized gains (losses):
Included in net loss................. (28.1) - (.9) .9 (29.4)
Included in other comprehensive
income (loss)...................... (69.0) (.2) - 1.4 -
Transfers in and/or (out) of Level 3 (a) (26.5) - (.5) - -
-------- ----- ----- ----- -------
Ending balance as of June 30, 2008....... $1,954.0 $34.3 $ 4.9 $ 5.2 $(361.9)
======== ===== ===== ===== =======
Amount of total gains (losses) for the six
months ended June 30, 2008
included in our net loss relating to assets
and liabilities still held as of the
reporting date......................... $(17.7) $ - $(.7) $ - $(29.4)
====== ====== ==== ===== ======
<FN>
- -----------
(a) Net transfers out of Level 3 are reported as having occurred at the
beginning of the period.
</FN>
Realized and unrealized investment gains and losses presented in the
preceding table represent gains and losses during the time the applicable
financial instruments were classified as Level 3.
Realized and unrealized gains (losses) on Level 3 assets are primarily
reported in either net investment income for policyholder and reinsurer accounts
and other special purpose portfolios, net realized investment gains (losses) or
insurance policy benefits within the consolidated statement of operations or
other comprehensive income (loss) within shareholders' equity based on the
appropriate accounting treatment for the instrument.
Purchases, sales, issuances and settlements, net, represent the activity
that occurred during the period that results in a change of the asset or
liability but does not represent changes in fair value for the instruments held
at the beginning of the period. Such activity primarily consists of purchases
and sales of fixed maturity, equity and trading securities, purchases and
settlements of derivative instruments, and changes to embedded derivative
instruments related to insurance products resulting from the issuance of new
contracts, or changes to existing contracts.
We review the fair value hierarchy classifications each reporting period.
Changes in the observability of the valuation attributes may result in a
reclassification of certain financial assets or liabilities. Such
reclassifications are reported as transfers in and out of Level 3 at the
beginning fair value for the reporting period in which the changes occur. There
were no such transfers in the six month period ending June 30, 2008.
The amount presented for gains (losses) included in our net loss for assets
and liabilities still held as of the reporting date primarily represents
impairments for actively managed fixed maturities, changes in fair value of
trading securities and certain derivatives and changes in fair value of embedded
derivative instruments included in liabilities for insurance products that exist
as of the reporting date.
SUBSEQUENT EVENT
On August 11, 2008, Conseco and CDOC, Inc. ("CDOC"), a wholly owned
subsidiary of Conseco (and together with Conseco, the "Conseco Parties"),
entered into a Transfer Agreement with Senior Health Care Transition Trust (the
40
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
-------------------
"Transition Trust"), pursuant to which the Conseco Parties would transfer the
stock of Conseco Senior to an independent trust to be named Senior Health Care
Oversight Trust (the "Independent Trust") for the exclusive benefit of Conseco
Senior's long-term care policyholders. Consummation of the transaction, which
conditioned upon receipt of the approval of the Pennsylvania Insurance
Department, is expected to occur in the fourth quarter of 2008.
In addition to the transfer of the Conseco Senior stock, the Conseco
Parties have agreed to contribute $175 million of additional capital to Conseco
Senior and the Independent Trust. Following the transfer, Conseco Senior will be
re-named Senior Health Insurance Company of Pennsylvania and will be run by
management transferred from Conseco.
To effect the transfer of the Conseco Senior stock to the Independent
Trust, Conseco has formed the Transition Trust, which has filed for regulatory
approval of the transfer with the Pennsylvania Insurance Department. Upon
receipt of such approval and satisfaction of all other closing conditions, the
Transition Trust will merge with and into the Independent Trust.
Conseco expects to record accounting charges totaling approximately $1.2
billion related to the transaction, comprised of Conseco Senior's equity (as
calculated in accordance with generally accepted accounting principles), an
additional valuation allowance for deferred tax assets and the capital
contribution to Conseco Senior and the Independent Trust. The accounting charges
are summarized as follows (dollars in millions):
Charges recognized in the second quarter of 2008:
Recognition of unrealized losses on investments expected to be transferred
to the Independent Trust................................................................... $ 205.7 (a)
Increase to deferred tax valuation allowance based on recent results which
have had a significant impact on taxable income and the expected
effects of the proposed transaction........................................................ 298.0
--------
Total charges recognized in the second quarter of 2008.................................. 503.7
--------
Charges expected to be recognized upon the completion of the transaction:
Write-off of remaining shareholder's equity of Conseco Senior and transaction expenses ....... 478.6 (a) (b)
Additional capital contribution............................................................... 175.0 (a)
--------
Total charges recognized upon the completion of the transaction......................... 653.6
--------
Total expected charges........................................................................... $1,157.3
========
<FN>
- -----------------
(a) Amount is before the potential tax benefit. A deferred tax valuation
allowance will be established for all future potential tax benefits
generated by these charges since management has concluded that it is
more likely than not that such tax benefits will not be utilized to
offset future taxable income. (b) Amount will be based on the actual
shareholder's equity of Conseco Senior at the completion of the
transaction and the actual expenses incurred to complete the
transaction. Such final amount will be different than the estimate
provided in this summary.
</FN>
The aforementioned $175.0 million capital contribution is expected to be
primarily in the form of cash and a note payable of $125.0 million on the
consummation date. The note is expected to be unsecured; have a five-year
maturity date; have a fixed rate of interest to be determined upon consummation;
and require annual principal payments of $25.0 million.
41
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at June 30, 2008, and the consolidated results of operations for the three and
six months ended June 30, 2008 and 2007, 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 2007 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 general economic, market and political conditions, including the
performance and fluctuations of the financial markets which may affect
our ability to raise capital or refinance our existing indebtedness;
o our ability to obtain adequate and timely rate increases on our
supplemental health products including our long-term care business;
o mortality, morbidity, the increased cost and 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 the recoverability of our deferred tax asset and the effect of
potential tax rate changes on its value;
o changes in accounting principles and the interpretation thereof;
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 and valuation of our investments, including the impact of
realized losses (including other-than-temporary impairment charges);
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;
42
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 eventual upgrades of the financial strength
ratings of Conseco and our insurance company subsidiaries as well as
the potential impact of rating downgrades on our business;
o the risk factors or uncertainties listed from time to time in our
filings with the SEC;
o our ability to continue to satisfy the financial ratio and balance
requirements and other covenants of our debt agreements;
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 changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products; and
o the receipt of regulatory approval and consummation of the plan to
transfer Conseco Senior Health Insurance Company to an independent
trust.
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, underserved, 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, Colonial Penn and Conseco Insurance Group, which are
defined on the basis of product distribution; a fourth segment comprised of
other business in run-off; and corporate operations. Our segments are described
below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company, 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 career agents and sales
managers. Bankers Life and Casualty Company markets its products under
its own brand name and Medicare Part D and Medicare Advantage products
primarily through marketing agreements with Coventry.
o Colonial Penn, which consists of the business of Colonial Penn Life
Insurance Company ("Colonial Penn"), markets graded benefit and
simplified issue life insurance directly to customers through
television advertising, direct mail, the internet and telemarketing.
Colonial Penn markets its products under its own brand name.
43
CONSECO, INC. AND SUBSIDIARIES
-------------------
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" brand names. Conseco Insurance Group includes the business
of Conseco Health, Conseco Life, Conseco Insurance Company and
Washington National Insurance Company, other than any run-off
long-term care and major medical insurance issued by those companies.
Such run-off business is included in the Other Business in Run-off
segment.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of: (i) long-term care
insurance sold in prior years through independent agents; and (ii)
major medical insurance. The Other Business in Run-off segment is
primarily comprised of long-term care business issued by Conseco
Senior and Washington National Insurance Company, subsidiaries that
were acquired in 1996 and 1997, respectively. As further discussed in
the note to the consolidated financial statements entitled "Subsequent
Event", the Company plans to transfer Conseco Senior to an independent
trust. Over 80 percent of the insurance liabilities in this segment
are expected to be transferred upon consummation of the transaction.
o Corporate operations, which consists of holding company activities and
certain noninsurance company businesses that are not related to our
operating segments.
Volatility in Credit Markets
Many portions of the credit market have recently experienced reduced
liquidity, higher volatility and widening credit spreads mainly as a result of
uncertainty arising from relatively poor performance in sectors of the mortgage
market, concern about corporate credit quality and the impact of related losses
on market participants. In connection with this uncertainty, we believe
investors and lenders have retreated from many investments in mortgage related
and structured securities, including collateralized mortgage-backed securities.
During the first six months of 2008, these market conditions contributed to the
$.7 billion increase in net unrealized investment losses (before amortization of
insurance acquisition costs and income taxes) related to our $20.1 billion
investment portfolio of fixed maturity securities. This increase in net
unrealized investment losses reflects increased risk premium for certain
security types, partially offset by the effects of a relatively low risk-free
interest rate environment. We believe these credit market conditions have
contributed to a higher level of impairments in our investment portfolio. We
expect to experience continued volatility in the valuation of our fixed maturity
securities, as well as a relatively high level of credit-related investment
losses, potentially including additional impairments of our investment
portfolio.
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2007 Annual Report on
Form 10-K for information on our accounting policies that we consider critical
in preparing our consolidated financial statements.
44
CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF OPERATIONS
The following tables and narratives summarize the operating results of our
segments for the periods presented (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Income (loss) before net realized investment gains
(losses), net of related amortization and income
taxes (a non-GAAP measure) (a):
Bankers Life.......................................... $ 34.6 $ 70.5 $ 63.7 $ 116.0
Colonial Penn......................................... 8.3 6.7 12.0 11.3
Conseco Insurance Group............................... 30.0 25.8 53.3 52.8
Other Business in Run-off............................. 12.2 (130.3) 10.9 (156.4)
Corporate operations.................................. (32.4) (42.4) (55.5) (73.2)
------- ------- ------- -------
52.7 (69.7) 84.4 (49.5)
------- ------- ------- -------
Net realized investment gains (losses), net of related
amortization:
Bankers Life.......................................... (10.2) (1.0) (27.0) (5.5)
Colonial Penn......................................... .7 .3 .1 .1
Conseco Insurance Group............................... (11.4) (13.6) (20.2) (29.7)
Other Business in Run-off............................. (206.8) (.1) (204.8) (.3)
Corporate operations.................................. (3.9) (1.2) (20.5) (1.2)
------- ------- ------- -------
(231.6) (15.6) (272.4) (36.6)
------- ------- ------- -------
Income (loss) before income taxes:
Bankers Life.......................................... 24.4 69.5 36.7 110.5
Colonial Penn......................................... 9.0 7.0 12.1 11.4
Conseco Insurance Group............................... 18.6 12.2 33.1 23.1
Other Business in Run-off............................. (194.6) (130.4) (193.9) (156.7)
Corporate operations.................................. (36.3) (43.6) (76.0) (74.4)
------- ------- ------- -------
Loss before income taxes........................... $(178.9) $ (85.3) $(188.0) $ (86.1)
======= ======= ======= =======
<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
45
CONSECO, INC. AND SUBSIDIARIES
-------------------
taxes" does not replace "income (loss) before income taxes" as a measure of
overall profitability. We may experience 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. In addition, management uses
this non-GAAP financial measure in its budgeting process, financial
analysis of segment performance and in assessing the allocation of
resources. We believe these non-GAAP financial measures enhance an
investor's understanding of our financial performance and allows them to
make more informed judgments about the Company as a whole. These measures
also highlight operating trends that might not otherwise be transparent.
The table above reconciles the non-GAAP measure to the corresponding GAAP
measure.
</FN>
General: Conseco is the top tier holding company for a group of insurance
companies operating throughout the United States that develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. We distribute these products through our Bankers Life
segment, which utilizes a career agency force, through our Colonial Penn
segment, which utilizes direct response marketing, and through our Conseco
Insurance Group segment, which utilizes professional independent producers. Our
Other Business in Run-off segment consists of: (i) long-term care products sold
in prior years through independent agents; and (ii) a very small amount of major
medical insurance. Most of the long-term care business in run-off relates to
business written by certain subsidiaries prior to their acquisitions by our
Predecessor in 1996 and 1997.
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- ---------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Premium collections:
Annuities............................................. $ 257.8 $ 200.5 $ 486.9 $ 412.7
Supplemental health................................... 470.8 356.6 906.3 722.9
Life.................................................. 53.8 52.1 101.8 100.2
--------- -------- --------- --------
Total collections................................... $ 782.4 $ 609.2 $ 1,495.0 $1,235.8
========= ======== ========= ========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 253.2 $ 283.0 $ 225.9 $ 281.9
Equity-indexed....................................... 1,147.1 730.0 1,095.3 693.7
Deposit based........................................ 4,419.8 4,523.9 4,458.8 4,537.5
Health................................................. 3,848.8 3,532.4 3,808.4 3,497.1
Life:
Interest sensitive................................... 382.8 360.7 381.4 358.3
Non-interest sensitive............................... 351.0 292.0 343.5 284.2
--------- -------- --------- --------
Total average liabilities for insurance
products, net of reinsurance ceded.............. $10,402.7 $9,722.0 $10,313.3 $9,652.7
========= ======== ========= ========
Revenues:
Insurance policy income............................... $ 543.4 $ 424.0 $ 1,040.4 $ 836.0
Net investment income:
General account invested assets..................... 153.5 142.2 302.9 282.9
Equity-indexed products............................. (17.5) 11.9 (34.8) 8.9
Other special-purpose portfolios.................... (.8) 1.0 (3.6) 4.2
Fee revenue and other income.......................... 2.1 2.7 3.7 3.9
--------- -------- --------- --------
Total revenues.................................... 680.7 581.8 1,308.6 1,135.9
--------- -------- --------- --------
Expenses:
Insurance policy benefits............................. 497.2 338.2 932.1 680.8
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products................ 43.5 45.1 87.7 89.8
Equity-indexed products............................. (6.3) 13.5 (5.7) 15.9
Amortization related to operations.................... 66.6 69.2 141.6 151.2
Other operating costs and expenses.................... 45.1 45.3 89.2 82.2
--------- -------- --------- --------
Total expenses.................................... 646.1 511.3 1,244.9 1,019.9
--------- -------- --------- --------
Income before net realized investment losses, net of related
amortization and income taxes........................... 34.6 70.5 63.7 116.0
--------- -------- --------- --------
Net realized investment losses........................ (12.1) (1.9) (31.4) (7.1)
Amortization related to net realized investment losses 1.9 .9 4.4 1.6
--------- -------- --------- --------
Net realized investment losses, net of related
amortization ................................... (10.2) (1.0) (27.0) (5.5)
--------- -------- --------- --------
Income before income taxes................................. $ 24.4 $ 69.5 $ 36.7 $ 110.5
========= ======== ========= ========
(continued)
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Health benefit ratios:
All health lines:
Insurance policy benefits.......................... $453.0 $294.9 $843.1 $592.8
Benefit ratio (a).................................. 93.3% 81.1% 91.4% 82.6%
Medicare supplement:
Insurance policy benefits.......................... $112.4 $108.8 $216.7 $214.1
Benefit ratio (a).................................. 71.3% 67.4% 67.9% 66.0%
PDP and PFFS:
Insurance policy benefits.......................... $161.3 $38.1 $272.8 $73.3
Benefit ratio (a).................................. 94.0% 80.9% 94.0% 86.5%
Long-term care:
Insurance policy benefits.......................... $179.3 $148.0 $353.6 $305.4
Benefit ratio (a).................................. 114.7% 95.4% 113.1% 99.0%
Interest-adjusted benefit ratio (b)................ 81.4% 64.6% 80.2% 68.3%
<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 $52.1 million and $47.9 million in the three months ended June
30, 2008 and 2007, respectively, and $103.0 million and $94.7 million in
the six months ended June 30, 2008 and 2007, respectively.
</FN>
Total premium collections were $782.4 million in the second quarter of
2008, up 28 percent from 2007 and were $1,495.0 million in the first six months
of 2008, up 21 percent from 2007. Premium collections include $162.4 million and
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
$44.9 million in the second quarters of 2008 and 2007, respectively, and $278.8
million and $83.5 million in the first six months of 2008 and 2007,
respectively, of premiums collected pursuant to 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
$10.4 billion in the second quarter of 2008, up 7.0 percent from 2007. Average
liabilities for insurance products, net of reinsurance ceded, were $10.3 billion
in the first six months of 2008, up 6.8 percent from 2007. The increase in such
liabilities was primarily due to increases in annuity and health 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 $171.5 million and $47.0
million in the second quarters of 2008 and 2007, respectively, and $290.2
million and $84.6 million in the six months ended June 30, 2008 and 2007,
respectively, of premium income from the quota-share agreements with Coventry.
Net investment income on general account invested assets (which excludes
income on policyholder accounts) was $153.5 million in the second quarter of
2008, up 7.9 percent from 2007 and was $302.9 million in the first six months of
2008, up 7.1 percent from 2007. The average balance of general account invested
assets was $10.5 billion and $9.9 billion in the second quarters of 2008 and
2007, respectively. The average yield on these assets was 5.86 percent and 5.74
percent in the second quarters of 2008 and 2007, respectively. The average
balance of general account invested assets was $10.4 billion and $9.8 billion in
the first six months of 2008 and 2007, respectively. The average yield on these
assets was 5.81 percent and 5.76 percent in the first six months of 2008 and
2007, respectively. The increase in general account invested assets is primarily
due to sales of our annuity and health products in recent periods.
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 expected
to be 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 $(14.0) million and $11.9 million in the second
quarters of 2008 and 2007, respectively, and were $(35.1) million and $8.9
million in the first six months of 2008 and 2007, respectively. Such amounts
also include income (loss) on trading securities which are held to act as hedges
for embedded derivatives related to equity-indexed products. Such trading
account income (loss) was $(3.5) million and $.3 million in the three and six
months ended June 30, 2008, respectively. There was no such trading account
income in the 2007 periods. 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.
Our results in the three and six months ended June 30, 2008, were affected
by a reduction to earnings of $5.7 million and $12.7 million, respectively,
related to equity-indexed annuity products (such variance primarily resulted
from the change in the value of the embedded derivative related to future
indexed benefits reported at estimated fair value in accordance with accounting
requirements, including a $2.0 million charge in the first quarter of 2008
related to the adoption of SFAS 157).
Net investment income on other special-purpose portfolios includes the
income related to Company-owned life insurance ("COLI") which was purchased as
an investment vehicle to fund the deferred compensation plan for certain agents.
The COLI assets are not assets of the 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 (loss) and totaled $(.8) million and $1.0 million in the
second quarters of 2008 and 2007, respectively, and $(3.6) million and $1.5
million in the six months ended June 30, 2008 and 2007, respectively. Also
during the first quarter of 2007, we recognized a death benefit of $2.7 million
under the COLI as income.
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
49
CONSECO, INC. AND SUBSIDIARIES
-------------------
policy benefit reserves), after three years from the original issuance of the
policy and over the lifetime of the policy, of not less than 65 percent on
individual products and not less than 75 percent on group products, as
determined in accordance with statutory accounting principles. Since the
insurance product liabilities we establish for Medicare supplement business are
subject to significant estimates, the ultimate claim liability we incur for a
particular period is likely to be different than our initial estimate. Our
insurance policy benefits reflected reserve redundancies from prior years of
$1.4 million and $3.4 million in the first six months of 2008 and 2007,
respectively. Excluding the effects of prior period claim reserve redundancies,
our benefit ratios would have been 68.3 percent and 67.0 percent in the first
six months of 2008 and 2007, respectively. We experienced higher incurred claims
in the second quarter of 2008.
The insurance policy benefits on our prescription drug plan ("PDP") and
PFFS business result from our quota-share reinsurance agreements with Coventry.
We began assuming the PDP business on January 1, 2006 and the PFFS business on
January 1, 2007. Effective May 1, 2008 and July 1, 2007, we entered into new
PFFS quota-share reinsurance agreements to assume 40 percent and 50 percent,
respectively, of the business written by Coventry under two large group
policies. During the three months ended June 30, 2008, we recognized a $3
million increase in insurance policy benefits due to changes in our estimates of
prior period claim costs on the PFFS business we assume from Coventry. In
addition, our benefit ratio on this block has increased as a result of the
recent addition of new PFFS groups through quota-share reinsurance agreements.
The expected benefit ratio on the PFFS business is higher than the expected
benefit ratio on the PDP business. Accordingly, the overall benefit ratio has
increased since the PFFS business is now a larger percentage of the entire
block.
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. The benefit ratio on our entire block of long-term care business in
the Bankers Life segment was 114.7 percent and 95.4 percent in the second
quarters of 2008 and 2007, respectively, and 113.1 percent and 99.0 percent in
the first six months of 2008 and 2007, respectively. The interest-adjusted
benefit ratio on this business was 81.4 percent and 64.6 percent in the second
quarters of 2008 and 2007, respectively, and 80.2 percent and 68.3 percent in
the first six months of 2008 and 2007, respectively. Since the insurance product
liabilities we establish for long-term care business are subject to significant
estimates, the ultimate claim liability we incur for a particular period is
likely to be different than our initial estimate. Our insurance policy benefits
reflected reserve redundancies (deficiencies) from prior years of $(4.6) million
and $3.4 million in the first six months of 2008 and 2007, respectively.
Excluding the effects of prior year claim reserve redundancies or deficiencies,
our benefit ratios would have been 111.7 percent and 100.1 percent in the first
six months of 2008 and 2007, respectively. The benefit ratio reflected an
increase in the number of incurred claims in the 2008 periods.
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 these rate increases. 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 June 30, 2008, all such
filings had been submitted for regulatory approval, and approximately 63 percent
of the rate increases had been approved by regulators and implemented. Remaining
approvals and implementations are expected to occur over the next six months.
Finally, an additional rate increase on the 65 percent of the block that
received an increase in 2006 will be filed in the third quarter of 2008.
Implementations of this rate increase are expected to begin in the fourth
quarter of 2008 and continue throughout 2009 as approvals are received.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $43.5 million in the second quarter of
2008, down 3.5 percent from 2007, and were $87.7 million in the first six months
of 2008, down 2.3 percent from 2007. The weighted average crediting rate for
these products was 3.6 percent and 3.7 percent in the second quarters of 2008
and 2007, respectively, and 3.6 percent and 3.7 percent in the first six months
of 2008 and 2007, respectively.
50
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 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 $66.6 million and $69.2 million in the second quarters of 2008 and
2007, respectively, and $141.6 million and $151.2 million in the first six
months of 2008 and 2007, respectively. During the first six months of 2008 and
2007, 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 $12.2 million in the first six months of 2008 (none of which was recognized
in the second quarter of 2008) and $25.4 million in the first six months of 2007
($6.5 million of which was recognized in the second quarter of 2007). We believe
such increases were partially related to competition from Medicare Advantage
products.
Other operating costs and expenses in our Bankers Life segment were $45.1
million in the second quarter of 2008, down .4 percent from 2007, and were $89.2
million in the first six months of 2008, up 8.5 percent from 2007. These
fluctuations were largely due to the expenses related to the marketing and
quota-share agreements with Coventry. Other operating costs and expenses include
the following (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Expenses related to the marketing and quota-share
agreements with Coventry........................ $11.3 $ 5.6 $19.7 $ 8.4
Commission expense................................. 5.5 5.8 10.4 11.0
Other operating expenses........................... 28.3 33.9 59.1 62.8
----- ----- ----- ------
Total........................................... $45.1 $45.3 $89.2 $82.2
===== ===== ===== =====
Net realized investment losses fluctuate each period. During the first six
months of 2008, net realized investment losses in this segment included $3.6
million of net gains from the sales of investments (primarily fixed maturities),
net of $35.0 million of writedowns of investments resulting from declines in
fair values that we concluded were other than temporary. During the first six
months of 2007, we recognized net realized investment losses in this segment of
$7.1 million from the sales of investments (primarily fixed maturities). There
were no such writedowns in the first six months of 2007.
Amortization related to net realized investment losses is the increase or
decrease in the amortization of insurance acquisition costs which results from
realized investment gains or losses. When we sell securities which back our
universal life and investment-type products at a gain (loss) and reinvest the
proceeds at a different yield, we increase (reduce) the amortization of
insurance acquisition costs in order to reflect the change in estimated gross
profits due to the gains (losses) realized and the resulting effect on estimated
future yields. Sales of fixed maturity investments resulted in a decrease in the
amortization of insurance acquisition costs of $1.9 million and $.9 million in
the second quarters of 2008 and 2007, respectively, and $4.4 million and $1.6
million in the first six months of 2008 and 2007, respectively.
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
Colonial Penn (dollars in millions)
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Premium collections:
Life................................................... $ 43.8 $ 26.0 $ 86.7 $ 52.7
Supplemental health.................................... 2.3 2.7 4.6 5.3
------ ------ ------ ------
Total collections.................................... $ 46.1 $ 28.7 $ 91.3 $ 58.0
====== ====== ====== ======
Average liabilities for insurance products:
Annuities-mortality based.............................. $ 86.5 $ 89.0 $ 86.9 $ 89.3
Health................................................. 20.9 23.0 21.2 23.2
Life:
Interest sensitive................................. 25.1 26.3 25.1 26.5
Non-interest sensitive............................. 561.9 558.4 561.6 558.6
------ ------ ------ ------
Total average liabilities for insurance
products, net of reinsurance ceded............ $694.4 $696.7 $694.8 $697.6
====== ====== ====== ======
Revenues:
Insurance policy income................................ $ 47.5 $ 29.4 $ 91.9 $ 58.7
Net investment income:
General account invested assets...................... 10.1 9.4 19.8 18.9
Trading account income related to reinsurer
accounts........................................... - (6.4) (.5) (5.5)
Change in value of embedded derivative related
to a modified coinsurance agreement................ - 6.4 - 5.5
Fee revenue and other income........................... .5 .1 .8 .3
------ ------ ------ ------
Total revenues..................................... 58.1 38.9 112.0 77.9
------ ------ ------ ------
Expenses:
Insurance policy benefits.............................. 35.5 23.9 70.5 49.5
Amounts added to annuity and interest-sensitive life
product account balances........................... .3 .3 .6 .6
Amortization related to operations..................... 7.4 4.9 14.8 9.7
Other operating costs and expenses..................... 6.6 3.1 14.1 6.8
------ ------ ------ ------
Total expenses..................................... 49.8 32.2 100.0 66.6
------ ------ ------ ------
Income before net realized investment gains and
income taxes............................................. 8.3 6.7 12.0 11.3
Net realized investment gains........................ .7 .3 .1 .1
------ ------ ------ ------
Income before income taxes.................................. $ 9.0 $ 7.0 $ 12.1 $ 11.4
====== ====== ====== ======
Total premium collections were $46.1 million in the second quarter of 2008,
up 61 percent from 2007, and were $91.3 million in the first six months of 2008,
up 57 percent from 2007. See "Premium Collections" for further analysis of
Colonial Penn's premium collections.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. The increase in the 2008 periods reflects: (i) the recapture of
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
the modified coinsurance agreement in the fourth quarter of 2007; and (ii) the
growth in this segment in recent periods. See "Premium Collections" for further
analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $10.1 million in the second
quarter of 2008, up 7.4 percent from 2007 and was $19.8 million in the first six
months of 2008, up 4.8 percent from 2007. The average balance of general account
invested assets was $679.2 million and $658.0 million in the second quarters of
2008 and 2007, respectively. The average yield on these assets was 5.92 percent
and 5.71 percent in the second quarters of 2008 and 2007, respectively. The
average balance of general account invested assets was $679.1 million and $671.0
million in the first six months of 2008 and 2007, respectively. The average
yield on these assets was 5.83 percent and 5.65 percent in the first six months
of 2008 and 2007, respectively.
Trading account income related to reinsurer accounts represents the income
on trading securities, which were designed to act as hedges for embedded
derivatives related to a modified coinsurance agreement. The income on our
trading account securities was designed to be substantially offset by the change
in value of embedded derivatives related to the modified coinsurance agreement
described below. As a result of the recapture of a modified coinsurance
agreement in the fourth quarter of 2007, such trading account securities were
sold in the first quarter of 2008.
Change in value of embedded derivatives related to a modified coinsurance
agreement is described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We had transferred the specific block of
investments related to this agreement to our trading account, which we carried
at estimated fair value with changes in such value recognized as trading account
income. The change in the value of the embedded derivative was largely offset by
the change in value of the trading securities. As a result of the recapture of
the modified coinsurance agreement in the fourth quarter of 2007, the embedded
derivative related to the agreement was eliminated.
Insurance policy benefits fluctuated as a result of: (i) the recapture of
the modified coinsurance agreement in the fourth quarter of 2007; and (ii) 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 increased
by 113 percent, to $6.6 million, in the second quarter of 2008, and by 107
percent to $14.1 million, in the first six months of 2008 as compared to the
same periods in 2007 primarily due to: (i) the recapture of the modified
coinsurance agreement in the fourth quarter of 2007; and (ii) the growth in this
segment in recent periods.
Net realized investment gains fluctuate each period. During the first six
months of 2008, net realized investment gains in this segment included $1.0
million of net gains from the sales of investments (primarily fixed maturities),
net of $.9 million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary. During the first six months
of 2007, we recognized net realized investment gains in this segment of $.1
million from the sales of investments (primarily fixed maturities). There were
no writedowns in the first six months of 2007.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Premium collections:
Annuities.............................................. $ 37.1 $ 113.0 $ 78.7 $ 233.1
Supplemental health.................................... 144.0 147.4 293.2 301.6
Life................................................... 66.9 70.0 138.8 147.2
-------- --------- -------- ---------
Total collections.................................... $ 248.0 $ 330.4 $ 510.7 $ 681.9
======== ========= ======== =========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 221.1 $ 230.9 $ 222.3 $ 232.5
Equity-indexed....................................... 895.9 1,633.4 892.9 1,597.2
Deposit based........................................ 767.5 2,845.8 778.0 2,893.4
Separate accounts and investment trust liabilities... 24.8 28.7 25.5 28.7
Health................................................. 2,501.4 2,448.8 2,494.2 2,445.6
Life:
Interest sensitive................................... 2,954.3 3,058.3 2,958.6 3,061.8
Non-interest sensitive............................... 1,402.7 1,346.1 1,411.7 1,352.1
-------- --------- -------- ---------
Total average liabilities for insurance products,
net of reinsurance ceded......................... $8,767.7 $11,592.0 $8,783.2 $11,611.3
======== ========= ======== =========
Revenues:
Insurance policy income.................................. $ 229.7 $ 236.3 $ 464.0 $ 478.3
Net investment income:
General account invested assets........................ 139.9 182.3 282.5 361.9
Equity-indexed products................................ (10.0) 16.9 (20.5) 13.1
Trading account income related to policyholder and
reinsurer accounts................................... (.1) (.5) (4.3) .3
Change in value of embedded derivatives related to
modified coinsurance agreements...................... 1.5 2.5 2.9 2.2
Other trading accounts................................. - 1.3 - .4
Fee revenue and other income............................. .4 .1 1.1 .3
-------- --------- -------- ---------
Total revenues....................................... 361.4 438.9 725.7 856.5
-------- --------- -------- ---------
Expenses:
Insurance policy benefits................................ 195.8 188.9 392.4 398.8
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products................... 37.9 58.4 78.4 116.9
Equity-indexed products................................ (.8) 28.6 2.3 37.1
Amortization related to operations....................... 31.0 47.0 61.1 85.2
Interest expense on investment borrowings................ 5.5 4.2 11.3 5.3
Costs related to a litigation settlement................. - 17.5 - 24.0
Other operating costs and expenses....................... 62.0 68.5 126.9 136.4
-------- --------- -------- ---------
Total expenses....................................... 331.4 413.1 672.4 803.7
-------- --------- -------- ---------
Income before net realized investment losses, net of
related amortization and income taxes.................... 30.0 25.8 53.3 52.8
-------- --------- -------- ---------
Net realized investment losses........................... (13.2) (25.4) (22.3) (54.7)
Amortization related to net realized investment losses... 1.8 11.8 2.1 25.0
-------- --------- -------- ---------
Net realized investment losses, net of related
amortization....................................... (11.4) (13.6) (20.2) (29.7)
-------- --------- -------- ---------
Income before income taxes.................................. $ 18.6 $ 12.2 $ 33.1 $ 23.1
======== ========= ======== =========
(continued)
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Health benefit ratios:
All health lines:
Insurance policy benefits........................... $112.5 $108.4 $224.9 $219.3
Benefit ratio (a)................................... 77.5% 72.0% 76.8% 72.3%
Medicare supplement:
Insurance policy benefits........................... $36.9 $40.1 $72.2 $80.5
Benefit ratio (a)................................... 71.9% 68.9% 68.8% 67.9%
Specified disease:
Insurance policy benefits........................... $73.4 $65.7 $148.3 $133.8
Benefit ratio (a)................................... 80.8% 73.2% 81.3% 74.4%
Interest-adjusted benefit ratio (b)................. 46.6% 40.4% 47.4% 41.6%
Other:
Insurance policy benefits........................... $2.2 $2.6 $4.4 $5.0
Benefit ratio(a).................................... 72.8% 107.3% 77.7% 104.3%
<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
$31.1 million and $29.5 million the three months ended June 30, 2008 and
2007, respectively, and $62.0 million and $59.0 million in the six months
ended June 30, 2008 and 2007, respectively.
</FN>
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Annuity 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
REALIC. 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 had 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. The earnings (loss) after income taxes on the
business from January 1, 2007 through September 28, 2007, was included in our
consolidated financial statements until the transaction was completed. Upon
completion, the earnings on this block of business were included as a component
of the loss on the transaction which was recognized in the third quarter of
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. As a result, the comparison of this segment's operating
results between periods is impacted by the coinsurance transaction.
Total premium collections were $248.0 million in the second quarter of
2008, down 25 percent from 2007 and were $510.7 million in the first six months
of 2008, down 25 percent from 2007. The decrease in collected premiums was
primarily due to lower equity-indexed annuity sales as we changed the pricing of
specific products and no longer emphasized the sale of certain products since
the second half of 2007. See "Premium Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$8.8 billion in the second quarter of 2008, down 24 percent from 2007. Average
liabilities for insurance products, net of reinsurance ceded were $8.8 billion
in the first six months of 2008, down 24 percent from 2007. The decrease in such
liabilities was primarily due to the coinsurance transaction discussed above and
policyholder redemptions and lapses exceeding new sales.
Insurance policy income is comprised of premiums earned on traditional
insurance policies which provide mortality or morbidity coverage and fees and
other charges assessed on other policies. The decrease in insurance policy
income is primarily due to lower income from Medicare supplement products due to
lapses exceeding new sales and lower premiums from our life insurance block. See
"Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $139.9 million in the second
quarter of 2008, down 23 percent from 2007 and was $282.5 million in the first
six months of 2008, down 22 percent from 2007. The average balance of general
account invested assets was $9.6 billion and $12.4 billion in the second
quarters of 2008 and 2007, respectively. Net investment income and the average
balance of general account invested assets both decreased as a result of the
coinsurance agreement discussed above. The average yield on these assets was
5.81 percent and 5.89 percent in the second quarters of 2008 and 2007,
respectively. The average balance of general account invested assets was $9.7
billion and $12.3 billion in the first six months of 2008 and 2007,
respectively. The average yield on these assets was 5.85 percent and 5.86
percent in the first six months of 2008 and 2007, 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 expected
to be more than adequate to cover the cost of the options and other costs
related to these policies. Net investment gains (losses) related to
equity-indexed products were $(7.4) million and $20.3 million in the second
quarters of 2008 and 2007, respectively, and $(20.7) million and $16.0 million
in the first six months of 2008 and 2007, respectively. Such amounts also
include income on trading securities which are held to act as hedges for
embedded derivatives related to equity-indexed products. Such trading account
income (loss) was $(2.6) million and $(3.4) million in the second quarters of
2008 and 2007, respectively, and was $.2 million and $(2.9) million in the first
six months of 2008 and 2007, respectively. Such amounts were mostly 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.
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our results in the three and six months ended June 30, 2008, were affected
by a reduction to earnings of $1 million and $3 million, respectively, related
to equity-indexed annuity products (such variance primarily resulted from the
change in the value of the embedded derivative related to future indexed
benefits reported at estimated fair value in accordance with accounting
requirements, including a $.8 million charge in the first quarter of 2008
related to the adoption of SFAS 157).
Trading account income related to policyholder and reinsurer accounts
represents the income on trading securities which are designed to act as hedges
for embedded derivatives related to certain modified coinsurance agreements. In
addition, such income includes the income on investments backing the market
strategies of certain annuity products which provide for different rates of cash
value growth based on the experience of a particular market strategy. The income
on our trading account securities is designed to substantially offset: (i) the
change in value of embedded derivatives related to modified coinsurance
agreements described below; and (ii) certain amounts included in insurance
policy benefits related to the aforementioned annuity products.
Change in value of embedded derivatives related to modified coinsurance
agreements is described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We have transferred the specific block of
investments related to these agreements to our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
trading account income. The change in the value of the embedded derivatives has
largely been offset by the change in value of the trading securities.
Net investment income on other trading accounts includes: (i) the change in
the fair value of a trading securities portfolio; and (ii) the change in fair
value of interest rate swaps. The trading securities were carried at estimated
fair value with changes in such value recognized as trading income. The change
in the value of the interest rate swaps was recognized in trading income. Prior
to December 31, 2007, these fixed rate securities were sold and the associated
interest rate swaps were terminated.
Insurance policy benefits were affected by a number of items as summarized
below.
Insurance margins (insurance policy income less insurance policy benefits)
related to life products declined $4.6 million in the three months ended June
30, 2008 and increased $2.9 million in the first six months of 2008, as compared
to the same periods in 2007. Such fluctuations are primarily due to changes in
mortality.
Insurance policy benefits also fluctuated as a result of the factors
summarized below for benefit ratios. Benefit ratios are calculated by dividing
the related insurance product's insurance policy benefits by insurance policy
income.
The benefit ratios on Conseco Insurance Group's Medicare supplement
products have been impacted by an increase in policyholder lapses following our
premium rate increase actions and competition from companies offering Medicare
Advantage products. We establish active life reserves for these policies, which
are in addition to amounts required for incurred claims. When policies lapse,
active life reserves for such lapsed policies are released, resulting in
decreased insurance policy benefits (although such decrease is substantially
offset by additional amortization expense). In addition, the insurance product
liabilities we establish for our Medicare supplement business are subject to
significant estimates and the ultimate claim liability we incur for a particular
period is likely to be different than our initial estimate. Our insurance policy
benefits reflected claim reserve redundancies from prior years of $1.2 million
and $.4 million in the first half of 2008 and 2007, respectively. Excluding the
effects of prior year claim reserve redundancies, our benefit ratios for the
Medicare supplement block would have been 70.0 percent and 68.2 percent in the
first six months of 2008 and 2007, 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 were $14.4
million and $18.1 million in the second quarters of 2008 and 2007, respectively,
and $32.7 million and $38.1 million in the first six months of 2008 and 2007,
respectively. Such decrease is primarily due to lower sales and higher incurred
claims.
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
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 will fluctuate depending on the claim experience during
the year. Insurance margins (insurance policy income less insurance policy
benefits) on these products were $17.5 million and $24.1 million in the second
quarters of 2008 and 2007, respectively, and were $34.0 million and $46.0
million in the first six months of 2008 and 2007, respectively. The decrease in
margins in the 2008 periods is primarily due to higher incurred claims.
The benefit ratios on Conseco Insurance Group's other products are subject
to fluctuations due to the smaller size of these blocks of business. We no
longer actively market these products.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $37.9 million in the second quarter of
2008, down 35 percent from 2007 and were $78.4 million in the first six months
of 2008, down 33 percent from 2007. The decrease was primarily a result of the
coinsurance agreement discussed above. The weighted average crediting rate for
these products was 4.1 percent and 4.0 percent in the first six months of 2008
and 2007, respectively. In addition, amounts added to policyholder account
balances for annuity products in the first quarter of 2008 includes a $3.0
million out-of-period expense to reflect previously unrecognized benefits on
certain annuity policies.
Amounts added to equity-indexed products generally fluctuate with the
corresponding related investment income accounts described above.
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. 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. The decrease in amortization expense in
the 2008 periods, as compared to the same periods in 2007, was primarily a
result of the coinsurance agreement discussed above.
In addition, during the second quarter of 2007, we were required to
accelerate the amortization of insurance acquisition costs related to our
universal life products by $7.7 million because the prior balance was not
recoverable by the value of future estimated gross profits on this block. This
additional amortization was necessary so that our insurance acquisition costs
would not exceed the value of future estimated gross profits and is expected to
continue to be recognized in subsequent periods. Because our insurance
acquisition costs are now equal to the value of future estimated gross profits,
this block is expected to generate break-even earnings in the future. In
addition, results for this block are expected to exhibit increased volatility in
the future, because the entire difference between our assumptions and actual
experience is expected to be reflected in earnings in the period such
differences occur.
Interest expense on investment borrowings includes $5.3 million and $3.9
million of interest expense on collateralized borrowings in the second quarters
of 2008 and 2007, respectively, and $11.0 million and $4.8 million in the first
six months of 2008 and 2007, respectively, as further described in the note to
the consolidated financial statements entitled "Investment Borrowings".
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
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
litigation settlement recognized in the 2007 periods represented changes to our
initial estimates based on the ultimate cost of the settlement, including the
effect of the 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.
Other operating costs and expenses were $62.0 million in the first quarter
of 2008, down 9.5 percent from 2007 and were $126.9 million in the first six
months of 2008, down 7.0 percent from 2007. Other operating costs and expenses
include commission expense of $19.0 million and $20.3 million in the second
quarters of 2008 and 2007, respectively, and $38.5 million and $40.6 million in
the first six months of 2008 and 2007, respectively. The decrease in expenses is
primarily due to lower litigation expenses and lower sales and marketing costs.
Net realized investment losses fluctuate each period. During the first six
months of 2008, net realized investment losses included $1.3 million of net
losses from the sales of investments (primarily fixed maturities), and $21.0
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary. During the first six months of 2007, net
realized investment losses in this segment included: (i) $1.7 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary; and (ii) $53.0 million of writedowns of
investments (which were subsequently transferred pursuant to a coinsurance
agreement completed in October 2007) as a result of our intent not to hold such
investments for a period of time sufficient to allow for a full recovery in
value.
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 a full
recovery in value), 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 $1.8 million and $11.8 million in
the second quarters of 2008 and 2007, respectively, and $2.1 million and $25.0
million in the first six months of 2008 and 2007, respectively.
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-off (a) (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
(Restated) (Restated)
Premium collections (all of which are renewal premiums):
Long-term care........................................ $ 73.7 $ 75.6 $ 149.5 $ 156.2
Major medical......................................... .4 .6 .9 1.2
-------- -------- -------- --------
Total collections................................ $ 74.1 $ 76.2 $ 150.4 $ 157.4
======== ======== ======== ========
Average liabilities for insurance products:
Long-term care........................................ $3,386.4 $3,332.5 $3,391.3 $3,300.5
Major medical......................................... 23.3 24.3 23.3 25.1
-------- -------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded..................... $3,409.7 $3,356.8 $3,414.6 $3,325.6
======== ======== ======== ========
Revenues:
Insurance policy income............................... $ 75.5 $ 78.1 $ 151.0 $ 157.6
Net investment income on general account invested
assets.............................................. 51.6 47.6 102.1 94.6
Fee revenue and other income.......................... .1 .1 .2 .2
-------- -------- -------- --------
Total revenues.................................... 127.2 125.8 253.3 252.4
-------- --------- -------- --------
Expenses:
Insurance policy benefits............................. 93.6 228.4 196.2 353.3
Amortization related to operations.................... 5.6 6.1 11.0 12.1
Other operating costs and expenses.................... 15.8 21.6 35.2 43.4
-------- -------- -------- --------
Total expenses.................................... 115.0 256.1 242.4 408.8
-------- -------- -------- --------
Income (loss) before net realized investment
gains (losses) and income taxes................. 12.2 (130.3) 10.9 (156.4)
Net realized investment losses........................ (206.8) (.1) (204.8) (.3)
-------- -------- -------- --------
Loss before income taxes.......................... $ (194.6) $ (130.4) $ (193.9) $ (156.7)
======== ========= ======== ========
Health benefit ratios:
Insurance policy benefits........................... $93.6 $228.4 $196.2 $353.3
Benefit ratio (b)................................... 123.9% 292.4% 129.9% 224.2%
Interest-adjusted benefit ratio (c)................. 56.5% 232.6% 63.1% 165.1%
<FN>
- --------------------
(a) As further discussed in the note to the consolidated financial statements
entitled "Subsequent Event", the Company plans to transfer Conseco Senior
to an independent trust. Over 80 percent of the insurance liabilities in
this segment are expected to be transferred upon consummation of the
transaction.
(b) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(c) 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.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 long-term care reserves in our
Other Business in Run-off segment was $50.9 million and $46.9 million in
the three months ended June 30, 2008 and 2007, respectively, and $100.8
million and $93.1 million in the six months ended June 30, 2008 and 2007,
respectively.
</FN>
Total premium collections were $74.1 million in the second quarter of 2008,
down 2.8 percent from 2007 and were $150.4 million in the first six months of
2008, down 4.4 percent from 2007. 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 $51.6 million
in the second quarter of 2008, up 8.4 percent from 2007 and was $102.1 million
in the first six months of 2008, up 7.9 percent from 2007. The average balance
of general account invested assets was $3.5 billion and $3.2 billion in the
second quarters of 2008 and 2007, respectively. The average yield on these
assets was 5.84 percent and 5.86 percent in the second quarters of 2008 and
2007, respectively. The average balance of general account invested assets was
$3.5 billion and $3.2 billion in the first six months of 2008 and 2007,
respectively. The average yield on these assets was 5.86 percent and 5.92
percent in the first six months of 2008 and 2007, respectively.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below.
Insurance policy benefits were $93.6 million in the second quarter of 2008,
down 59 percent from 2007 and were $196.2 million in the first six months of
2008, down 44 percent from 2007.
The benefit ratio on our Other Business in Run-off segment (including the
long-term care block and the small remaining major medical block) was 123.9
percent and 292.4 percent in the second quarters of 2008 and 2007, respectively,
and 129.9 percent and 224.2 percent in the first six months of 2008 and 2007,
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
in the first six months of 2008 and 2007 reflected reserve deficiencies from
prior years of $3.1 million and $131.9 million, respectively. Excluding the
effects of prior year claim reserve redundancies or deficiencies, our benefit
ratios would have been 127.9 percent and 140.5 percent in the first six months
of 2008 and 2007, respectively. The benefit ratios in the 2008 periods reflect
lower claim expense and increased terminations. The 2007 benefit ratios reflect
the significantly higher level of incurred claims experienced in these periods
resulting in increases in reserves for future benefits as discussed below,
adverse development on claims incurred in prior periods as discussed below, and
decreases in policy income. The prior period deficiencies have resulted from the
impact of paid claim experience being different than prior estimates, changes in
actuarial assumptions and refinements to claimant data used to determine claim
reserves.
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
The net cash flows from long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in benefits will be partially offset
by investment income earned on the assets which have accumulated. The
interest-adjusted benefit ratio for long-term care products is calculated by
dividing the insurance product's insurance policy benefits less interest income
on the accumulated assets backing the insurance liabilities by insurance policy
income. The interest-adjusted benefit ratio on this business was 56.5 percent
and 232.6 percent in the second quarters of 2008 and 2007, respectively, and
63.1 percent and 165.1 percent in the first six months of 2008 and 2007,
respectively. Excluding the effects of prior year claim reserve redundancies or
deficiencies, our interest-adjusted benefit ratios would have been 61.1 percent
and 81.4 percent in the first six months of 2008 and 2007, respectively.
This segment includes long-term care insurance inforce, which was primarily
issued through independent agents by certain subsidiaries prior to their
acquisitions by our Predecessor 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
recent periods.
In each quarterly period, we calculate our best estimate of claim reserves
based on all of the information available to us at that time, which necessarily
takes into account new experience emerging during the period. Our actuaries
estimate these claim reserves using various generally recognized actuarial
methodologies which are based on informed estimates and judgments that are
believed to be appropriate. Additionally, an external actuarial firm provides
consulting services which involve a review of the Company's judgments and
estimates for claim reserves on the long-term care block in the Other Business
in Run-off segment on a quarterly basis. As additional experience emerges and
other data become available, these estimates and judgments are reviewed and may
be revised. Significant assumptions made in estimating claim reserves for
long-term care policies include expectations about the: (i) future duration of
existing claims; (ii) cost of care and benefit utilization; (iii) interest rate
utilized to discount claim reserves; (iv) claims that have been incurred but not
yet reported; (v) claim status on the reporting date; (vi) claims that have been
closed but are expected to reopen; and (vii) correspondence that has been
received that will ultimately become claims that have payments associated with
them.
During the second quarter of 2007, we increased claim liabilities for the
long-term care insurance block in our Other Business in Run-off segment by $118
million as a result of changes in our estimates of claim reserves incurred in
prior periods. Approximately $20 million of this increase related to claims with
incurrence dates in the first quarter of 2007 and $98 million related to claims
with incurrence 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 Old Conseco. 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.
62
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 a long-term care block of business written by
Transport (which was acquired by our Predecessor) 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.
We have been aggressively seeking actuarially justified rate increases and
pursuing other actions on our long-term care policies. During the third quarter
of 2006, we began a new program to file requests for rate increases on various
long-term care products in the Other Business in Run-off segment as we believe
the existing rates were too low to fund expected future benefits. These filings
are expected to be the first of three rounds of rate increase filings for many
of the same policies, and in some cases we requested three years of successive
rate increases. Based on recent experience, certain of the policies in this
segment will continue to be unprofitable even if we obtain the three rounds of
rate increases, and it is likely that we will request additional rate increases
when the current program is complete. We have chosen to request a series of
smaller rate increases, rather than a single large increase, to limit the impact
on a policyholder's premiums in any single year. The effects of the first round
of rate filings have been partially realized in our premium revenue with the
remaining impact expected to be realized by the end of 2008. In the second
quarter of 2007, we began filing requests for the second round of rate increases
on many of the same policies. As of June 30, 2008, almost all of the expected
second round filings had been submitted for regulatory approval, and
approximately 86 percent of the expected amounts had been approved by
regulators. The full effect of all three rounds of rate increases may not be
fully realized until 2011. 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 actuarially justified rate increases currently
pending or for the additional rate increases we plan to file especially in light
of the magnitude of some past premium rate increases and current consumer and
regulator sentiment. 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 we are unable to raise our premium rates because
we fail to obtain approval for actuarially justified rate increases in one or
more states, our financial condition and results of operations could be
adversely affected.
Amortization related to operations includes amortization of insurance
acquisition costs.
Other operating costs and expenses were $15.8 million in the second quarter
of 2008, down 27 percent from 2007 and were $35.2 million in the first six
months of 2008, down 19 percent from 2007. Other operating costs and expenses
include commission expense of $7.1 million and $8.0 million in the second
quarters of 2008 and 2007, respectively, and $14.6 million and $16.3 million in
the six months ended June 30, 2008 and 2007, respectively.
Net realized investment gains (losses) fluctuate each period. During the
first six months of 2008, net realized investment gains included: (i) $3.2
million of net gains from the sales of investments (primarily fixed maturities);
(ii) $2.3 million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary; and (iii) $205.7 million of
writedowns of investments (which are expected to be transferred to an
independent trust as further discussed in the note to the consolidated financial
statements entitled "Subsequent Event") as a result of our intent not to hold
such investments for a period of time sufficient to allow for a full recovery in
value. During the first six months of 2007, we recognized net realized
investment losses of $.3 million from the sales of investments (primarily fixed
maturities). There were no such writedowns in the first six months of 2007.
63
CONSECO, INC. AND SUBSIDIARIES
-------------------
Corporate Operations (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Corporate operations:
Interest expense on corporate debt.................... $(13.9) $(16.9) $(30.3) $(33.0)
Net investment income ................................ 1.2 .8 2.7 1.9
Fee revenue and other income.......................... 1.6 2.0 2.7 4.1
Net operating results of variable interest entity..... 1.7 2.3 3.2 4.7
Costs related to a litigation settlement.............. - (17.5) - (24.0)
Other operating costs and expenses.................... (23.0) (13.1) (33.8) (26.9)
------ ------ ------ ------
Loss before net realized investment losses and
income taxes...................................... (32.4) (42.4) (55.5) (73.2)
Net realized investment losses........................ (3.9) (1.2) (20.5) (1.2)
------ ------ ------ ------
Loss before income taxes............................ $(36.3) $(43.6) $(76.0) $(74.4)
====== ====== ====== ======
Interest expense on corporate debt was impacted by the amendment of the
Company's credit facility in June 2007. Our average corporate debt outstanding
was $1,194.4 million and $1,023.4 million during the first six months of 2008
and 2007, respectively. The average interest rate on our debt was 4.8 percent
and 6.1 percent during the first six months of 2008 and 2007, respectively.
Net investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income and
fluctuated along with the change in the amount of invested assets in this
segment.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. Fee revenue and other income decreased primarily as
a result of a decrease in the market value of investments managed for others,
upon which these fees are based.
Net operating results of variable interest entity represent the operating
results of a VIE. The VIE is consolidated in accordance with FIN 46R. Although
we do not control this entity, we consolidate it because we are the primary
beneficiary. This entity was established to issue securities and use the
proceeds to invest in loans and other permitted assets.
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. In the second
quarter of 2008, we recognized a $9.6 million charge related to the
consolidation of our Chicago facilities and $2.3 million of expenses related to
the plan to transfer Conseco Senior to an independent trust.
Net realized investment losses often fluctuate each period. During the
first six months of 2008, net realized investment losses in this segment
included $12.4 million from the sale of investments (primarily fixed maturities)
and $8.1 million of writedowns due to other-than-temporary declines in value on
certain securities. All such realized investment losses and writedowns in the
2008 periods related to investments held by a VIE. During the first six months
of 2007, net realized investment losses in this segment included a writedown of
$1.2 million due to an other-than-temporary decline in value of an investment.
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
PREMIUM COLLECTIONS
In accordance with GAAP, insurance policy income in our consolidated
statement of operations consists of premiums earned for traditional insurance
policies that have life contingencies or morbidity features. For annuity and
universal life contracts, premiums collected are not reported as revenues, but
as deposits to insurance liabilities. We recognize revenues for these products
over time in the form of investment income and surrender or other charges.
Our insurance segments sell products through three primary distribution
channels -- career agents (our Bankers Life segment), direct marketing (our
Colonial Penn segment) and independent producers (our Conseco Insurance Group
segment). Our career agency force in the Bankers Life segment sells primarily
Medicare supplement and long-term care insurance policies, Medicare Part D
contracts, 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
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. Our independent
producer distribution channel in the Conseco Insurance Group segment consists of
a general agency and insurance brokerage distribution system comprised of
independent licensed agents doing business in all fifty states, the District of
Columbia, and certain protectorates of the United States. Independent producers
are a diverse network of independent agents, insurance brokers and marketing
organizations. Our independent producer distribution channel sells primarily
specified disease and Medicare supplement insurance policies, universal life
insurance and annuities.
Agents, insurance brokers and marketing companies who market our products
and prospective purchasers of our products use the financial strength ratings of
our insurance subsidiaries as an important factor in determining whether to
market or purchase. Ratings have the most impact on our annuity,
interest-sensitive life insurance and long-term care products. The current
financial strength ratings of our primary insurance subsidiaries (except Conseco
Senior) from A.M. Best, S&P and Moody's are "B+ (Good)", "BB+" and "Baa3",
respectively. The current financial strength ratings of Conseco Senior from A.M.
Best, S&P and Moody's are "C++ (Marginal)", "CCC-" and "Caa1", respectively. For
a description of these ratings and additional information on our ratings, see
"Liquidity for Insurance Operations."
We set premium rates on our health insurance policies based on facts and
circumstances known at the time we issue the policies using assumptions about
numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. We also consider historical claims information,
industry statistics, the rates of our competitors and other factors. If our
actual claims experience is less favorable than we anticipated and we are unable
to raise our premium rates, our financial results may be adversely affected. We
generally cannot raise our health insurance premiums in any state until we
obtain the approval of the state insurance regulator. We review the adequacy of
our premium rates regularly and file rate increases on our products when we
believe such rates are too low. It is likely that we will not be able to obtain
approval for all requested premium rate increases. If such requests are denied
in one or more states, our net income may decrease. If such requests are
approved, increased premium rates may reduce the volume of our new sales and may
cause existing policyholders to lapse their policies. If the healthier
policyholders allow their policies to lapse, this would reduce our premium
income and profitability in the future.
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................ $132.8 $ 91.5 $ 265.1 $ 176.9
------ ------ -------- --------
Other fixed (first-year)............................... 124.0 108.1 219.7 234.1
Other fixed (renewal).................................. 1.0 .9 2.1 1.7
------ ------ -------- --------
Subtotal - other fixed annuities..................... 125.0 109.0 221.8 235.8
------ ------ -------- --------
Total annuities...................................... 257.8 200.5 486.9 412.7
------ ------ -------- --------
Supplemental health:
Medicare supplement (first-year)....................... 19.4 20.0 38.5 42.2
Medicare supplement (renewal).......................... 131.2 133.8 272.0 278.6
------ ------ -------- --------
Subtotal - Medicare supplement....................... 150.6 153.8 310.5 320.8
------ ------ -------- --------
Long-term care (first-year)............................ 10.6 12.2 21.6 23.8
Long-term care (renewal)............................... 144.6 143.2 290.2 289.8
------ ------ -------- --------
Subtotal - long-term care............................ 155.2 155.4 311.8 313.6
------ ------ -------- --------
PDP and PFFS (first year).............................. 116.1 25.9 186.5 41.9
PDP and PFFS (renewal)................................. 46.3 19.0 92.3 41.6
------ ------ -------- --------
Subtotal - PDP and PFFS.............................. 162.4 44.9 278.8 83.5
------ ------ -------- --------
Other health (first-year).............................. .5 .2 .9 .4
Other health (renewal)................................. 2.1 2.3 4.3 4.6
------ ------ -------- --------
Subtotal - other health.............................. 2.6 2.5 5.2 5.0
------ ------ -------- --------
Total supplemental health............................ 470.8 356.6 906.3 722.9
------ ------ -------- --------
Life insurance:
First-year............................................. 22.5 25.3 41.0 46.7
Renewal................................................ 31.3 26.8 60.8 53.5
------ ------ -------- --------
Total life insurance................................. 53.8 52.1 101.8 100.2
------ ------ -------- --------
Collections on insurance products:
Total first-year premium collections on insurance
products............................................ 425.9 283.2 773.3 566.0
Total renewal premium collections on insurance
products............................................. 356.5 326.0 721.7 669.8
------ ------ -------- --------
Total collections on insurance products.............. $782.4 $609.2 $1,495.0 $1,235.8
====== ====== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections in this
segment increased 29 percent, to $257.8 million, in the second quarter of 2008,
and 18 percent, to $486.9 million, in the first six months of 2008, as compared
to the same periods in 2007. Premium collections from our equity-indexed
products were favorably impacted by the general stock market performance which
has made these products attractive to certain customers.
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
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 decreased 2.1 percent, to $150.6 million, in the second quarter of 2008,
and 3.2 percent, to $310.5 million, in the first six months of 2008, as compared
to the same periods in 2007.
Premiums collected on Bankers Life's long-term care policies in the 2008
periods were comparable to the same periods in 2007.
Premiums collected on PDP and PFFS business relate to various quota-share
reinsurance agreements with Coventry. Effective May 1, 2008 and July 1, 2007, we
entered into new PFFS quota-share reinsurance agreements with Coventry pursuant
to which we received $81.1 million and $131.5 million of first-year premiums in
the three and six months ended June 30, 2008, respectively. Premiums collected
on our other PFFS business increased $36.9 million and $73.7 million in the
three and six months ended June 30, 2008, respectively, as compared to the same
periods in 2007.
Life products in this segment are sold primarily to the senior market
through our career agents. Life premiums collected in this segment in the 2008
periods were comparable to the same periods in 2007.
Colonial Penn (dollars in millions)
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Premiums collected by product:
Life insurance:
First-year.............................................. $ 8.9 $ 7.0 $17.3 $13.7
Renewal................................................. 34.9 19.0 69.4 39.0
----- ----- ----- -----
Total life insurance.................................. 43.8 26.0 86.7 52.7
----- ----- ----- -----
Supplemental health (all of which are renewal premiums):
Medicare supplement..................................... 2.1 2.5 4.2 4.8
Other health............................................ .2 .2 .4 .5
----- ----- ----- -----
Total supplemental health............................. 2.3 2.7 4.6 5.3
----- ----- ----- -----
Collections on insurance products:
Total first-year premium collections on insurance
products.............................................. 8.9 7.0 17.3 13.7
Total renewal premium collections on insurance
products.............................................. 37.2 21.7 74.0 44.3
----- ----- ----- -----
Total collections on insurance products............... $46.1 $28.7 $91.3 $58.0
===== ===== ===== =====
67
CONSECO, INC. AND SUBSIDIARIES
-------------------
Life products in this segment are sold primarily to the senior market. Life
premiums collected in this segment increased 68 percent, to $43.8 million, in
the second quarter of 2008, and 65 percent, to $86.7 million, in the first six
months of 2008, compared to the same periods in 2007. Graded benefit life
products sold through our direct response marketing channel accounted for $42.3
million and $24.8 million of our total collected premiums in the second quarters
of 2008 and 2007, respectively, and $83.8 million and $50.2 million in the first
six months of 2008 and 2007, respectively. Collected premiums have been impacted
by the recapture in the fourth quarter of 2007 of a block of traditional life
insurance inforce that had been ceded in 2002 to REALIC.
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.
Conseco Insurance Group (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)........................... $ 33.4 $104.1 $ 71.6 $211.0
Equity-indexed (renewal).............................. 2.1 2.6 3.9 4.7
------ ------ ------ ------
Subtotal - equity-indexed annuities................. 35.5 106.7 75.5 215.7
------ ------ ------ ------
Other fixed (first-year).............................. 1.0 4.2 2.0 13.6
Other fixed (renewal)................................. .6 2.1 1.2 3.8
------ ------ ------ ------
Subtotal - other fixed annuities.................... 1.6 6.3 3.2 17.4
------ ------ ------ ------
Total annuities..................................... 37.1 113.0 78.7 233.1
------ ------ ------ ------
Supplemental health:
Medicare supplement (first-year)...................... 2.3 5.2 5.1 11.8
Medicare supplement (renewal)......................... 47.3 50.9 97.6 104.1
------ ------ ------ ------
Subtotal - Medicare supplement...................... 49.6 56.1 102.7 115.9
------ ------ ------ ------
Specified disease (first-year)........................ 8.9 7.7 17.8 15.0
Specified disease (renewal)........................... 82.6 81.4 167.3 166.2
------ ------ ------ ------
Subtotal - specified disease........................ 91.5 89.1 185.1 181.2
------ ------ ------ ------
Other health (first-year)............................. .9 - 1.4 -
Other health (renewal)................................ 2.0 2.2 4.0 4.5
------ ------ ------ ------
Subtotal - other health............................. 2.9 2.2 5.4 4.5
------ ------ ------ ------
Total supplemental health........................... 144.0 147.4 293.2 301.6
------ ------ ------ ------
Life insurance:
First-year............................................ 1.2 1.1 1.9 2.3
Renewal............................................... 65.7 68.9 136.9 144.9
------ ------ ------ ------
Total life insurance................................ 66.9 70.0 138.8 147.2
------ ------ ------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products............................................ 47.7 122.3 99.8 253.7
Total renewal premium collections on insurance
products............................................ 200.3 208.1 410.9 428.2
------ ------ ------ ------
Total collections on insurance products............. $248.0 $330.4 $510.7 $681.9
====== ====== ====== ======
68
CONSECO, INC. AND SUBSIDIARIES
-------------------
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity premiums
collected in this segment totaled $37.1 million in the second quarter of 2008,
compared to $113.0 million in the same period of 2007, and $78.7 million in the
first six months of 2008, compared to $233.1 million in the same period of 2007.
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. Collected premiums for this product totaled $35.5
million in the second quarter of 2008, compared to $106.7 million in the same
period of 2007, and $75.5 million in the first six months of 2008, compared to
$215.7 million in the same period of 2007. In the second half 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.
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 to $1.6 million in the
second quarter of 2008, compared to $6.3 million in the same period of 2007, and
$3.2 million in the first six months of 2008, compared to $17.4 million in the
same period of 2007, primarily due to a decrease in new sales.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers. Our profits on supplemental health
policies depend on the overall level of sales, the length of time the business
remains inforce, investment yields, claim experience and expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment decreased 12 percent, to $49.6 million, in the second quarter of
2008, and 11 percent, to $102.7 million, in the first six months of 2008, as
compared to the same periods in 2007. 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 increased 2.7 percent, to
$91.5 million in the second quarter of 2008, and 2.2 percent, to $185.1 million,
in the first six months of 2008, as compared to the same periods in 2007. Such
increase is primarily due to higher new sales.
First-year premiums collected on other health products are due to the
introduction of a new short-term disability product in the fourth quarter of
2007. Renewal premiums collected from other health products have decreased from
period to period as we no longer actively market many of these products.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected decreased 4.4
percent, to $66.9 million, in the second quarter of 2008, and 5.7 percent, to
$138.8 million, in the first six months of 2008, compared to the same periods in
2007.
69
CONSECO, INC. AND SUBSIDIARIES
-------------------
Other Business in Run-off (dollars in millions):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2008 2007 2008 2007
---- ---- ---- ----
Premiums collected by product (all of which are renewal
premiums):
Long-term care......................................... $73.7 $75.6 $149.5 $156.2
Major medical.......................................... .4 .6 .9 1.2
----- ----- ------ ------
Total renewal premium collections on insurance
products........................................... $74.1 $76.2 $150.4 $157.4
===== ===== ====== ======
The Other Business in Run-off segment includes blocks of business that we
no longer market or underwrite and are managed separately from our other
businesses. This segment consists of: (i) long-term care insurance sold in prior
years through independent agents; and (ii) major medical insurance.
Long-term care premiums collected in this segment decreased 2.5 percent, to
$73.7 million, in the second quarter of 2008, and 4.3 percent, to $149.5
million, in the first six months of 2008, compared to the same periods in 2007.
Most of the long-term care premiums in this segment relate to business written
by certain subsidiaries prior to their acquisitions by our Predecessor in 1996
and 1997 and was sold through the independent producer distribution channel. The
performance of this business did not meet the expectations we had when the
blocks were acquired. As a result, we ceased selling new long-term care policies
through this distribution channel in 2003. We expect this segment's long-term
care premiums to reflect additional policy lapses in the future, partially
offset by premium rate increases.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between June 30, 2008 and
December 31, 2007, primarily reflect: (i) our net loss for the six months ended
June 30, 2008; and (ii) changes in the fair value of actively managed fixed
maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At June 30, 2008, we decreased the
carrying value of such investments by $1,185.7 million as a result of this fair
value adjustment.
Our capital structure as of June 30, 2008, and December 31, 2007, was as
follows (dollars in millions):
June 30, December 31,
2008 2007
---- ----
Total capital:
Corporate notes payable................................................ $1,189.7 $1,193.7
Shareholders' equity:
Common stock........................................................ 1.9 1.9
Additional paid-in capital.......................................... 4,073.6 4,068.6
Accumulated other comprehensive loss................................ (639.2) (273.3)
Retained earnings (accumulated deficit)............................. (54.2) 438.7
-------- --------
Total shareholders' equity....................................... 3,382.1 4,235.9
-------- --------
Total capital.................................................... $4,571.8 $5,429.6
======== ========
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CONSECO, INC. AND SUBSIDIARIES
-------------------
The following table summarizes certain financial ratios as of and for the
six months ended June 30, 2008, and as of and for the year ended December 31,
2007:
June 30, December 31,
2008 2007
---- ----
Book value per common share................................................................... $18.31 $22.94
Book value per common share, excluding accumulated other comprehensive
income (loss) (a).......................................................................... 21.77 24.42
Ratio of earnings to fixed charges............................................................ (b) (c)
Ratio of earnings to fixed charges and preferred dividends.................................... (b) (d)
Debt to total capital ratios:
Corporate debt to total capital............................................................ 26% 22%
Corporate debt to total capital, excluding accumulated other comprehensive
income (loss) (a)........................................................................ 23% 21%
<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 $188.0 million less than fixed charges.
(c) For such ratio, earnings were $173.0 million less than fixed charges.
(d) For such ratio, earnings were $194.7 million less than fixed charges.
</FN>
71
CONSECO, INC. AND SUBSIDIARIES
-------------------
Liquidity for insurance operations
Our insurance companies (other than Conseco Senior) 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.
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 collateralized borrowings.
At June 30, 2008, the carrying value of the FHLBI common stock was $22.5
million. Collateralized borrowings totaled $450.0 million as of June 30, 2008,
and the proceeds were used to purchase fixed maturity securities. The borrowings
are classified as investment borrowings in the accompanying consolidated balance
sheet. The borrowings are collateralized by investments with an estimated fair
value of $508.0 million at June 30, 2008, which are maintained in a custodial
account for the benefit of the FHLBI. The following summarizes the terms of the
borrowings (dollars in millions):
Amount Maturity Interest rate
borrowed date at June 30, 2008
-------- ---- ----------------
$ 54.0 May 2012 Variable rate - 2.638%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 2.770%
146.0 November 2015 Fixed rate - 5.300%
100.0 November 2015 Fixed rate - 4.890%
100.0 December 2015 Fixed rate - 4.710%
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 three of
the Company's insurance subsidiaries, Colonial Penn, Conseco Senior and Conseco
Life, because each such insurance subsidiary has incurred statutory losses in a
12 month period in excess of 50 percent of its capital and surplus. The
statutory losses of Colonial Penn are primarily attributable to the recapture of
a block of life insurance business in fourth quarter of 2007 that had previously
been ceded to an unaffiliated reinsurer in 2002 under a modified coinsurance
agreement. Colonial Penn paid a recapture fee of $63.0 million and will
recognize profits or losses on the recaptured business as they emerge over time.
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, an increase in claims incurred in
2006 and 2007 and strengthening of statutory active life reserves using the
prospective unlocking method (as permitted by insurance regulators), all of
which related to long-term care policies. Based on our discussions with state
regulators, we do not expect the regulators to take any actions against Colonial
Penn, 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 not generated sufficient income to cover its expenses
and, in the aggregate, Conseco has made more than $900 million of capital
contributions to Conseco Senior since its acquisition in 1996. We elected to
make a capital contribution to Conseco Senior of $56.0 million which was accrued
at December 31, 2007 and paid in February 2008. We were under no obligation to
make such capital contributions to Conseco Senior, and we may determine not to
make additional contributions in the future. No assurances can be given that we
will make future contributions or otherwise make capital available to Conseco
Senior. Absent additional capital contributions, Conseco Senior will be reliant
on actuarially justified
72
CONSECO, INC. AND SUBSIDIARIES
-------------------
premium rate increases to provide it with sufficient capital. See the
"Subsequent Event" footnote to our consolidated financial statements for
information regarding the proposed transfer of Conseco Senior to an Independent
Trust.
Conseco Senior has been aggressively seeking actuarially justified rate
increases and pursuing other actions on our long-term care policies. During the
third quarter of 2006, we began a new program to file requests for rate
increases on various long-term care products in the Other Business in Run-off
segment as we believe the existing rates were too low to fund expected future
benefits. These filings are expected to be the first of three rounds of rate
increase filings for many of the same policies, and in some cases we requested
three years of successive rate increases. Based on recent experience, certain of
the policies in this segment will continue to be unprofitable even if we obtain
the three rounds of rate increases, and it is likely that we will request
additional rate increases when the current program is complete. We have chosen
to request a series of smaller rate increases, rather than a single large
increase, to limit the impact on a policyholder's premiums in any single year.
The effects of the first round of rate filings have been partially realized in
our premium revenue with the remaining impact expected to be realized by the end
of 2008. In the second quarter of 2007, we began filing requests for the second
round of rate increases on many of the same policies. As of June 30, 2008,
almost all of the expected second round filings had been submitted for
regulatory approval, and approximately 86 percent of the expected amounts had
been approved by regulators. The full effect of all three rounds of rate
increases may not be fully realized until 2011. 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 actuarially justified rate increases
currently pending or for the additional rate increases we plan to file
especially in light of the magnitude of some past premium rate increases and
current consumer and regulator sentiment. 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 we are unable to raise our premium
rates because we fail to obtain approval for actuarially justified rate
increases in one or more states, our financial condition and results of
operations could be adversely affected.
Financial Strength Ratings of our Insurance Subsidiaries
Financial strength ratings provided by A.M. Best, S&P and Moody's are the
rating agency's opinions of the ability of our insurance subsidiaries to repay
policyholder claims and obligations when due.
On August 12, 2008, A.M. Best placed the financial strength ratings of our
primary insurance subsidiaries, as well as Conseco Senior, under review with
developing implications. These ratings actions follow the Company's announcement
of its plan to transfer Conseco Senior to an independent trust as further
discussed in the note to the consolidated financial statements entitled
"Subsequent Event." 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)". Prior to A.M. Best's rating actions on August 12, 2008, the outlook
for the ratings of our primary insurance subsidiaries, as well as Conseco
Senior, was 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 11, 2008, S&P affirmed: (i) the financial strength ratings of
"BB+" of our primary insurance subsidiaries; (ii) Conseco Senior's "CCC-"
rating; and (iii) the outlook remains negative for both our primary insurance
companies and Conseco Senior 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
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.
73
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.
Liquidity of the Holding Companies
At June 30, 2008, Conseco Inc. and CDOC, our wholly owned subsidiary and a
guarantor under the Second Amended Credit Facility, held unrestricted cash of
$97.7 million. Conseco Inc. and CDOC are holding companies with no business
operations of their own; they depend on their operating subsidiaries for cash to
make principal and interest payments on debt, and to pay administrative expenses
and income taxes. Conseco and CDOC receive cash from insurance subsidiaries,
consisting of dividends and distributions, principal and interest payments on
surplus debentures and tax-sharing payments, as well as cash from non-insurance
subsidiaries consisting of dividends, distributions, loans and advances. The
principal non-insurance subsidiaries that provide cash to Conseco and CDOC are
40|86 Advisors, Inc., which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives fees from the
insurance subsidiaries for providing administrative services. A deterioration in
the financial condition, earnings or cash flow of the material subsidiaries of
Conseco or CDOC for any reason could hinder such subsidiaries' ability to pay
cash dividends or other disbursements to Conseco and/or CDOC, which, in turn,
would limit Conseco's and/or CDOC's ability to meet debt service requirements
and satisfy other financial obligations. In addition, we may need to contribute
additional capital to certain insurance subsidiaries to strengthen their surplus
and this could affect the ability of our top tier insurance subsidiary to pay
dividends. We made capital contributions totaling $13.0 million to CLTX, our top
tier insurance subsidiary, in the first six months of 2008. On July 23, 2008,
CLTX transferred ownership of Conseco Senior, Conseco Health and Washington
National (which owns Conseco Insurance and Conseco Life) to CDOC.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of (or in a few states, the lesser of): (i) statutory net gain
from operations or net income for the prior year; or (ii) 10 percent of
statutory capital and surplus as of the end of the preceding year. Any dividends
in excess of these levels require the approval of the director or commissioner
of the applicable state insurance department.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
provide assurance that we will possess sufficient income and liquidity to meet
all of our liquidity requirements and other obligations.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted following the insurance law of its state of domicile with
such state's insurance regulator as the receiver for such insurer's property and
business. In the event of a default on our debt or our insolvency, liquidation
or other reorganization, our creditors and stockholders would have no right to
proceed against the assets of our insurance subsidiaries or to cause their
liquidation under federal and state bankruptcy laws.
As further discussed in the note to the consolidated financial statements
entitled "Subsequent Event", the Company will make a $175.0 million capital
contribution to Conseco Senior upon consummation of the transfer of the stock of
Conseco Senior to the Independent Trust. The $175.0 million capital contribution
is expected to be primarily in the form of cash and a note payable of $125.0
million on the consummation date. The note is expected to be unsecured; have a
five-year maturity date; have a fixed rate of interest to be determined upon
consummation; and require annual principal payments of $25.0 million. Such
amounts are expected to be funded by the Company's operating activities.
74
CONSECO, INC. AND SUBSIDIARIES
-------------------
During the first six months of 2008, we made scheduled principal payments
totaling $4.3 million on our Second Amended Credit Facility. The scheduled
repayment of our Second Amended Credit Facility is as follows (dollars in
millions):
Remainder of 2008.............................. $ 4.4
2009.......................................... 8.7
2010.......................................... 8.8
2011.......................................... 8.7
2012.......................................... 8.8
2013.......................................... 821.8
------
$861.2
======
The Second Amended Credit Facility includes an $80.0 million revolving
credit facility that can be used for general corporate purposes and that would
mature on June 22, 2009. There were no amounts outstanding under the revolving
credit facility at June 30, 2008. The Company pays a commitment fee equal to .50
percent of the unused portion of the revolving credit facility on an annualized
basis.
Pursuant to the Second Amended Credit Facility, as long as the debt to
total capitalization ratio (as defined in the Second Amended Credit Facility) is
greater than 20 percent and certain insurance subsidiaries (as defined in the
Second Amended Credit Facility) have financial strength ratings of less than A-
from A.M. Best, the Company is required to make mandatory prepayments with all
or a portion of the proceeds from the following transactions or events
including: (i) the issuance of certain indebtedness; (ii) equity issuances;
(iii) certain asset sales or casualty events; and (iv) excess cash flows as
defined in the Second Amended Credit Facility (the first such payment, if
applicable, would not be paid prior to the first quarter of 2009). The Company
may make optional prepayments at any time in minimum amounts of $3.0 million or
any multiple of $1.0 million in excess thereof.
Under the Second Amended Credit Facility, we may pay cash dividends on our
common stock or repurchase our common stock in an aggregate amount of up to
$300.0 million over the term of the facility. We have repurchased $87.2 million
of our common stock. No repurchases were made in the first six months of 2008.
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.
The Second Amended Credit Facility requires the Company to maintain various
financial ratios and balances, as defined in the agreement, including a debt to
total capitalization ratio of not more than 30 percent at all times (such ratio
was 23 percent at June 30, 2008). Although the completion of the previously
announced transaction to transfer Conseco Senior to an independent trust would
increase our debt to total capital ratio, we expect to be in compliance with all
financial ratios and balances required by the Second Amended Credit Facility.
The pro forma Credit Facility debt to total capitalization ratio assuming the
proposed transaction had been completed at June 30, 2008 is approximately 28
percent.
75
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At June 30, 2008, 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................................................ $13,904.9 $30.2 $ (741.6) $13,193.5
United States Treasury securities and obligations of
United States government corporations and agencies................ 186.6 16.7 (1.6) 201.7
States and political subdivisions................................... 494.9 1.2 (18.5) 477.6
Debt securities issued by foreign governments....................... 8.8 .2 (.2) 8.8
Asset-backed securities............................................. 402.8 .8 (68.6) 335.0
Collateralized debt obligations..................................... 44.9 - (10.5) 34.4
Commercial mortgage-backed securities............................... 894.5 - (78.7) 815.8
Mortgage pass-through securities.................................... 91.4 - (.8) 90.6
Collateralized mortgage obligations................................. 3,726.6 2.3 (189.2) 3,539.7
--------- ----- --------- ---------
Total investment grade actively managed fixed maturities........ 19,755.4 51.4 (1,109.7) 18,697.1
--------- ----- --------- ---------
Below-investment grade:
Corporate securities................................................ 1,536.6 1.4 (124.3) 1,413.7
States and political subdivisions................................... 5.0 - (.7) 4.3
Debt securities issued by foreign governments....................... 4.2 - (.6) 3.6
Collateralized debt obligations..................................... 11.8 - (2.9) 8.9
Commercial mortgage-backed securities............................... 23.2 - (3.0) 20.2
Collateralized mortgage obligations................................. .6 - - .6
--------- ----- --------- ---------
Total below-investment grade actively
managed fixed maturities..................................... 1,581.4 1.4 (131.5) 1,451.3
--------- ----- --------- ---------
Total actively managed fixed maturities............................. $21,336.8 $52.8 $(1,241.2) $20,148.4
========= ===== ========= =========
Equity securities...................................................... $34.0 $.3 $ - $34.3
===== === ===== =====
76
CONSECO, INC. AND SUBSIDIARIES
-------------------
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our actively managed
fixed maturity securities by category as of June 30, 2008 (dollars in millions):
Percent of
Gross gross
Percent of unrealized unrealized
Carrying value fixed maturities losses losses
-------------- ---------------- ------ ------
Collateralized mortgage obligations........... $ 3,540.3 17.6% $ (189.2) 15.2%
Utilities..................................... 1,829.3 9.1 (80.5) 6.5
Energy/pipelines.............................. 1,673.2 8.3 (58.6) 4.7
Food/beverage................................. 1,161.4 5.8 (49.7) 4.0
Banks......................................... 1,088.2 5.4 (141.5) 11.4
Healthcare/pharmaceuticals.................... 1,095.7 5.4 (42.5) 3.4
Insurance..................................... 1,017.3 5.0 (79.9) 6.4
Commercial mortgage-backed securities......... 836.0 4.1 (81.7) 6.6
Real estate/REITs............................. 740.4 3.7 (59.0) 4.8
Cable/media................................... 753.2 3.7 (47.3) 3.8
Brokerage..................................... 564.0 2.8 (54.1) 4.4
Telecom....................................... 550.8 2.7 (29.7) 2.4
Capital goods................................. 499.3 2.5 (14.4) 1.2
States and political subdivisions............. 481.9 2.4 (19.2) 1.6
Aerospace/defense............................. 455.7 2.3 (16.1) 1.3
Transportation................................ 455.3 2.3 (23.4) 1.9
Building materials............................ 421.9 2.1 (31.6) 2.5
Asset-backed securities....................... 335.0 1.7 (68.6) 5.5
Technology.................................... 341.2 1.7 (16.2) 1.3
Consumer products............................. 217.5 1.1 (11.9) 1.0
U.S. government............................... 201.7 1.0 (1.6) .1
Other......................................... 1,889.1 9.3 (124.5) 10.0
--------- ----- --------- -----
Total actively managed fixed maturities.... $20,148.4 100.0% $(1,241.2) 100.0%
========= ===== ========= =====
Below-Investment Grade Securities
At June 30, 2008, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,581.4 million, or 7.4 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,451.3 million, or 92 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$384.0 million and an estimated fair value of $357.2 million are held by a VIE
that we are required to consolidate. These fixed maturity securities are legally
isolated and are not available to the Company. The liabilities of such VIE will
be satisfied from the cash flows generated by these securities and are not
obligations of the Company. See "Investments in Variable Interest Entity"
concerning the Company's commitment to provide additional capital of up to $25
million to the VIE. At June 30, 2008, our total investment in the VIE was $51.9
million and 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-
77
CONSECO, INC. AND SUBSIDIARIES
-------------------
investment grade securities, as in all investments, through careful credit
analysis, strict investment policy guidelines, and diversification by issuer
and/or guarantor and by industry.
Net Realized Investment Gains (Losses)
During the first six months of 2008, we recognized net realized investment
losses of $278.9 million, which were comprised of: (i) $5.9 million of net
losses from the sales of investments (primarily fixed maturities) with proceeds
of $4.3 billion; (ii) $67.3 million of writedowns of investments for other than
temporary declines in fair value; and (iii) $205.7 million of writedowns of
investments (which are expected to be transferred to an independent trust as
further discussed in the note to the consolidated financial statements entitled
"Subsequent Event") as a result of our intent not to hold such investments for a
period of time sufficient to allow for a full recovery in value. During the
first six months of 2007, net realized investment losses included: (i) $7.3
million of net losses from the sales of investments (primarily fixed maturities)
with proceeds of $3.8 billion; (ii) $2.9 million of writedowns of investments
for other than temporary declines in fair value; and (iii) $53.0 million of
writedowns of investments (which were subsequently transferred pursuant to a
coinsurance agreement completed in October 2007) as a result of our intent not
to hold such investments for a period of time sufficient to allow for a full
recovery in value. At June 30, 2008, there were no fixed maturity securities in
default as to the payment of principal or interest. At June 30, 2008, we had one
mortgage loan with a carrying value of $28.4 million which was in foreclosure.
During the six months ended June 30, 2008, we sold $.6 billion of fixed
maturity investments which resulted in gross investment losses (before income
taxes) of $65.1 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.
The following summarizes the investments sold at a loss during the first
six months of 2008 which had been continuously in an unrealized loss position
exceeding 20 percent of the amortized cost basis prior to the sale for the
period indicated (dollars in millions):
At date of sale
------------------
Number of Amortized Fair
Period issuers cost value
------ ------- ---- -----
Less than 6 months prior to sale........................ 19 $30.5 $14.7
Greater than or equal to 6 and less than 12 months
prior to sale ........................................ 4 10.4 5.8
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 or risk
premium; (iv) the near-term prospects for fundamental improvement in specific
circumstances likely to affect the value of the investment; (v) 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 a
full recovery in value; (viii) the underlying current and prospective asset and
enterprise values of the issuer and the extent to which the recoverability of
the carrying value of our investment may be affected by changes in such values;
(ix) unfavorable changes in cash flows on structured securities including
mortgage-backed and asset-backed securities; and (x) other subjective factors.
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 June 30,
2008, 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. Asset-backed securities,
collateralized debt obligations, commercial mortgage-backed securities, mortgage
pass-through securities and collateralized mortgage obligations are collectively
referenced to as "structured securities". Many 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................................................................. $ 87.1 $ 84.0
Due after one year through five years................................................... 1,100.5 1,051.2
Due after five years through ten years.................................................. 4,340.4 4,060.6
Due after ten years..................................................................... 7,204.1 6,648.8
--------- ---------
Subtotal............................................................................. 12,732.1 11,844.6
Structured securities................................................................... 4,207.0 3,853.3
--------- ---------
Total................................................................................ $16,939.1 $15,697.9
========= =========
The following summarizes the investments in our portfolio rated
below-investment grade which have been continuously in an unrealized loss
position exceeding 20 percent of the cost basis for the period indicated as of
June 30, 2008 (dollars in millions):
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------ ---------- ----- ---- ----------
Less than 6 months................. 35 $77.7 $(20.9) $56.8
Greater than or equal to
6 months and less
than 12 months................... 5 20.3 (5.3) 15.0
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CONSECO, INC. AND SUBSIDIARIES
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The following table summarizes the gross unrealized losses of our actively
managed fixed maturity securities by category and ratings category as of June
30, 2008 (dollars in millions):
Below -
Investment grade investment grade Total gross
-------------------- ---------------------- unrealized
AAA/AA/A BBB BB B and below losses
-------- --- -- ----------- ------
Collateralized mortgage obligations.. $188.9 $ .3 $ - $ - $ 189.2
Banks................................ 112.6 28.0 .4 .5 141.5
Commercial mortgage-backed
securities......................... 41.8 36.9 3.0 - 81.7
Utilities............................ 38.5 39.8 .8 1.4 80.5
Insurance............................ 69.7 10.0 - .2 79.9
Asset-backed securities.............. 57.2 11.4 - - 68.6
Real estate/REITs.................... 11.5 40.2 3.5 3.8 59.0
Energy/pipelines..................... 12.5 42.8 2.5 .8 58.6
Brokerage............................ 46.6 6.0 - 1.5 54.1
Food/beverage........................ 22.5 19.5 3.9 3.8 49.7
Cable/media.......................... 7.2 21.0 8.6 10.5 47.3
Healthcare/pharmaceuticals........... 28.7 8.1 2.6 3.1 42.5
Building materials................... 1.9 19.4 8.0 2.3 31.6
Telecom.............................. 12.8 13.0 2.3 1.6 29.7
Transportation....................... 5.2 17.1 .1 1.0 23.4
States and political subdivisions.... 17.8 .7 - .7 19.2
Technology........................... 7.7 4.8 1.6 2.1 16.2
Aerospace/defense.................... 8.1 6.9 1.0 .1 16.1
Retail............................... 3.9 8.6 1.3 1.4 15.2
Capital goods........................ 10.1 4.2 .1 - 14.4
Collateralized debt obligations...... 1.6 8.9 2.9 - 13.4
Consumer products.................... 3.8 4.5 - 3.6 11.9
Paper................................ - 8.8 1.0 1.0 10.8
Entertainment/hotels................. .4 5.2 2.6 1.2 9.4
Gaming............................... - - 5.9 1.3 7.2
Autos................................ .9 - 1.6 4.5 7.0
Chemicals............................ 1.2 1.8 2.6 1.1 6.7
Textiles............................. 3.4 .2 .1 .9 4.6
Metals and mining.................... 2.6 1.6 .1 .2 4.5
U.S. Treasury and Obligations........ 1.6 - - - 1.6
Foreign governments.................. .2 - .6 - .8
Mortgage pass-through securities..... .8 - - - .8
Other................................ 2.7 15.6 23.6 2.2 44.1
------ ------ ----- ----- --------
Total actively managed fixed
maturities....................... $724.4 $385.3 $80.7 $50.8 $1,241.2
====== ====== ===== ===== ========
At June 30, 2008, we held no individual non-investment grade structured
security that had an unrealized loss greater than $5.0 million.
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
June 30, 2008 (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...... $ 10.4 $ (.1) $ 9.4 $ (1.5) $ 19.8 $ (1.6)
States and political subdivisions. 245.6 (11.8) 93.4 (7.4) 339.0 (19.2)
Debt securities issued by
foreign governments............ 3.8 (.2) 3.5 (.6) 7.3 (.8)
Corporate securities.............. 7,741.0 (381.8) 3,737.5 (484.1) 11,478.5 (865.9)
Asset-backed securities........... 114.8 (9.8) 163.6 (58.8) 278.4 (68.6)
Collateralized debt obligations... 3.4 (1.6) 39.8 (11.8) 43.2 (13.4)
Commercial mortgage-backed
securities..................... 450.9 (13.2) 271.0 (68.5) 721.9 (81.7)
Mortgage pass-through securities.. 67.9 (.8) .9 - 68.8 (.8)
Collateralized mortgage
obligations.................... 1,881.6 (76.4) 859.4 (112.8) 2,741.0 (189.2)
--------- ------- -------- ------- --------- ---------
Total actively managed
fixed maturities............... $10,519.4 $(495.7) $5,178.5 $(745.5) $15,697.9 $(1,241.2)
========= ======= ======== ======= ========= =========
Equity securities................. $.4 $ - $ - $ - $.4 $ -
=== ===== ===== ===== === =====
Based on management's current assessment of investments with unrealized
losses at June 30, 2008, 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). We generally intend to
hold securities in unrealized loss positions until they recover. However, from
time to time, our intent on an individual security may change, based upon market
or other unforeseen developments. In such instances, we sell securities in the
ordinary course of managing our portfolio to meet diversification, credit
quality, yield, duration and liquidity requirements. If a loss is recognized
from a sale subsequent to a balance sheet date due to these unexpected
developments, the loss is recognized in the period in which the intent to hold
the securities to recovery no longer exists.
Structured Securities
At June 30, 2008, fixed maturity investments included $4.8 billion of
structured securities (or 24 percent of all fixed maturity 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 structured securities may occur more frequently, often
monthly. In many instances, we are subject to the risk that the amount and
timing of principal and interest payments may vary from expectations. For
example, prepayments may occur at the option of the issuer and prepayment rates
are influenced by a number of factors that cannot be predicted with certainty,
including: the relative sensitivity of the underlying assets backing the
security to changes in interest rates; a variety of economic, geographic and
other factors; and various security-specific structural considerations (for
example, the repayment priority of a given security in a securitization
structure).
In general, the rate of prepayments on structured securities increases when
prevailing interest rates decline significantly in absolute terms and also
relative to the interest rates on the underlying assets. The yields recognized
on structured securities purchased at a discount to par will increase (relative
to the stated rate) when the underlying assets prepay faster than expected.
81
CONSECO, INC. AND SUBSIDIARIES
-------------------
The yields recognized on structured securities purchased at a premium will
decrease (relative to the stated rate) when the underlying assets 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. When this occurs, the average
maturity and duration of the structured securities increase, which decreases the
yield on structured securities purchased at a discount because the discount is
realized as income at a slower rate, and it increases the yield on those
purchased at a premium because of a decrease in the annual amortization of the
premium.
For structured securities included in actively managed fixed maturities
that were purchased at a discount or premium, we recognize investment income
using an effective yield based on anticipated future prepayments and the
estimated final maturity of the securities. Actual prepayment experience is
periodically reviewed and effective yields are recalculated when differences
arise between the prepayments originally anticipated and the actual prepayments
received and currently anticipated. For credit sensitive mortgage-backed and
asset-backed securities, and for securities that can be prepaid or settled in a
way that we would not recover substantially all of our investment, the effective
yield is recalculated on a prospective basis. Under this method, the amortized
cost basis in the security is not immediately adjusted and a new yield is
applied prospectively. For all other structured and asset-backed securities, the
effective yield is recalculated when changes in assumptions are made, and
reflected in our income on a retrospective basis. Under this method, the
amortized cost basis of the investment in the securities is adjusted to the
amount that would have existed had the new effective yield been applied since
the acquisition of the securities. Such adjustments were not significant in the
first six months of 2008.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral, at June 30, 2008 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 33.0 $ 23.0 $ 22.3
4 percent - 5 percent............................................................... 487.7 473.3 461.0
5 percent - 6 percent............................................................... 4,282.3 4,112.1 3,834.7
6 percent - 7 percent............................................................... 490.9 487.1 441.4
7 percent - 8 percent............................................................... 93.9 91.8 77.2
8 percent and above................................................................. 8.2 8.6 8.7
-------- -------- --------
Total structured securities.................................................. $5,396.0 $5,195.9 $4,845.3
======== ======== ========
The amortized cost and estimated fair value of structured securities at
June 30, 2008, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
------------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- --------- ------ ----------
Pass-throughs, sequential and equivalent securities....................... $2,003.4 $1,940.6 10%
Planned amortization class, target amortization class and
accretion-directed bonds............................................... 1,791.3 1,667.7 8
Commercial mortgage-backed securities..................................... 917.8 836.1 4
Asset-backed securities................................................... 402.8 335.0 2
Collateralized debt obligations........................................... 56.7 43.3 -
Other..................................................................... 23.9 22.6 -
-------- -------- --
Total structured securities........................................ $5,195.9 $4,845.3 24%
======== ======== ==
Pass-throughs, sequentials and equivalent securities have unique prepayment
variability characteristics. Pass-through securities typically return principal
to the holders based on cash payments from the underlying mortgage obligations.
Sequential securities 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
82
CONSECO, INC. AND SUBSIDIARIES
-------------------
support or companion classes insulating the timing of receipt of cash flows from
the consequences of both faster prepayments (average life shortening) and slower
prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are secured by commercial
real estate mortgages, generally income producing properties that are managed
for profit. Property types include multi-family dwellings including apartments,
retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and
office buildings. 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 Loans
Our investment portfolio includes structured securities collateralized by
sub prime residential loans with a market value of $84.6 million and a book
value of $102.5 million at June 30, 2008. These securities represent less than
..4 percent of our consolidated investment portfolio. Of these securities, $29.1
million (35 percent) were rated AAA, $33.3 million (39 percent) were rated AA
and $22.2 million (26 percent) were rated A. 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 loans extended over
several years, primarily from 2003 to 2007. At June 30, 2008, we held no sub
prime securities collateralized by residential loans extended in 2006 and we
held $7.0 million extended in 2007.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS IN VARIABLE INTEREST ENTITY
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. Repayment of the principal balance of the investment borrowings of Fall
Creek begin in 2012 based on available cash flows from the assets and such
borrowings mature in 2017. At June 30, 2008 and December 31, 2007, the carrying
value of our investment in Fall Creek was $51.9 million and $47.0 million,
respectively. The following tables provide supplemental information about the
assets, liabilities, revenues and expenses of Fall Creek which have been
consolidated in accordance with FIN 46R, after giving effect to the elimination
of our investment in Fall Creek and investment management fees earned by a
subsidiary of the Company (dollars in millions):
June 30, December 31,
2008 2007
---- ----
Assets:
Actively managed fixed maturities.................................................. $365.3 $465.9
Cash and cash equivalents - restricted............................................. 12.7 16.1
Accrued investment income.......................................................... 2.5 5.1
Other assets....................................................................... 10.2 6.9
------ ------
Total assets................................................................... $390.7 $494.0
====== ======
Liabilities:
Other liabilities.................................................................. $ 13.1 $ 12.2
Investment borrowings due to others................................................ 359.2 447.2
Investment borrowings due to the Company........................................... 47.0 47.0
------ ------
Total liabilities.............................................................. 419.3 506.4
------ ------
Equity (deficit):
Capital provided by the Company.................................................... 6.3 1.6
Capital provided by others......................................................... 4.1 4.1
Accumulated other comprehensive loss............................................... (27.0) (25.0)
Retained earnings (deficit)........................................................ (12.0) 6.9
------ ------
Total equity (deficit)......................................................... (28.6) (12.4)
------ ------
Total liabilities and equity (deficit)......................................... $390.7 $494.0
====== ======
84
CONSECO, INC. AND SUBSIDIARIES
-------------------
Three months ended Six months ended
June 30, June 30,
-------------------- ------------------
2008 2007 2008 2007
---- ---- ---- ----
Revenues:
Net investment income - deposit accounts........... $ 5.1 $9.1 $ 13.0 $18.0
Fee revenue and other income....................... .2 .2 .4 .2
----- ---- ------ -----
Total revenues................................. 5.3 9.3 13.4 18.2
----- ---- ------ -----
Expenses:
Interest expense................................... 3.5 6.8 10.0 13.2
Other operating expenses........................... .1 .2 .2 .3
----- ---- ------ -----
Total expenses................................. 3.6 7.0 10.2 13.5
----- ---- ------ -----
Income (loss) before net realized investment
losses and income taxes...................... 1.7 2.3 3.2 4.7
Net realized investment losses........................ (3.9) - (20.5) -
----- ---- ------ -----
Income (loss) before income taxes.............. $(2.2) $2.3 $(17.3) $ 4.7
===== ==== ====== =====
The investment borrowings of Fall Creek may become due and payable if
certain threshold ratios (based on the entity's leverage and the market value of
its assets) are not met for a specified period of time. During the first quarter
of 2008, such threshold ratio was not met and was amended. Subsequent to the
amendment, Fall Creek sold assets of $90 million (which resulted in net realized
investment losses of $11.2 million), and paid down investment borrowings of
$83.5 million in the first quarter of 2008. Pursuant to the amendment, we
committed to provide additional capital to Fall Creek for up to $25 million
(under defined circumstances), $5 million of which was contributed through June
30, 2008 (none of which was contributed in the second quarter of 2008). In the
first six months of 2008, we recognized $8.1 million of writedowns of
investments held by Fall Creek resulting from declines in fair values that we
concluded were other than temporary.
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, 2007. There have been no material changes in the first six months
of 2008 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, 2007, which is described in
our Annual Report on Form 10-K, Item 9A, the Chief Executive Officer and Chief
Financial Officer concluded that, as of June 30, 2008, Conseco's disclosure
controls and procedures were not effective.
85
CONSECO, INC. AND SUBSIDIARIES
-------------------
As disclosed in our 2007 Annual Report on Form 10-K, we did not maintain
effective controls over the accounting and disclosure of insurance policy
benefits, amortization expense, the liabilities for insurance products and the
value of policies inforce at the Effective Date. Specifically, controls 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
were not effective. These control deficiencies resulted in the misstatement of
our insurance policy benefits, amortization expense, the liabilities for
insurance products and the value of policies inforce at the Effective Date and
related disclosures in the consolidated financial statements, and in the
restatement of our consolidated financial statements for 2006 and 2005, each of
the quarters of 2006 and the first three quarters of 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 our annual or interim financial
statements would not be prevented or detected on a timely basis.
Conseco has devoted significant efforts and resources towards remediation
of the material weakness relating to the actuarial reporting process.
Nonetheless, the material weakness continued to exist as of June 30, 2008.
Conseco's management continues to assign the highest priority to Conseco's
remediation efforts, with the goal of remediating the material weakness by the
end of 2008. However, due to the nature of the remediation process and the need
to allow adequate time after implementation to evaluate and test the
effectiveness of the revised controls, no assurance can be given as to the
timing of achievement of remediation. Conseco recognizes that further
improvement in its internal control over the actuarial reporting process is
essential. Over time, Conseco intends to reduce its reliance on manual controls
and procedures. As part of its remediation efforts, Conseco intends to develop
improved systems and processes which will allow it to rely on front-end
preventative controls which will be more sustainable over the long term. Conseco
recognizes that further investment is needed to improve the actuarial reporting
systems and processes and is committed to making the investments for these
improvements.
Changes to Internal Control Over Financial Reporting. There were no changes
in the Company's internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) during the six months ended
June 30, 2008, that have materially affected, or are reasonably likely to
materially affect, Conseco's internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Information required for Part II, Item 1 is incorporated by reference to
the discussion under the heading "Litigation and Other Legal Proceedings" in the
footnotes to our consolidated financial statements included in Part I, Item 1 of
this Form 10-Q.
ITEM 1A. RISK FACTORS.
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors could
have a material adverse effect on the business, financial condition or results
of operations of Conseco. Refer to "Risk Factors" in Conseco's Annual Report on
Form 10-K for the year ended December 31, 2007, for further discussion of such
risk factors. There have been no material changes from such previously disclosed
risk factors, except as set forth below:
Future issuances or repurchases of our equity, or transfers of our equity by
third parties, may impair our future ability to use a substantial amount of our
existing net operating loss carryforwards.
As of June 30, 2008, we had approximately $5.0 billion of federal tax net
operating loss carryforwards and $.8 billion of capital loss carryforwards,
resulting in a gross deferred tax asset of approximately $2.0 billion, expiring
in years 2008 through 2028. The timing and manner in which Conseco will be able
to utilize some of its net operating loss carryforwards is limited by Section
382 of the Internal Revenue Code of 1986, as amended. Section 382 imposes
limitations on a corporation's ability to use its net operating loss
carryforwards when it undergoes an "ownership change." Because Conseco underwent
an ownership change as the result of its reorganization, the Section 382
limitation applies to the Company. Losses that are subject to the current
Section 382 limitation may only be utilized by the Company up to
86
CONSECO, INC. AND SUBSIDIARIES
-------------------
approximately $142 million per year, with any unused amounts carried forward to
the following year. Absent an additional ownership change, our Section 382
limitation for 2008 will be approximately $559 million (including $417 million
of unused amounts carried forward from prior years).
Future transactions and the timing of such transactions could cause an
additional ownership change for Section 382 income tax purposes. Such
transactions may include, but are not limited to, additional repurchases or
issuances of common stock (including upon conversion of our outstanding 3.50%
convertible debentures), or acquisitions or sales of shares of Conseco stock by
certain holders of our shares, including persons who have held, currently hold
or may accumulate in the future five percent or more of our outstanding common
stock for their own account. Many of these transactions are beyond our control.
If an additional ownership change were to occur for purposes of Section 382, we
would be required to calculate a new annual restriction (which would supersede
the current $142 million annual limit) on the use of our net operating loss
carryforwards to offset future taxable income, but we would be able to continue
to carry forward unused amounts from prior years. The new annual restriction
would be calculated based upon the value of Conseco's equity at the time of such
ownership change, multiplied by a federal long-term tax exempt rate (currently
approximately 4.7 percent), and the new annual restriction could effectively
eliminate our ability to use a substantial portion of our net operating loss
carryforwards to offset future taxable income. We regularly monitor ownership
change (as calculated for purposes of Section 382) and, as of June 30, 2008, we
were below the 50 percent ownership change level that would trigger further
impairment of our ability to utilize our net operating loss carryforwards. See
the "Income Taxes" footnote to our financial statements contained herein for
additional information regarding our tax loss carryforwards and other tax
matters.
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(b)
------ ---------- --------- ----------------- ---------------------------
(dollars in millions)
April 1 through
April 30.......... - $ - - $262.8
May 1 through
May 31............ 1,472 11.67 - 262.8
June 1 through
June 30........... 1,541 9.91 - 262.8
----- -----
Total................. 3,013 10.77 - 262.8
===== =====
<FN>
- ------------
(a) The Company purchased 1,472 and 1,541 shares of its common stock in May and
June 2008, respectively, 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.
(b) On December 21, 2006, the Company announced a common share repurchase
program of up to $150 million. On May 8, 2007, the Company announced that
the maximum amount that was authorized under the common share repurchase
program had been increased to $350 million.
</FN>
87
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
At the Company's annual meeting on May 21, 2008, the shareholders
re-elected ten directors to serve terms expiring at next year's annual meeting.
The results of the voting were as follows (there were no broker non-votes):
For Withheld
--- --------
Donna A. James................................ 152,018,734 19,806,173
Debra J. Perry................................ 139,037,009 32,787,898
C. James Prieur............................... 151,949,567 19,875,340
Philip R. Roberts............................. 139,055,381 32,769,526
Michael T. Tokarz............................. 152,014,923 19,809,984
R. Glenn Hilliard............................. 151,665,623 20,159,284
Neal C. Schneider............................. 139,053,879 32,771,028
Michael S. Shannon............................ 152,018,890 19,806,017
John G. Turner................................ 139,075,600 32,749,307
Doreen A. Wright.............................. 139,054,927 32,769,980
Roger Keith Long.............................. 155,300 0
At the annual meeting, the shareholders also approved the following
proposals:
For Against Abstentions
--- ------- -----------
To approve the amendment to the
Company's certificate of incorporation
to eliminate the plurality voting standard
in uncontested director elections.......... 169,793,348 1,899,220 132,339
To approve the amendment to the
Company's certificate of incorporation
to declassify the board of directors....... 169,255,709 2,440,628 128,570
To ratify the appointment of
PricewaterhouseCoopers LLP
as the Company's independent
registered public accounting
firm for 2008.............................. 170,717,437 1,009,180 98,290
88
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 5. OTHER INFORMATION.
None.
ITEM 6. EXHIBITS.
3.1 Amended and Restated Certificate of Incorporation of Conseco, Inc.
10.36 Amended and Restated Employment Agreement dated as of May 27, 2008
between Conseco Services, LLC and Steven M. Stecher.
10.37 Form A Statement Regarding the Acquisition of Control of Conseco
Senior Health Insurance Company, including the Transfer Agreement
dated as of August 11, 2008 by and among Conseco, Inc., CDOC, Inc.
and Senior Health Care Transition Trust incorporated by reference
to Exhibit 10.37 of our Current Report on Form 8-K filed August
11, 2008.
10.38 Employment Agreement dated as of June 11, 2008 between Conseco
Services, LLC and Matthew J. Zimpfer.
12.1 Computation of Ratio of Earnings to Fixed Charges and Preferred
Dividends.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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CONSECO, INC. AND SUBSIDIARIES
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: August 13, 2008 By: /s/ Edward J. Bonach
--------------------
Edward J. Bonach
Executive Vice President and Chief
Financial Officer (authorized officer
and principal financial officer)
90