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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
[ X ] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 2008 or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
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Commission file number: 001-31792
Conseco, Inc.
Delaware No. 75-3108137
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State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
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Address of principal executive offices Telephone
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of Each Exchange on which Registered
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Common Stock, par value $0.01 per New York Stock Exchange
share
Rights to purchase Series A Junior New York Stock Exchange
Participating Preferred Stock
Securities registered pursuant to Section 12(g) of the Act:
3.50% Convertible Debentures due September 30, 2035
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [ X ]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or 15(d) of the Act. Yes [ ] No [ X ]
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days: Yes [ X ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
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 ]
At June 30, 2008, the last business day of the Registrant's most recently
completed second fiscal quarter, the aggregate market value of the Registrant's
common equity held by nonaffiliates was approximately $1.8 billion.
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 March 6, 2009: 184,753,758
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's definitive
proxy statement for the 2009 annual meeting of shareholders are incorporated by
reference into Part III of this report.
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TABLE OF CONTENTS
Page
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PART I
Item 1. Business of Conseco......................................................... 3
Item 1A. Risk Factors................................................................ 21
Item 1B. Unresolved Staff Comments................................................... 35
Item 2. Properties.................................................................. 35
Item 3. Legal Proceedings........................................................... 35
Item 4. Submission of Matters to a Vote of Security Holders......................... 35
Executive Officers of the Registrant........................................ 36
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities................................... 37
Item 6. Selected Consolidated Financial Data........................................ 40
Item 7. Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations............................... 41
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................. 109
Item 8. Consolidated Financial Statements and Supplementary Data.................... 110
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................................ 193
Item 9A. Controls and Procedures..................................................... 193
Item 9B. Other Information........................................................... 195
PART III
Item 10. Directors, Executive Officers and Corporate Governance...................... 195
Item 11. Executive Compensation...................................................... 195
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters................................................. 195
Item 13. Certain Relationships and Related Transactions, and Director Independence... 195
Item 14. Principal Accountant Fees and Services...................................... 195
PART IV
Item 15. Exhibits and Financial Statement Schedules.................................. 196
2
PART I
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ITEM 1. BUSINESS OF CONSECO.
Conseco, Inc., a Delaware corporation ("CNO"), is the holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation (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, 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. As of December 31, 2008, we had shareholders' equity of $1.6 billion
and assets of $28.8 billion. For the year ended December 31, 2008, we had
revenues of $4.2 billion and a net loss of $1.1 billion. See our consolidated
financial statements and accompanying footnotes for additional financial
information about the Company and its segments.
We manage our business through the following: three primary operating
segments, Bankers Life, Colonial Penn and Conseco Insurance Group, which are
defined on the basis of product distribution, and corporate operations, which
consists of holding company activities and certain noninsurance company
businesses that are not part of our other segments. Prior to the fourth quarter
of 2008, we had a fourth segment comprised of other business in run-off. The
other business in run-off segment had included blocks of business that we no
longer market or underwrite and were managed separately from our other
businesses. Such segment had consisted of: (i) long-term care insurance sold in
prior years through independent agents; and (ii) major medical insurance. As a
result of the Transfer, as further discussed below, a substantial portion of the
long-term care business in the other business in run-off segment is presented as
discontinued operations in our consolidated financial statements. The remaining
business that was included in our former other business in run-off segment is
now reflected in our Conseco Insurance Group segment. Accordingly, we have
restated all prior year segment disclosures to conform to management's current
view of the Company's operating segments. Our segments are described below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company, 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 approximately 5,500
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 Health Care ("Coventry").
o Colonial Penn, which consists of the business of Colonial Penn Life
Insurance Company ("Colonial Penn"), markets primarily graded benefit
and simplified issue life insurance directly to customers through
television advertising, direct mail, the internet and telemarketing.
Colonial Penn markets its products under its own brand name.
o 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
approximately 400 independent marketing organizations ("IMOs") that
represent over 2,400 independent producing agents, including
approximately 575 from Performance Matters Associates, Inc. ("PMA"), a
wholly owned marketing company. This segment markets its products
under the "Conseco" and "Washington National" brand names. Conseco
Insurance Group includes primarily the business of Conseco Health
Insurance Company ("Conseco Health"), Conseco Life Insurance Company
("Conseco Life"), Conseco Insurance Company and Washington National
Insurance Company ("Washington National"). This segment also includes
blocks of long-term care and other health business of these companies
that we no longer market or underwrite.
TRANSFER OF SENIOR HEALTH INSURANCE COMPANY OF PENNSYLVANIA TO AN
INDEPENDENT TRUST
On November 12, 2008, Conseco and CDOC, Inc. ("CDOC"), a wholly owned
subsidiary of Conseco, completed the transfer (the "Transfer") of the stock of
Senior Health Insurance Company of Pennsylvania ("Senior Health", formerly known
as Conseco Senior Health Insurance Company prior to its name change in October
2008) to Senior Health Care Oversight
3
Trust, an independent trust (the "Independent Trust") for the exclusive benefit
of Senior Health's long-term care policyholders. Consummation of the transaction
was subject to the approval of the Pennsylvania Insurance Department.
In connection with the Transfer, the Company entered into a $125.0 million
Senior Note due November 12, 2013 (the "Senior Note"), payable to Senior Health.
The note has a five-year maturity date; a 6 percent interest rate; and requires
annual principal payments of $25.0 million. As a condition of the order from the
Pennsylvania Insurance Department approving the Transfer, Conseco agreed that it
would not pay cash dividends on its common stock while any portion of the $125.0
million note remained outstanding.
During 2008, Conseco recorded accounting charges totaling $1.0 billion
related to the Transfer, comprised of Senior Health's equity (as calculated in
accordance with generally accepted accounting principles), an additional
valuation allowance for deferred tax assets, the capital contribution to Senior
Health and the Independent Trust and transaction expenses.
OUR STRATEGIC DIRECTION AND 2009 PRIORITIES
It is our vision to be a premier provider of insurance products to
America's middle-income families and seniors. Our insurance companies help
protect them from financial adversity: Medicare supplement, long-term care,
cancer, heart/stroke and accident policies protect people against unplanned
expenses; annuities and life products help people plan for their financial
future. We believe our products meet the needs of our target markets.
We believe our middle market target is underserved by a majority of financial
service providers and that the aging population will create strong growth in
these target markets. Important trends impacting middle market consumers
include:
o Increased life expectancy.
o Discontinuance or reduction in employer-sponsored benefit programs.
o Rising healthcare costs.
o Projected gaps between the annual costs and revenues of
government-sponsored plans such as Social Security and Medicare.
We believe our multiple distribution channels provide broad reach across the
market since consumers can access our products through an agent (Bankers Life or
Conseco Insurance Group), without an agent (Colonial Penn), and at the worksite
(Conseco Insurance Group).
Our major goals for 2009 include:
o Managing capital and liquidity to maintain compliance with debt
covenants.
o Maintaining strong growth at Bankers Life.
o Continuing to improve the focus and profitability mix of sales at
Conseco Insurance Group.
o Improving earnings stability and reducing volatility.
o Completing the remediation project relating to our material weakness
in internal controls.
o Continuing to reduce our enterprise exposure to long-term care
business.
o Improving profitability of existing lines of business or disposing of
underperforming blocks of business.
4
OTHER INFORMATION
CNO is the successor to our Predecessor. We emerged from bankruptcy on the
Effective Date. Our Predecessor was organized in 1979 as an Indiana corporation
and commenced operations in 1982. Our executive offices are located at 11825 N.
Pennsylvania Street, Carmel, Indiana 46032, and our telephone number is (317)
817-6100. Our annual reports on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act are available
free of charge on our website at www.conseco.com as soon as reasonably
practicable after they are electronically filed with, or furnished to, the
Securities and Exchange Commission (the "SEC"). These filings are also available
on the SEC's website at www.sec.gov. In addition, the public may read and copy
any document we file at the SEC's Public Reference Room located at 100 F Street,
NE, Room 1580, Washington, D.C. 20549. The public may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
Copies of these filings are also available, without charge, from Conseco
Investor Relations, 11825 N. Pennsylvania Street, Carmel, IN 46032.
Our website also includes the charters of our Audit and Enterprise Risk
Committee, Executive Committee, Governance and Strategy Committee, Human
Resources and Compensation Committee and Investment Committee, as well as our
Corporate Governance Operating Principles and our Code of Business Conduct and
Ethics that applies to all officers, directors and employees. Copies of these
documents are available free of charge on our website at www.conseco.com or from
Conseco Investor Relations at the address shown above. Within the time period
specified by the SEC and the New York Stock Exchange, we will post on our
website any amendment to our Code of Business Conduct and Ethics and any waiver
applicable to our principal executive officer, principal financial officer or
principal accounting officer.
In June 2008, we filed with the New York Stock Exchange the Annual CEO
Certification regarding the Company's compliance with their Corporate Governance
listing standards as required by Section 303A.12(a) of the New York Stock
Exchange Listed Company Manual. In addition, we have filed as exhibits to this
2008 Form 10-K the applicable certifications of the Company's Chief Executive
Officer and Chief Financial Officer required under Section 302 of the
Sarbanes-Oxley Act of 2002 regarding the Company's public disclosures.
Data in Item 1 are provided as of or for the year ended December 31, 2008
(as the context implies), unless otherwise indicated.
MARKETING AND DISTRIBUTION
Insurance
Our insurance subsidiaries develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We sell these products through three primary distribution channels:
career agents, professional independent producers (some of whom sell one or more
of our product lines exclusively) and direct marketing. We had premium
collections of $4.5 billion, $4.0 billion and $4.0 billion in 2008, 2007 and
2006, respectively.
Our insurance subsidiaries collectively hold licenses to market our
insurance products in all fifty states, the District of Columbia, and certain
protectorates of the United States. Sales to residents of the following states
accounted for at least five percent of our 2008 collected premiums: Florida (7.4
percent), California (7.1 percent), Pennsylvania (6.3 percent) and Texas (5.9
percent).
We believe that most purchases of life insurance, accident and health
insurance and annuity products occur only after individuals are contacted and
solicited by an insurance agent. Accordingly, the success of our distribution
system is largely dependent on our ability to attract and retain experienced and
highly motivated agents. A description of our primary distribution channels is
as follows:
Career Agents. This agency force of approximately 5,500 agents and sales
managers working from 156 branch offices, establishes one-on-one contact with
potential policyholders and promotes strong personal relationships with existing
policyholders. The career agents sell primarily supplemental health and
long-term care insurance policies, life insurance and annuities. In 2008, this
distribution channel accounted for $3,320.5 million, or 73 percent, of our total
collected premiums. These agents sell Bankers Life and Casualty policies, as
well as Coventry's Medicare Part D and Medicare Advantage products, and
typically visit the prospective policyholder's home to conduct personalized
"kitchen-table" sales presentations.
5
After the sale of an insurance policy, the agent serves as a contact person for
policyholder questions, claims assistance and additional insurance needs.
Professional Independent Producers. Professional independent producers are
a diverse network of independent agents, insurance brokers and marketing
organizations. The general agency and insurance brokerage distribution system is
comprised of independent licensed agents doing business in all fifty states, the
District of Columbia, and certain protectorates of the United States. In 2008,
this distribution channel in our Conseco Insurance Group segment collected
$1,021.4 million, or 23 percent, of our total premiums.
Marketing organizations typically recruit agents for the Conseco Insurance
Group segment by advertising our products and commission structure through
direct mail advertising or through seminars for agents and brokers. These
organizations bear most of the costs incurred in marketing our products. We
compensate the marketing organizations by paying them a percentage of the
commissions earned on new sales generated by agents recruited by such
organizations. Certain of these marketing organizations are specialty
organizations that have a marketing expertise or a distribution system related
to a particular product or market, such as worksite and individual supplemental
health products. During 1999 and 2000, the Conseco Insurance Group segment
purchased three organizations that specialize in marketing and distributing
supplemental health products and combined them under the name PMA. In 2008, the
PMA distribution channel accounted for $233.4 million, or 5 percent, of our
total collected premiums.
Direct Marketing. This distribution channel is engaged primarily in the
sale of graded benefit life insurance policies through Colonial Penn. In 2008,
this channel accounted for $183.0 million, or 4 percent, of our total collected
premiums.
Products
The following table summarizes premium collections by major category and
segment for the years ended December 31, 2008, 2007 and 2006 (dollars in
millions):
Total premium collections
2008 2007 2006
---- ---- ----
Supplemental health:
Bankers Life............................................................ $1,887.0 $1,546.1 $1,308.3
Colonial Penn........................................................... 8.9 10.4 12.0
Conseco Insurance Group................................................. 621.8 633.4 655.8
-------- -------- --------
Total supplemental health............................................ 2,517.7 2,189.9 1,976.1
-------- -------- --------
Annuities:
Bankers Life............................................................ 1,224.1 885.5 997.5
Conseco Insurance Group................................................. 129.8 368.6 433.3
-------- -------- --------
Total annuities...................................................... 1,353.9 1,254.1 1,430.8
-------- -------- --------
Life:
Bankers Life............................................................ 209.4 200.0 184.2
Colonial Penn........................................................... 174.1 113.7 97.2
Conseco Insurance Group................................................. 269.8 287.3 314.6
-------- -------- --------
Total life........................................................... 653.3 601.0 596.0
-------- -------- --------
Total premium collections.................................................. $4,524.9 $4,045.0 $4,002.9
======== ======== ========
In addition, the long-term care business included in our discontinued
operations had collected premiums of $225.9 million, $269.1 million and $283.6
million in 2008, 2007 and 2006, respectively.
6
Our insurance companies collected premiums from the following products:
Supplemental Health
Supplemental Health Premium Collections (dollars in millions)
2008 2007 2006
---- ---- ----
Medicare supplement:
Bankers Life................................................................. $ 636.6 $ 636.1 $ 629.1
Colonial Penn................................................................ 8.1 9.4 10.9
Conseco Insurance Group...................................................... 203.8 225.9 244.2
-------- -------- --------
Total..................................................................... 848.5 871.4 884.2
-------- -------- --------
Long-term care:
Bankers Life ................................................................ 625.7 622.4 592.4
Conseco Insurance Group ..................................................... 33.7 36.7 39.4
-------- -------- --------
Total..................................................................... 659.4 659.1 631.8
-------- -------- --------
Prescription Drug Plan and Medicare Advantage products
included in Bankers Life..................................................... 614.0 277.8 76.7
-------- -------- --------
Specified disease products included in
Conseco Insurance Group...................................................... 374.6 359.2 357.7
-------- -------- --------
Other:
Bankers Life ................................................................ 10.7 9.8 10.1
Colonial Penn................................................................ .8 1.0 1.1
Conseco Insurance Group...................................................... 9.7 11.6 14.5
-------- -------- --------
Total..................................................................... 21.2 22.4 25.7
-------- -------- --------
Total supplemental health premium collections.................................... $2,517.7 $2,189.9 $1,976.1
======== ======== ========
The following describes our major supplemental health products:
Medicare Supplement. Medicare supplement collected premiums were $848.5
million during 2008 or 19 percent of our total collected premiums. Medicare is a
federal health insurance program for disabled persons and seniors (age 65 and
older). Part A of the program provides protection against the costs of
hospitalization and related hospital and skilled nursing facility care, subject
to an initial deductible, related coinsurance amounts and specified maximum
benefit levels. The deductible and coinsurance amounts are subject to change
each year by the federal government. Part B of Medicare covers doctor's bills
and a number of other medical costs not covered by Part A, subject to deductible
and coinsurance amounts for charges approved by Medicare. The deductible amount
is subject to change each year by the federal government.
Medicare supplement policies provide coverage for many of the hospital and
medical expenses which the Medicare program does not cover, such as deductibles,
coinsurance costs (in which the insured and Medicare share the costs of medical
expenses) and specified losses which exceed the federal program's maximum
benefits. Our Medicare supplement plans automatically adjust coverage to reflect
changes in Medicare benefits. In marketing these products, we currently
concentrate on individuals who have recently become eligible for Medicare by
reaching the age of 65. Approximately 55 percent of new sales of Medicare
supplement policies in 2008 were to individuals who had recently reached the age
of 65.
Both Bankers Life and Conseco Insurance Group sell Medicare supplement
insurance.
Long-Term Care. Long-term care collected premiums were $659.4 million
during 2008, or 15 percent of our total collected premiums. Long-term care
products provide coverage, within prescribed limits, for nursing homes, home
healthcare, or a combination of both. We sell the long-term care plans primarily
to retirees and, to a lesser degree, to older
7
self-employed individuals in the middle-income market.
Current nursing home care policies cover incurred charges up to a daily
fixed-dollar limit with an elimination period (which, similar to a deductible,
requires the insured to pay for a certain number of days of nursing home care
before the insurance coverage begins), subject to a maximum benefit. Home
healthcare policies cover incurred charges after a deductible or elimination
period and are subject to a weekly or monthly maximum dollar amount, and an
overall benefit maximum. Comprehensive policies cover both nursing home care and
home healthcare. We monitor the loss experience on our long-term care products
and, when necessary, apply for rate increases in the jurisdictions in which we
sell such products. Regulatory filings are made before we increase our premiums
on these products.
A portion of our long-term care business resides in the Conseco Insurance
Group segment. This business was sold through the independent producer
distribution channel and was largely underwritten by certain of our subsidiaries
prior to their acquisitions by our Predecessor in 1996 and 1997. The performance
of these blocks of business did not meet the expectations we had when the blocks
were acquired. As a result, we ceased selling new long-term care policies
through this distribution channel in 2003.
We continue to sell long-term care insurance through the Bankers Life
career agent distribution channel. This business is underwritten using stricter
underwriting and pricing standards than had previously been used on our acquired
blocks of long-term care business included in the Conseco Insurance Group
segment.
Prescription Drug Plan and Medicare Advantage. The Medicare Prescription
Drug, Improvement and Modernization Act of 2003 (the "MMA") provided for the
introduction of a prescription drug program under Medicare Part D. Persons
eligible for Medicare can receive their Part D coverage through a stand-alone
Prescription Drug Plan ("PDP"). In order to offer a PDP product to our current
and potential future policyholders without investment in management and
infrastructure, we entered into a national distribution agreement with Coventry
to use our career and independent agents to distribute Coventry's PDP product,
Advantra Rx. We receive a fee based on the premiums collected on plans sold
through our distribution channels. In addition, Conseco has a quota-share
reinsurance agreement with Coventry for Conseco enrollees that provides Conseco
with a specified percentage of net premiums and related profits subject to a
risk corridor. The Part D program was effective January 1, 2006. PDP collected
premiums were $71.6 million during 2008 or 2 percent of our total collected
premiums.
Conseco expanded its strategic alliance with Coventry by entering into
national distribution agreements under which our career agents began
distributing Coventry's Private-Fee-For-Service ("PFFS") plan, with coverage
beginning January 1, 2007. The PFFS product, Advantra Freedom, is a Medicare
Advantage plan designed to provide seniors with more choices and better coverage
at lower cost than original Medicare and Medicare Advantage plans offered
through HMOs. Under the agreement, we receive a fee based on the number of PFFS
plans sold through our distribution channels. In addition, Conseco has a
quota-share reinsurance agreement with Coventry for Conseco enrollees that
provides Conseco with a specified percentage of the net premiums and related
profits.
During 2007 and 2008, Conseco entered into three quota-share reinsurance
agreements with Coventry related to the PFFS business written by Coventry under
certain group policies. Conseco receives a specified percentage of the net
premiums and related profits associated with this business as long as the ceded
revenue margin is less than or equal to five percent. In order to reduce the
required statutory capital associated with the assumption of this business,
Conseco terminated two group policy quota-share agreements as of December 31,
2008 and will terminate the last agreement on June 30, 2009. Premiums assumed
through these reinsurance agreements totaled $313.5 million in 2008 (including
$185.3 million assumed through the agreement to be terminated on June 30, 2009).
The income before income taxes related to the assumed business was $.4 million
during the year ended December 31, 2008.
PFFS collected premiums were $542.4 million in 2008 or 12 percent of our
total collected premiums.
Specified Disease Products. Specified disease collected premiums were
$374.6 million during 2008, or 8 percent of our total collected premiums. These
policies generally provide fixed or limited benefits. Cancer insurance and
heart/stroke products are guaranteed renewable individual accident and health
insurance policies. Payments under cancer insurance policies are generally made
directly to, or at the direction of, the policyholder following diagnosis of, or
treatment for, a covered type of cancer. Heart/stroke policies provide for
payments directly to the policyholder for treatment of a covered heart disease,
heart attack or stroke. Accident products combine insurance for accidental death
with limited benefit disability income insurance. Hospital indemnity products
provide a fixed dollar amount per day of confinement in a hospital. The benefits
provided under the specified disease policies do not necessarily reflect the
actual cost incurred by the insured as a
8
result of the illness, or accident, and benefits are not reduced by any other
medical insurance payments made to or on behalf of the insured.
Approximately 79 percent of the total number of our specified disease
policies inforce was sold with return of premium or cash value riders. The
return of premium rider generally provides that, after a policy has been in
force for a specified number of years or upon the policyholder reaching a
specified age, we will pay to the policyholder, or in some cases, a beneficiary
under the policy, the aggregate amount of all premiums paid under the policy,
without interest, less the aggregate amount of all claims incurred under the
policy. For some policies, the return of premium rider does not have any claim
offset. 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.
Other Supplemental Health Products. Other supplemental health product
collected premiums were $21.2 million during 2008. This category includes
various other health products such as major medical health insurance, senior
hospital indemnity and disability income products which are sold in small
amounts or other products which are no longer actively marketed.
Annuities
Annuity premium collections (dollars in millions)
2008 2007 2006
---- ---- ----
Equity-indexed annuity:
Bankers Life............................................................. $ 522.8 $ 437.4 $ 276.5
Conseco Insurance Group.................................................. 123.7 344.6 378.5
-------- -------- --------
Total equity-indexed annuity premium collections...................... 646.5 782.0 655.0
-------- -------- --------
Other fixed annuity:
Bankers Life............................................................. 701.3 448.1 721.0
Conseco Insurance Group.................................................. 6.1 24.0 54.8
-------- -------- --------
Total fixed annuity premium collections............................... 707.4 472.1 775.8
-------- -------- --------
Total annuity premium collections........................................... $1,353.9 $1,254.1 $1,430.8
======== ======== ========
During 2008, we collected annuity premiums of $1,353.9 million or 30
percent of our total premiums collected. Annuity products include equity-indexed
annuity, traditional fixed rate annuity and single premium immediate annuity
products sold through both Bankers Life and Conseco Insurance Group. Annuities
offer a tax-deferred means of accumulating savings for retirement needs, and
provide a tax-efficient source of income in the payout period. Our major source
of income from fixed rate annuities is the spread between the investment income
earned on the underlying general account assets and the interest credited to
contractholders' accounts. For equity-indexed annuities, our major source of
income is the spread between the investment income earned on the underlying
general account assets and the cost of the index options purchased to provide
index-based credits to the contractholders' accounts.
Sales of many of our annuity products have been affected by the financial
strength ratings assigned to our insurance subsidiaries by independent rating
agencies. The current financial strength rating of our primary insurance
subsidiaries from A.M. Best Company ("A.M. Best") is "B" which was downgraded
from "B+" on March 4, 2009. During the second half of 2007, we changed the
pricing of specific products and we no longer emphasized the sale of certain
products sold by professional independent agents resulting in a decrease in
collected premiums, partially offset by the sales of several new products
distributed through new national partners. Career agents selling annuity
products in the Bankers Life segment are less sensitive in the near-term to A.M.
Best ratings, since these agents only sell our products.
We believe the sales of our equity-indexed products in Bankers Life were
favorably impacted in 2007 and the first half of 2008 due in part to general
stock market conditions which made these products attractive relative to fixed
annuities.
Premium collections from Bankers Life's fixed annuity products increased
sharply in the last half of 2008 due to volatility in the financial markets
which made these products more attractive to customers. The increase in
short-term interest rates in 2007 resulted in lower first-year fixed annuity
sales as certain other competing products, such as certificates
9
of deposits, had become attractive relative to fixed annuities.
The following describes the major annuity products:
Equity-Indexed Annuities. These products accounted for $646.5 million, or
14 percent, of our total premium collections during 2008. The account value (or
"accumulation value") of these annuities is credited in an amount that is based
on changes in a particular index during a specified period of time. Within each
contract issued, each equity-indexed annuity specifies:
o The index to be used;
o The time period during which the change in the index is measured, and
at the end of which, the change in the index is applied to the account
value. The time period of the contract ranges from 1 to 4 years.
o The method used to measure the change in the index.
o The measured change in the index may be multiplied by a "participation
rate" (percentage of change in the index) before the credit is
applied. Some policies guarantee the initial participation rate for
the life of the contract, and some vary the rate for each period.
o The measured change in the index may also be limited to a "cap" before
the credit is applied. Some policies guarantee the initial cap for the
life of the contract, and some vary the cap for each period.
o The measured change in the index may also be limited to the excess in
the measured change over a "margin" before the credit is applied. Some
policies guarantee the initial margin for the life of the contract,
and some vary the margin for each period.
These products have guaranteed minimum cash surrender values, regardless of
actual index performance and the resulting indexed-based interest credits
applied.
We generally buy call options and similar investments on the applicable
indices in an effort to hedge potential increases to policyholder benefits
resulting from increases in the indices to which the product's return is linked.
Fixed Rate Annuities. These products include fixed rate single-premium
deferred annuities ("SPDAs"), flexible premium deferred annuities ("FPDAs") and
single-premium immediate annuities ("SPIAs"). These products accounted for
$707.4 million, or 16 percent, of our total premium collections during 2008. Our
fixed rate SPDAs and FPDAs typically have an interest rate (the "crediting
rate") that is guaranteed by the Company for the first policy year, after which
we have the discretionary ability to change the crediting rate to any rate not
below a guaranteed minimum rate. The guaranteed rates on annuities written
recently range from 2.5 percent to 3.0 percent, and the rates, on all policies
inforce range from 2.5 percent to 6.0 percent. The initial crediting rate is
largely a function of:
o the interest rate we can earn on invested assets acquired with the new
annuity fund deposits;
o the costs related to marketing and maintaining the annuity products;
and
o the rates offered on similar products by our competitors.
For subsequent adjustments to crediting rates, we take into account current and
prospective yields on investments, annuity surrender assumptions, competitive
industry pricing and the crediting rate history for particular groups of annuity
policies with similar characteristics.
In 2008, a significant portion of our new annuity sales were "bonus
interest" products. The initial crediting rate on these products specifies a
bonus crediting rate of 3.0 percent of the annuity deposit for the first policy
year only. After the first year, the bonus interest portion of the initial
crediting rate is automatically discontinued, and the renewal crediting rate is
established. As of December 31, 2008, the average crediting rate, excluding
bonuses, on our outstanding traditional annuities was 3.6 percent.
10
Withdrawals from deferred annuities (including equity-indexed annuities)
are generally subject to a surrender charge of 3 percent to 19 percent in the
first year, declining to zero over a 4 to 16 year period, depending on issue age
and product. Surrender charges are set at levels intended to protect us from
loss on early terminations and to reduce the likelihood that policyholders will
terminate their policies during periods of increasing interest rates. This
practice is intended to lengthen the duration of policy liabilities and to
enable us to maintain profitability on such policies.
Penalty-free withdrawals from deferred annuities of up to 10 percent of
either premiums or account value are available in most plans after the first
year of the annuity's term.
Some deferred annuity products apply a market value adjustment during the
surrender charge period. This adjustment is determined by a formula specified in
the annuity contract, and may increase or decrease the cash surrender value
depending on changes in the amount and direction of market interest rates or
credited interest rates at the time of withdrawal. The resulting cash surrender
values will be at least equal to the guaranteed minimum values.
SPIAs accounted for $33.1 million, or .7 percent, of our total premiums
collected in 2008. SPIAs are designed to provide a series of periodic payments
for a fixed period of time or for life, according to the policyholder's choice
at the time of issuance. Once the payments begin, the amount, frequency and
length of time over which they are payable are fixed. SPIAs often are purchased
by persons at or near retirement age who desire a steady stream of payments over
a future period of years. The single premium is often the payout from a
terminated annuity contract. The implicit interest rate on SPIAs is based on
market conditions when the policy is issued. The implicit interest rate on our
outstanding SPIAs averaged 6.8 percent at December 31, 2008.
Life Insurance
Life insurance premium collections (dollars in millions)
2008 2007 2006
---- ---- ----
Interest-sensitive life products:
Bankers Life............................................................... $ 63.7 $ 63.4 $ 62.2
Colonial Penn.............................................................. .5 .5 .6
Conseco Insurance Group.................................................... 202.5 214.0 235.0
------ ------ ------
Total interest-sensitive life premium collections....................... 266.7 277.9 297.8
------ ------ ------
Traditional life:
Bankers Life............................................................... 145.7 136.6 122.0
Colonial Penn.............................................................. 173.6 113.2 96.6
Conseco Insurance Group.................................................... 67.3 73.3 79.6
------ ------ ------
Total traditional life premium collections.............................. 386.6 323.1 298.2
------ ------ ------
Total life insurance premium collections...................................... $653.3 $601.0 $596.0
====== ====== ======
Life products include traditional and interest-sensitive life insurance
products. These products are currently sold through Bankers Life, Conseco
Insurance Group and Colonial Penn. During 2008, we collected life insurance
premiums of $653.3 million, or 14 percent, of our total collected premiums.
Sales of life products are affected by the financial strength ratings assigned
to our insurance subsidiaries by independent rating agencies. See "Competition"
below.
Interest-Sensitive Life Products. These products include universal life and
other interest-sensitive life products that provide whole life insurance with
adjustable rates of return related to current interest rates. They accounted for
$266.7 million, or 5.9 percent, of our total collected premiums in 2008. These
products are marketed by professional independent producers and, to a lesser
extent, career agents (including professional independent producers and career
agents specializing in worksite sales). The principal differences between
universal life products and other interest-sensitive life products are policy
provisions affecting the amount and timing of premium payments. Universal life
policyholders may vary the frequency and size of their premium payments, and
policy benefits may also fluctuate according to such payments. Premium payments
under other interest-sensitive policies may not be varied by the policyholders.
Universal life products include equity-indexed universal life products. The
account value of these policies is credited with interest at a guaranteed rate,
plus additional interest credits based on changes in a particular stock index
during a specified time period.
11
Traditional Life. These products accounted for $386.6 million, or 8.5
percent, of our total collected premiums in 2008. Traditional life policies,
including whole life, graded benefit life, term life and single premium whole
life products, are marketed through professional independent producers, career
agents and direct response marketing. Under whole life policies, the
policyholder generally pays a level premium over an agreed period or the
policyholder's lifetime. The annual premium in a whole life policy is generally
higher than the premium for comparable term insurance coverage in the early
years of the policy's life, but is generally lower than the premium for
comparable term insurance coverage in the later years of the policy's life.
These policies, which we continue to market on a limited basis, combine
insurance protection with a savings component that gradually increases in amount
over the life of the policy. The policyholder may borrow against the savings
component generally at a rate of interest lower than that available from other
lending sources. The policyholder may also choose to surrender the policy and
receive the accumulated cash value rather than continuing the insurance
protection. Term life products offer pure insurance protection for life with a
guaranteed level premium for a specified period of time -- typically 10, 15, 20
or 30 years. In some instances, these products offer an option to return the
premium at the end of the guaranteed period.
Traditional life products also include graded benefit life insurance
products. Graded benefit life products accounted for $168.5 million, or 3.7
percent, of our total collected premiums in 2008. Graded benefit life insurance
products are offered on an individual basis primarily to persons age 50 to 80,
principally in face amounts of $350 to $30,000, without medical examination or
evidence of insurability. Premiums are paid as frequently as monthly. Benefits
paid are less than the face amount of the policy during the first two years,
except in cases of accidental death. Our Colonial Penn segment markets graded
benefit life policies under its own brand name using direct response marketing
techniques. New policyholder leads are generated primarily from television,
print advertisements and direct response mailings.
Traditional life products also include single premium whole life insurance.
This product requires one initial lump sum payment in return for providing life
insurance protection for the insured's entire lifetime. Single premium whole
life products accounted for $32.1 million, or .7 percent, of our total collected
premiums in 2008.
INVESTMENTS
40|86 Advisors, Inc. ("40|86 Advisors"), a registered investment adviser
and wholly-owned subsidiary of Conseco, Inc., manages the investment portfolios
of our insurance subsidiaries. 40|86 Advisors had approximately $18.9 billion of
assets (at fair value) under management at December 31, 2008, of which $18.1
billion were assets of our subsidiaries and $.8 billion were assets managed for
third parties. Our general account investment strategies are to:
o maintain a largely investment-grade, diversified fixed-income
portfolio;
o maximize the spread between the investment income we earn and the
yields we pay on investment products within acceptable levels of risk;
o provide adequate liquidity;
o construct our investment portfolio considering expected liability
durations, cash flows and other requirements; and
o maximize total return through active investment management.
During 2008, 2007 and 2006, we recognized net realized investment losses of
$262.4 million, $158.0 million and $46.6 million, respectively, excluding any
such amounts included in discontinued operations. During 2008, net realized
investment losses were comprised of: (i) $100.1 million of net losses from the
sales of investments (primarily fixed maturities); and (ii) $162.3 million of
writedowns of investments for other than temporary declines in fair value. A
substantial portion of the net investment losses realized on sales of
investments in 2007 were recognized on the sale of securities collateralized by
sub prime residential mortgage loans. We decided to sell these securities given
our concerns regarding the effect future adverse developments could have on the
value of these securities. For further information on our sub prime holdings,
refer to the caption entitled "Other Investments" in the "Investments" section
of Management's Discussion and Analysis of Financial Condition and Results of
Operations.
Investment activities are an integral part of our business because
investment income is a significant component of our revenues. The profitability
of many of our insurance products is significantly affected by spreads between
interest yields on investments and rates credited on insurance liabilities.
Although substantially all credited rates on SPDAs, FPDAs and
12
interest sensitive life products may be changed annually (subject to minimum
guaranteed rates), changes in crediting rates may not be sufficient to maintain
targeted investment spreads in all economic and market environments. In
addition, competition, minimum guaranteed rates and other factors, including the
impact of surrenders and withdrawals, may limit our ability to adjust or to
maintain crediting rates at levels necessary to avoid narrowing of spreads under
certain market conditions. As of December 31, 2008, the average yield, computed
on the cost basis of our actively managed fixed maturity portfolio, was 6.0
percent, and the average interest rate credited or accruing to our total
insurance liabilities was 4.5 percent.
We manage the equity-based risk component of our equity-indexed annuity
products by:
o purchasing equity-based options with similar payoff characteristics;
and
o adjusting the participation rate to reflect the change in the cost of
such options (such cost varies based on market conditions).
The price of the options we purchase to manage the equity-based risk
component of our equity-indexed annuities varies based on market conditions. The
price of the options generally increases with increases in the volatility of the
applicable indices, which may either reduce the profitability of the
equity-indexed products or cause us to lower participation rates. Accordingly,
volatility of the indices adds uncertainty regarding the profitability of our
equity-indexed products. We attempt to mitigate this risk by adjusting the
participation rates to reflect the change in the cost of such options.
We seek to manage the interest rate risk inherent in our invested assets
with the interest rate characteristics of our insurance liabilities. We attempt
to minimize this exposure by managing the durations and cash flows of our fixed
maturity investments and insurance liabilities. For example, duration measures
the expected change in the fair value of assets and liabilities for a given
change in interest rates. If interest rates increase by 1 percent, the fair
value of a fixed maturity security with a duration of 5 years is typically
expected to decrease in value by approximately 5 percent. When the estimated
durations of assets and liabilities are similar, a change in the value of assets
should be largely offset by a change in the value of liabilities.
We calculate asset and liability durations using our estimates of future
asset and liability cash flows. At December 31, 2008, the duration of our fixed
maturity investments (as modified to reflect prepayments and potential calls)
was approximately 7.6 years and the duration of our insurance liabilities was
approximately 7.8 years. The difference between these durations indicates that
our investment portfolio had a shorter duration and, consequently, was less
sensitive to interest rate fluctuations than that of our liabilities at that
date. We generally seek to minimize the gap between asset and liability
durations.
For information regarding the composition and diversification of the
investment portfolio of our subsidiaries, see "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations --
Investments."
COMPETITION
The markets in which we operate are highly competitive. Our current ratings
have had an adverse impact on our ability to compete in certain markets.
Compared to Conseco, many companies in the financial services industry are
larger, have greater capital, technological and marketing resources, have better
access to capital and other sources of liquidity at a lower cost, offer broader
and more diversified product lines and have larger staffs. An expanding number
of banks, securities brokerage firms and other financial intermediaries also
market insurance products or offer competing products, such as mutual fund
products, traditional bank investments and other investment and retirement
funding alternatives. We also compete with many of these companies and others in
providing services for fees. In most areas, competition is based on a number of
factors, including pricing, service provided to distributors and policyholders
and ratings. Conseco's subsidiaries must also compete to attract and retain the
allegiance of agents, insurance brokers and marketing companies.
In the individual health insurance business, companies compete primarily on
the bases of marketing, service and price. Pursuant to federal regulations, the
Medicare supplement products offered by all companies have standardized policy
features. This increases the comparability of such policies and intensifies
competition based on other factors. See "Insurance Underwriting" and
"Governmental Regulation" for additional information. In addition to competing
with the products of other insurance companies, commercial banks, thrifts,
mutual funds and broker dealers, our insurance products compete with health
maintenance organizations, preferred provider organizations and other health
care-related institutions which provide medical benefits based on contractual
agreements.
13
We believe that the volatility in the financial markets in the second half
of 2008, its impact on the capital position of many competitors, and subsequent
actions by regulators and rating agencies have altered the competitive
environment. In particular, these factors have emphasized financial strength as
a significant differentiator from the perspective of consumers. The effects of
the current market conditions may also lead to consolidation in the insurance
industry. Although we can not predict the ultimate impact of these conditions,
we believe that the strongest companies will have a competitive advantage as a
result of the current circumstances.
An important competitive factor for life insurance companies is the ratings
they receive from nationally recognized rating organizations. Agents, insurance
brokers and marketing companies who market our products and prospective
purchasers of our products use the ratings of our insurance subsidiaries as one
factor in determining which insurer's products to market or purchase. Ratings
have the most impact on our annuity, interest-sensitive life insurance and
long-term care products. Insurance financial strength ratings are opinions
regarding an insurance company's financial capacity to meet the obligations of
its insurance policies in accordance with their terms. They are not directed
toward the protection of investors, and such ratings are not recommendations to
buy, sell or hold securities.
On March 4, 2009, A.M. Best downgraded the financial strength ratings of
our primary insurance subsidiaries to "B" from "B+" and such ratings have been
placed under review with negative implications. The "B" rating is assigned to
companies that have a fair ability, in A.M. Best's opinion, to meet their
current obligations to policyholders, but are financially vulnerable to adverse
changes in underwriting and economic conditions. A.M. Best ratings for the
industry currently range from "A++ (Superior)" to "F (In Liquidation)" and some
companies are not rated. An "A++" rating indicates a superior ability to meet
ongoing obligations to policyholders. A.M. Best has sixteen possible ratings.
There are six ratings above our "B" rating and nine ratings that are below our
rating.
On February 26, 2009, Standard & Poor's Ratings Services ("S&P") downgraded
the financial strength ratings of our primary insurance subsidiaries to "BB-"
from "BB+" and the outlook remained negative for our primary insurance
subsidiaries. On March 2, 2009, S&P placed the financial strength ratings of our
primary insurance subsidiaries on credit watch with negative implications. A
rating on credit watch with negative implications highlights the potential
direction of a rating focusing on identifiable events and short-term trends that
cause ratings to be placed under special surveillance by S&P. A "negative"
designation means that a rating may be lowered. 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. S&P has twenty-one possible ratings. There are twelve
ratings above our "BB-" rating and eight ratings that are below our rating.
On March 3, 2009, Moody's Investors Service ("Moody's") downgraded the
financial strength ratings of our primary insurance subsidiaries to "Ba2" from
"Ba1" and the outlook remained negative for our primary insurance subsidiaries.
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 "Ba2" offers questionable financial
security and, often, the ability of these companies to meet policyholders'
obligations may be very moderate and thereby not well safeguarded in the future.
Moody's has twenty-one possible ratings. There are eleven ratings above our
"Ba2" rating and nine ratings that are below our rating.
A.M. Best, S&P and Moody's review our ratings from time to time. We cannot
provide any assurance that the ratings of our insurance subsidiaries will remain
at their current levels or predict the impact of any future rating changes on
our business.
INSURANCE UNDERWRITING
Under regulations promulgated by the National Association of Insurance
Commissioners ("NAIC") (an association of state regulators and their staffs) and
adopted as a result of the Omnibus Budget Reconciliation Act of 1990, we are
prohibited from underwriting our Medicare supplement policies for certain
first-time purchasers. If a person applies for insurance within six months after
becoming eligible by reason of age, or disability in certain limited
circumstances, the application may not be rejected due to medical conditions.
Some states prohibit underwriting of all Medicare supplement policies. For other
prospective Medicare supplement policyholders, such as senior citizens who are
transferring to our products, the underwriting procedures are relatively
limited, except for policies providing prescription drug coverage.
14
Before issuing long-term care products, we generally apply detailed
underwriting procedures to assess and quantify the insurance risks. We require
medical examinations of applicants (including blood and urine tests, where
permitted) for certain health insurance products and for life insurance products
which exceed prescribed policy amounts. These requirements vary according to the
applicant's age and may vary by type of policy or product. We also rely on
medical records and the potential policyholder's written application. In recent
years, there have been significant regulatory changes with respect to
underwriting certain types of health insurance. An increasing number of states
prohibit underwriting and/or charging higher premiums for substandard risks. We
monitor changes in state regulation that affect our products, and consider these
regulatory developments in determining the products we market and where we
market them.
Our specified disease policies are individually underwritten using a
simplified issue application. Based on an applicant's responses on the
application, the underwriter either: (i) approves the policy as applied for;
(ii) approves the policy with reduced benefits; or (iii) rejects the
application.
Most of our life insurance policies are underwritten individually, although
standardized underwriting procedures have been adopted for certain low
face-amount life insurance coverages. After initial processing, insurance
underwriters obtain the information needed to make an underwriting decision
(such as medical examinations, doctors' statements and special medical tests).
After collecting and reviewing the information, the underwriter either: (i)
approves the policy as applied for; (ii) approves the policy with an extra
premium charge because of unfavorable factors; or (iii) rejects the application.
We underwrite group insurance policies based on the characteristics of the
group and its past claim experience. Graded benefit life insurance policies are
issued without medical examination or evidence of insurability. There is minimal
underwriting on annuities.
LIABILITIES FOR INSURANCE PRODUCTS
At December 31, 2008, the total balance of our liabilities for insurance
products was $24.2 billion. These liabilities are generally payable over an
extended period of time. The profitability of our insurance products depends on
pricing and other factors. Differences between our expectations when we sold
these products and our actual experience could result in future losses.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and standard actuarial tables, of
mortality, morbidity, lapse rates, investment experience and expense levels. For
all of our insurance products, we establish an active life reserve, a liability
for due and unpaid claims, claims in the course of settlement and incurred but
not reported claims. In addition, for our supplemental health insurance
business, we establish a reserve for the present value of amounts not yet due on
incurred claims. Many factors can affect these reserves and liabilities, such as
economic and social conditions, inflation, hospital and pharmaceutical costs,
changes in doctrines of legal liability and extra-contractual damage awards.
Therefore, our reserves and liabilities are necessarily based on extensive
estimates, assumptions and historical experience. Establishing reserves is an
uncertain process, and it is possible that actual claims will materially exceed
our reserves and have a material adverse effect on our results of operations and
financial condition. Our financial results depend significantly upon the extent
to which our actual claims experience is consistent with the assumptions we used
in determining our reserves and pricing our products. If our assumptions with
respect to future claims are incorrect, or our reserves are insufficient to
cover our actual losses and expenses, we would be required to increase our
liabilities, which would negatively affect our operating results.
REINSURANCE
Consistent with the general practice of the life insurance industry, our
subsidiaries enter into both facultative and treaty agreements of indemnity
reinsurance with other insurance companies in order to reinsure portions of the
coverage provided by our insurance products. Indemnity reinsurance agreements
are intended to limit a life insurer's maximum loss on a large or unusually
hazardous risk or to diversify its risk. Indemnity reinsurance does not
discharge the original insurer's primary liability to the insured. Our reinsured
business is ceded to numerous reinsurers. Based on our periodic review of their
financial statements, insurance industry reports and reports filed with state
insurance departments, we believe the assuming companies are able to honor all
contractual commitments.
15
As of December 31, 2008, the policy risk retention limit of our insurance
subsidiaries was generally $.8 million or less. Reinsurance ceded by Conseco
represented 21 percent of gross combined life insurance inforce and reinsurance
assumed represented 2.1 percent of net combined life insurance inforce. Our
principal reinsurers at December 31, 2008 were as follows (dollars in millions):
Ceded life A.M. Best
Name of Reinsurer insurance inforce rating
- ----------------- ----------------- ---------
Swiss Re Life and Health America Inc.................................... $ 3,682.3 A
Security Life of Denver Insurance Company............................... 3,083.9 A+
Reassure America Life Insurance Company ("REALIC") (a).................. 1,482.1 A
RGA Reinsurance Company................................................. 946.9 A+
Munich American Reassurance Company..................................... 914.4 A+
Lincoln National Life Insurance Company................................. 676.1 A+
Scor Global Life Re Insurance Co of Texas............................... 562.9 A-
Hannover Life Reassurance Company....................................... 416.1 A
General Re Life Corporation............................................. 408.4 A++
All others (b).......................................................... 1,632.8
---------
$13,805.9
=========
<FN>
- --------------------
(a) In addition to the life insurance business summarized above, REALIC
has assumed certain annuity business from our insurance subsidiaries
through a coinsurance agreement. Such business had total insurance
policy liabilities of $2.3 billion at December 31, 2008.
(b) No other single reinsurer assumed greater than 3 percent of the total
ceded business inforce.
</FN>
EMPLOYEES
At December 31, 2008, we had approximately 3,700 full time employees,
including 1,150 employees supporting our Bankers Life segment, 350 employees
supporting our Colonial Penn segment and 2,200 employees supporting our Conseco
Insurance Group segment and corporate segment. None of our employees are covered
by a collective bargaining agreement. We believe that we have good relations
with our employees.
GOVERNMENTAL REGULATION
Our insurance businesses are subject to extensive regulation and
supervision by the insurance regulatory agencies of the jurisdictions in which
they operate. This regulation and supervision is primarily for the benefit and
protection of customers, and not for the benefit of investors or creditors.
State laws generally establish supervisory agencies that have broad regulatory
authority, including the power to:
o grant and revoke business licenses;
o regulate and supervise sales practices and market conduct;
o establish guaranty associations;
o license agents;
o approve policy forms;
o approve premium rates and premium rate increases for some lines of
business such as long-term care and Medicare supplement;
o establish reserve requirements;
o prescribe the form and content of required financial statements and
reports;
16
o determine the reasonableness and adequacy of statutory capital and
surplus;
o perform financial, market conduct and other examinations;
o define acceptable accounting principles; and
o regulate the types and amounts of permitted investments.
In addition, the NAIC issues model laws and regulations, many of which have
been adopted by state insurance regulators, relating to:
o reserve requirements;
o risk-based capital ("RBC") standards;
o codification of insurance accounting principles;
o investment restrictions;
o restrictions on an insurance company's ability to pay dividends; and
o product illustrations.
In addition to the regulations described above, most states have also
enacted laws or regulations regarding the activities of insurance holding
company systems, including acquisitions, the terms of surplus debentures, the
terms of transactions between insurance companies and their affiliates and other
related matters. Various notice and reporting requirements generally apply to
transactions between insurance companies and their affiliates within an
insurance holding company system, depending on the size and nature of the
transactions. These requirements may include prior regulatory approval or prior
notice for certain material transactions. Currently, the Company and its
insurance subsidiaries are registered as a holding company system pursuant to
such laws and regulations in the domiciliary states of the insurance
subsidiaries. In addition, the Company's insurance subsidiaries routinely report
to other jurisdictions.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the 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 generally accepted accounting principles ("GAAP"). These regulations
generally permit dividends to be paid from statutory earned surplus of the
insurance company for any 12-month period in amounts equal to the greater of, or
in a few states, the lesser of:
o statutory net gain from operations or statutory net income for the
prior year; or
o 10 percent of statutory capital and surplus at the end of the
preceding year.
Any dividends in excess of these levels require the approval of the director or
commissioner of the applicable state insurance department.
In accordance with an order from the Florida Office of Insurance
Regulation, Washington National may not distribute funds to any affiliate or
shareholder without prior notice to the Florida Office of Insurance Regulation.
In addition, the RBC and other capital requirements described below can also
limit, in certain circumstances, the ability of our insurance subsidiaries to
pay dividends.
Our insurance subsidiaries that have long-term care business have made
insurance regulatory filings seeking actuarially justified rate increases on our
long-term care policies. 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
17
could be adversely affected.
During 2006, the Florida legislature enacted a statute, known as House Bill
947, intended to provide new protections to long-term care insurance
policyholders. Among other requirements, this statute requires: (i) claim
experience of affiliated long-term care insurers to be pooled in determining
justification for rate increases for Florida policyholders; and (ii) insurers
with closed blocks of long-term care insurance to not raise rates above the
comparable new business premium rates offered by affiliated insurers. The manner
in which the requirements of this statute are applied to our long-term care
policies in Florida (including policies subject to the order from the Florida
Office of Insurance Regulation as described in "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations") may
affect our ability to achieve our anticipated rate increases on this business.
Most states have also enacted legislation or adopted administrative
regulations that affect the acquisition (or sale) of control of insurance
companies. The nature and extent of such legislation and regulations vary from
state to state. Generally, these regulations require an acquirer of control to
file detailed information and the plan of acquisition, and to obtain
administrative approval prior to the acquisition of control. "Control" is
generally defined as the direct or indirect power to direct or cause the
direction of the management and policies of a person and is rebuttably presumed
to exist if a person or group of affiliated persons directly or indirectly owns
or controls 10 percent or more of the voting securities of another person.
Using statutory statements filed with state regulators annually, the NAIC
calculates certain financial ratios to assist state regulators in monitoring the
financial condition of insurance companies. A "usual range" of results for each
ratio is used as a benchmark. In the past, variances in certain ratios of our
insurance subsidiaries have resulted in inquiries from insurance departments, to
which we have responded. These inquiries have not led to any restrictions
affecting our operations.
The NAIC's RBC requirements provide a tool for insurance regulators to
determine the levels of statutory capital and surplus an insurer must maintain
in relation to its insurance and investment risks and the need for possible
regulatory attention. The RBC requirements provide four levels of regulatory
attention, varying with the ratio of the insurance company's total adjusted
capital (defined as the total of its statutory capital and surplus, asset
valuation reserve and certain other adjustments) to its RBC (as measured on
December 31 of each year), as follows:
o if a company's total adjusted capital is less than 100 percent but
greater than or equal to 75 percent of its RBC (the "Company Action
Level"), the company must submit a comprehensive plan to the
regulatory authority proposing corrective actions aimed at improving
its capital position;
o if a company's total adjusted capital is less than 75 percent but
greater than or equal to 50 percent of its RBC, the regulatory
authority will perform a special examination of the company and issue
an order specifying the corrective actions that must be taken;
o if a company's total adjusted capital is less than 50 percent but
greater than or equal to 35 percent of its RBC (the "Authorized
Control Level"), the regulatory authority may take any action it deems
necessary, including placing the company under regulatory control; and
o if a company's total adjusted capital is less than 35 percent of its
RBC (the "Mandatory Control Level"), the regulatory authority must
place the company under its control.
In addition, the RBC requirements provide for a trend test if a company's
total adjusted capital is between 100 percent and 125 percent of its RBC at the
end of the year. The trend test calculates the greater of the decrease in the
margin of total adjusted capital over RBC:
o between the current year and the prior year; and
o for the average of the last 3 years.
It assumes that such decrease could occur again in the coming year. Any company
whose trended total adjusted capital is less than 95 percent of its RBC would
trigger a requirement to submit a comprehensive plan as described above for the
Company Action Level.
In January 2009, the NAIC considered, but declined, a number of reserve and
capital relief requests made by
18
the American Council of Life Insurers, acting on behalf of its member companies.
These requests, if adopted, would have generally resulted in lower statutory
reserve and capital requirements, effective December 31, 2008, for life
insurance companies. However, notwithstanding the NAIC's action on these
requests, insurance companies have the right to approach the insurance regulator
in their respective state of domicile and request relief. Insurance subsidiaries
of the Company requested and were granted certain permitted practices, with a
beneficial impact on statutory capital as of December 31, 2008.
The 2008 statutory annual statements filed with the state insurance
regulators of each of our insurance subsidiaries reflected total adjusted
capital in excess of the levels subjecting the subsidiaries to any regulatory
action. No assurances can be given that we will make future contributions or
otherwise make capital available to our insurance subsidiaries.
In addition to the RBC requirements, certain states have established
minimum capital requirements for insurance companies licensed to do business in
their state. These additional requirements generally have not had a significant
impact on the Company's insurance subsidiaries, but the capital requirements in
Florida have caused Conseco Health to maintain a higher level of capital and
surplus than it would otherwise maintain and have thus limited its ability to
pay dividends. Refer to the note entitled "Statutory Information (Based on
Non-GAAP Measures)" in our notes to consolidated financial statements for more
information on our RBC ratios.
In addition, although we are under no obligation to do so, we may elect to
contribute additional capital to strengthen the surplus of certain insurance
subsidiaries. Any election regarding the contribution of additional capital to
our insurance subsidiaries could affect the ability of our insurance
subsidiaries to pay dividends to the holding company. The ability of our
insurance subsidiaries to pay dividends is also impacted by various criteria
established by rating agencies to maintain or receive higher ratings and by the
capital levels that we target for our insurance subsidiaries.
The NAIC has adopted model long-term care policy language providing
nonforfeiture benefits and has proposed a rate stabilization standard for
long-term care policies. Various bills are introduced from time to time in the
U.S. Congress which propose the implementation of certain minimum consumer
protection standards in all long-term care policies, including guaranteed
renewability, protection against inflation and limitations on waiting periods
for pre-existing conditions. Federal legislation permits premiums paid for
qualified long-term care insurance to be tax-deductible medical expenses and for
benefits received on such policies to be excluded from taxable income.
Our insurance subsidiaries are required, under guaranty fund laws of most
states, to pay assessments up to prescribed limits to fund policyholder losses
or liabilities of insolvent insurance companies. Assessments can be partially
recovered through a reduction in future premium taxes in some states.
Most states mandate minimum benefit standards and benefit ratios for
accident and health insurance policies. We are generally required to maintain,
with respect to our individual long-term care policies, minimum anticipated
benefit ratios over the entire period of coverage of not less than 60 percent.
With respect to our Medicare supplement policies, we are generally required to
attain and maintain an actual benefit ratio, after three years, of not less than
65 percent. We provide to the insurance departments of all states in which we
conduct business annual calculations that demonstrate compliance with required
minimum benefit ratios for both long-term care and Medicare supplement
insurance. These calculations are prepared utilizing statutory lapse and
interest rate assumptions. In the event that we fail to maintain minimum
mandated benefit ratios, our insurance subsidiaries could be required to provide
retrospective refunds and/or prospective rate reductions. We believe that our
insurance subsidiaries currently comply with all applicable mandated minimum
benefit ratios.
The federal government does not directly regulate the insurance business.
However, federal legislation and administrative policies in several areas,
including pension regulation, age and sex discrimination, financial services
regulation, securities regulation, privacy laws and federal taxation, do affect
the insurance business. Legislation has been introduced from time to time in
Congress that could result in the federal government assuming some direct role
in the regulation of insurance. In view of recent events involving certain
financial institutions, it is possible that the federal government will heighten
its oversight of insurers, possibly through a federal system of insurance
regulation.
Numerous proposals to reform the current health care system (including
Medicare) have been introduced in Congress and in various state legislatures.
Proposals have included, among other things, modifications to the existing
employer-based insurance system, a quasi-regulated system of "managed
competition" among health plans, and a single-payer, public program. Changes in
health care policy could significantly affect our business. For example, Federal
comprehensive major medical or long-term care programs, if proposed and
implemented, could partially or fully replace some of Conseco's current
products. Recent federal and state legislation and legislative proposals
relating to healthcare reform contain features that
19
could severely limit or eliminate our ability to vary our pricing terms or apply
medical underwriting standards, which could have the effect of increasing our
benefit ratios and adversely affecting our financial results. Also, Medicare
reform and legislation concerning prescription drugs could affect our ability to
price or sell our products.
The United States Department of Health and Human Services has issued
regulations under the Health Insurance Portability and Accountability Act
relating to standardized electronic transaction formats, code sets and the
privacy of member health information. These regulations, and any corresponding
state legislation, affect our administration of health insurance.
A number of states have passed or are considering legislation that limits
the differentials in rates that insurers could charge for health care coverages
between new business and renewal business for similar demographic groups. State
legislation has also been adopted or is being considered that would make health
insurance available to all small groups by requiring coverage of all employees
and their dependents, by limiting the applicability of pre-existing conditions
exclusions, by requiring insurers to offer a basic plan exempt from certain
benefits as well as a standard plan, or by establishing a mechanism to spread
the risk of high risk employees to all small group insurers. Congress and
various state legislators have from time to time proposed changes to the health
care system that could affect the relationship between health insurers and their
customers, including external review. We cannot predict with certainty the
effect of any legislative proposals on our insurance businesses and operation.
The asset management activities of 40|86 Advisors are subject to various
federal and state securities laws and regulations. The SEC and certain state
securities commissions are the principal regulators of our asset management
operations. In addition, Conseco has a subsidiary that is registered as a
broker/dealer, which is regulated by the Financial Industry Regulatory Authority
and by state securities commissioners.
FEDERAL INCOME TAXATION
Our annuity and life insurance products generally provide policyholders
with an income tax advantage, as compared to other savings investments such as
certificates of deposit and bonds, because taxes on the increase in value of the
products are deferred until received by policyholders. With other savings
investments, the increase in value is generally taxed as earned. Annuity
benefits and life insurance benefits, which accrue prior to the death of the
policyholder, are generally not taxable until paid. Life insurance death
benefits are generally exempt from income tax. Also, benefits received on
immediate annuities (other than structured settlements) are recognized as
taxable income ratably, as opposed to the methods used for some other
investments which tend to accelerate taxable income into earlier years. The tax
advantage for annuities and life insurance is provided in the Internal Revenue
Code (the "Code"), and is generally followed in all states and other United
States taxing jurisdictions.
In recent years, Congress enacted legislation to lower marginal tax rates,
reduce the federal estate tax gradually over a ten-year period, with total
elimination of the federal estate tax in 2010, and increase contributions that
may be made to individual retirement accounts and 401(k) accounts. While these
tax law changes will sunset at the beginning of 2011 absent future congressional
action, they could in the interim diminish the appeal of our annuity and life
insurance products. Additionally, Congress has considered, from time to time,
other possible changes to the U.S. tax laws, including elimination of the tax
deferral on the accretion of value of certain annuities and life insurance
products. It is possible that further tax legislation will be enacted which
would contain provisions with possible adverse effects on our annuity and life
insurance products.
Our insurance company subsidiaries are taxed under the life insurance
company provisions of the Code. Provisions in the Code require a portion of the
expenses incurred in selling insurance products to be deducted over a period of
years, as opposed to immediate deduction in the year incurred. This provision
increases the tax for statutory accounting purposes, which reduces statutory
earnings and surplus and, accordingly, decreases the amount of cash dividends
that may be paid by the life insurance subsidiaries.
Our income tax expense includes deferred income taxes arising from
temporary differences between the financial reporting and tax bases of assets
and liabilities, capital loss carryforwards and net operating loss carryforwards
("NOLs"). In evaluating our deferred income tax assets, we consider whether it
is more likely than not that the deferred income tax assets will be realized.
The ultimate realization of our deferred income tax assets depends upon
generating future taxable income during the periods in which our temporary
differences become deductible and before our NOLs expire. In addition, the use
of our NOLs is dependent, in part, on whether the Internal Revenue Service
("IRS") ultimately agrees with the tax position we plan to take in our current
and future tax returns. Accordingly, with respect to our deferred tax assets, we
assess the need
20
for a valuation allowance on an ongoing basis.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance equal to our entire balance of
net deferred income tax assets because, at that time, the realization of such
deferred tax assets in future periods was uncertain. As of December 31, 2008,
2007 and 2006, we determined that a full valuation allowance was no longer
necessary. However, as further discussed in the note to the consolidated
financial statements entitled "Income Taxes", we continue to believe that it is
necessary to have a valuation allowance on a portion of our deferred tax asset.
This determination was made by evaluating each component of the deferred tax
assets and assessing the effects of limitations or issues on the value of such
component to be fully recognized in the future.
ITEM 1A. RISK FACTORS.
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors could
have a material adverse effect on the business, financial condition or results
of operations of Conseco. In addition, please refer to the "Cautionary Statement
Regarding Forward-Looking Statements" included in "Item 7 - Management's
Discussion and Analysis of Consolidated Financial Condition and Results of
Operations".
Our Second Amended Credit Facility contains various restrictive covenants
and required financial ratios that limit our operating flexibility; our
current credit ratings may adversely affect our ability to access capital
and the cost of such capital, which could have a material adverse effect on
our financial condition and results of operations.
As of December 31, 2008, we had $911.8 million principal amount of debt
outstanding under our secured credit agreement (the "Second Amended Credit
Facility"). The Second Amended Credit Facility imposes a number of covenants and
financial ratios as defined in the Second Amended Credit Facility that we must
meet or maintain. The following describes the financial ratios and amounts as of
December 31, 2008:
Covenant under the Balance or Margin for adverse
Second Amended ratio as of development from
Credit Facility December 31, 2008 December 31, 2008 levels
--------------- ----------------- ------------------------
Aggregate risk-based capital ratio......... greater than or equal 255% Reduction to
to 250% statutory capital and
surplus of
approximately $25
million, or an
increase to the risk-
based capital of
approximately $10
million.
Combined statutory capital and surplus..... greater than $1,270 $1,366 million Reduction to
million combined statutory
capital and surplus
of approximately
$96 million.
Debt to total capitalization ratio......... not more than 30% 28% Reduction to
shareholders' equity
of approximately
$273 million or
additional debt of
$117 million.
Interest coverage ratio.................... greater than or equal 2.35 to 1 Reduction in cash
to 2.00 to 1 for each flows to the holding
rolling four quarters company of
approximately
$20 million.
21
As described in the note to the consolidated financial statements entitled
"Subsequent Events", on March 30, 2009, we completed an amendment to our Second
Amended Credit Facility, which provides for, among other things: (i) additional
margins between our current financial status and certain financial covenant
requirements through June 30, 2010; (ii) higher interest rates and the payment
of a fee; (iii) new restrictions on the ability of the Company to incur
additional indebtedness; and (iv) the ability of the lenders to appoint a
financial advisor at the Company's expense.
These covenants place 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
covenants, the lenders could declare all outstanding borrowings, accrued
interest and fees to be immediately due and payable. If the lenders under our
Second Amended Credit Facility would elect to accelerate the amounts due, the
holders of our 3.50% Convertible Debentures due September 30, 2035 (the
"Debentures") and Senior Note could elect to take similar action with respect to
those debts. If that were to occur, we would not have sufficient liquidity to
repay our indebtedness.
Our Second Amended Credit Facility also imposes restrictions that limit our
ability to take certain actions, including the following:
o incur additional indebtedness or refinance existing indebtedness;
o transfer or sell assets unless the net proceeds are reinvested in our
insurance operations or used to reduce the amount due under the Second
Amended Credit Facility;
o enter into mergers or other business combinations;
o pay cash dividends or repurchase stock; and
o make certain investments and capital expenditures.
Absent a waiver or modification by the senior credit facility lenders,
these restrictions impact the manner in which we operate our business and could
limit the ability of the Company to be able to raise sufficient funds to repay
the Debentures when due. The Debentures are putable to the Company on September
30, 2010. See the note to the consolidated financial statements entitled "Notes
Payable - Direct Corporate Obligations" for further information related to the
Debentures.
S&P has assigned a "CCC" rating on our senior secured debt with a negative
outlook. In S&P's view, an obligation rated "CCC" is currently vulnerable to
nonpayment and is dependent upon favorable business, financial and economic
conditions to meet its financial commitment on the obligation. S&P has a total
of twenty-two separate categories rating senior debt, ranging from "AAA
(Extremely Strong)" to "D (Payment Default)." There are seventeen ratings above
our "CCC" rating and four ratings that are below our rating. Moody's has
assigned a "Caa1" rating on our senior secured debt with a negative outlook. In
Moody's view, an obligation rated "Caa1" is in poor standing and there may be
present elements of danger with respect to principal or interest. Moody's has a
total of twenty-one separate categories in which to rate senior debt, ranging
from "Aaa (Exceptional)" to "C (Lowest Rated)." There are sixteen ratings above
our "Caa1" rating and four ratings that are below our rating. A negative outlook
by S&P and Moody's is an opinion regarding the likely direction of a rating over
the medium term. If we were to require additional capital, either to refinance
our existing indebtedness or for any other reason, our current senior debt
ratings, as well as economic conditions in the credit markets generally, could
severely restrict our access to and the cost of such capital.
See "Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operations - Consolidated Financial Condition;
Liquidity of the Holding Companies" for additional information regarding the
Company's liquidity.
Our liquidity and ability to meet our holding company obligations may be
constrained by the ability of our insurance subsidiaries to distribute cash
to us.
CNO and CDOC, a guarantor under the Second Amended Credit Facility, 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. CNO 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 our non-insurance subsidiaries consisting of dividends,
distributions, loans and advances. A deterioration in the financial condition,
earnings or cash flow of our significant subsidiaries for any reason could
hinder the ability of such subsidiaries to pay cash dividends or other
disbursements to CNO and/or CDOC which would limit the ability of CNO to meet
its debt service requirements and satisfy other financial obligations. In
addition, we may elect to contribute additional capital to certain insurance
subsidiaries to strengthen their surplus and this could limit the amount
available at our insurance
22
subsidiaries to pay dividends. Accordingly, this could limit our ability to meet
debt service requirements and satisfy other holding company financial
obligations.
The obligations under our Second Amended Credit Facility are guaranteed by
our current and future domestic subsidiaries, other than our insurance
subsidiaries and certain immaterial subsidiaries. CDOC's guarantee under the
Second Amended Credit Facility is secured by a lien on substantially all of the
assets of the guarantors, including the stock of Conseco Life Insurance Company
of Texas ("Conseco Life of Texas") (which is the parent of Bankers Life and
Casualty Company, Bankers Conseco Life Insurance Company ("Bankers Conseco
Life") and Colonial Penn), Washington National (which is the parent of Conseco
Insurance Company and Conseco Life) and Conseco Health. If we fail to make the
required payments, do not meet the financial covenants or otherwise default on
the terms of the Second Amended Credit Facility, the stock of Conseco Life of
Texas, Washington National and Conseco Health could be transferred to the
lenders under such facility. Any such transfer would have a material adverse
effect on our business, financial condition and results of operations, and would
have a significant adverse effect on the market value of our common stock.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the ability of our insurance subsidiaries to pay dividends is subject
to state insurance department regulations. Insurance regulations generally
permit dividends to be paid from statutory earned surplus of the insurance
company without regulatory approval for any 12-month period in amounts equal to
the greater of (or in a few states, the lesser of): (i) statutory net gain from
operations or statutory net income for the prior year; or (ii) 10 percent of
statutory capital and surplus as of the end of the preceding year. This type of
dividend is referred to as "ordinary dividends". Any dividends in excess of
these levels require the approval of the director or commissioner of the
applicable state insurance department. This type of dividend is referred to as
"extraordinary dividends". During 2008, our insurance subsidiaries paid cash
dividends of $20 million to CDOC. Each of the immediate insurance subsidiaries
of CDOC has negative earned surplus at December 31, 2008. Accordingly, any
dividend payments from the insurance subsidiaries to the holding Company will
require the prior approval of the director or commissioner of the applicable
state insurance department. During 2009, we are expecting our insurance
subsidiaries to pay approximately $60 million of extraordinary dividends to CDOC
($25 million of which has been approved). In addition, during 2009, we are
expecting our insurance subsidiaries to pay interest of $44.5 million on surplus
debentures ($21.2 million of which has been approved). The remaining dividends
and surplus debenture interest payments will require prior regulatory approval.
Although we believe the dividends and surplus debenture interest payments we are
expecting to pay during 2009 are consistent with payments that have been
approved by insurance regulators in prior years, there can be no assurance that
such payments will be approved or that the financial condition of our insurance
subsidiaries will not change, making future approvals unlikely. Dividends and
other payments from our non-insurance subsidiaries to CNO or CDOC do not require
approval by any regulatory authority or other third party.
In accordance with an order from the Florida Office of Insurance
Regulation, Washington National may not distribute funds to any affiliate or
shareholder without prior notice to the Florida Office of Insurance Regulation.
In addition, the RBC and other capital requirements described below can also
limit, in certain circumstances, the ability of our insurance subsidiaries to
pay dividends.
Certain states have established minimum capital requirements for insurance
companies licensed to do business in their state. These additional requirements
generally have not had a significant impact on the Company's insurance
subsidiaries, but the capital requirements in Florida have caused Conseco Health
to maintain a higher level of capital and surplus than it would otherwise
maintain and have thus limited its ability to pay dividends.
In addition, although we are under no obligation to do so, we may elect to
contribute additional capital to strengthen the surplus of certain insurance
subsidiaries. Any election regarding the contribution of additional capital to
our insurance subsidiaries could affect the ability of our top tier insurance
subsidiaries to pay dividends. The ability of our insurance subsidiaries to pay
dividends is also impacted by various criteria established by rating agencies to
maintain or receive higher ratings and by the capital levels that we target for
our insurance subsidiaries.
The agreements between our insurance subsidiaries and Conseco Services, LLC
and 40|86 Advisors, respectively, were previously approved by the domestic
insurance regulator for each insurance company, and any payments thereunder do
not require further regulatory approval.
23
The following table sets forth the aggregate amount of dividends and other
distributions that our insurance subsidiaries paid to us in each of the last two
fiscal years (dollars in millions):
Years ended December 31,
------------------------
2008 2007
---- ----
Dividends................................................................... $ 20.0 $ 50.0
Surplus debenture interest.................................................. 56.4 69.9
Fees for services provided pursuant to service agreements................... 83.2 92.9
Tax sharing payments........................................................ 1.1 1.9
------ ------
Total paid................................................................ $160.7 $214.7
====== ======
Risks associated with current economic environment
Over the past year, the U.S. economy has experienced unprecedented credit
and liquidity issues and entered into a recession. Following several years of
rapid credit expansion, a sharp contraction in mortgage lending coupled with
dramatic declines in home prices, rising mortgage defaults and increasing home
foreclosures, resulted in significant write-downs of asset values by financial
institutions, including government-sponsored entities and major commercial and
investment banks. These write-downs, initially of mortgage-backed securities but
spreading to most sectors of the credit markets, and to credit default swaps and
other derivative securities, have caused many financial institutions to seek
additional capital, to merge with larger and stronger institutions, to be
subsidized by the U.S. government and, in some cases, to fail. Reflecting
concern about the stability of the financial markets, generally, and the
strength of counterparties, many lenders and institutional investors have
reduced and, in some cases, ceased to provide funding to borrowers, including
other financial institutions. These factors, combined with declining business
and consumer confidence and increased unemployment, have precipitated an
economic slowdown and fears of a prolonged recession.
Even under more favorable market conditions, general factors such as the
availability of credit, consumer spending, business investment, capital market
conditions and inflation affect our business. For example, in an economic
downturn, higher unemployment, lower family income, lower corporate earnings,
lower business investment and lower consumer spending may depress the demand for
life insurance, annuities and other insurance products. In addition, this type
of economic environment may result in higher lapses or surrenders of policies.
Accordingly, the risks we face related to general economic and business
conditions are more pronounced given the severity and magnitude of the recent
adverse economic and market conditions experienced.
More specifically, our business is exposed to the performance of the debt
and equity markets, which have been materially and adversely affected by recent
economic developments. Adverse conditions, including but not limited to, a lack
of buyers in the marketplace, volatility, credit spread changes, and benchmark
interest rate changes, have affected and will continue to impact the liquidity
and value of our investments. The manner in which poor debt and equity market
performance and changes in interest rates have adversely affected, and will
continue to adversely affect, our business, financial condition, growth and
profitability include, but are not limited to, the following:
o The value of our investment portfolio has declined, which has resulted
in, and may continue to result in, higher realized and/or unrealized
losses. For example, in 2008 the value of our investments decreased by
$2.5 billion due to net unrealized losses on investments. A widening
of credit spreads, such as the market has experienced recently,
increases the net unrealized loss position of our investment portfolio
and may ultimately result in increased realized losses. The value of
our investment portfolio can also be affected by illiquidity and by
changes in assumptions or inputs we use in estimating fair value.
Further, certain types of securities in our investment portfolio, such
as asset-backed securities supported by residential and commercial
mortgages, have been disproportionately affected. Continued adverse
capital market conditions could result in further realized and/or
unrealized losses.
o Changes in interest rates also have other effects related to our
investment portfolio. In periods of increasing interest rates, life
insurance policy loans, surrenders and withdrawals could increase as
policyholders seek investments with higher returns. This could require
us to sell invested assets at a time when their prices are depressed
by the increase in interest rates, which could cause us to realize
investment losses. Conversely, during periods of declining interest
rates, we could experience increased premium payments on products with
flexible premium features, repayment of policy loans and increased
percentages of policies remaining in force. We would obtain lower
returns on investments made with these cash flows. In addition,
borrowers may prepay or redeem bonds in our investment
24
portfolio so that we might have to reinvest those proceeds in lower
yielding investments. As a consequence of these factors, we could
experience a decrease in the spread between the returns on our
investment portfolio and amounts credited to policyholders and
contract owners, which could adversely affect our profitability.
o The attractiveness of certain of our products may decrease because
they are linked to the equity markets and assessments of our financial
strength, resulting in lower profits. Increasing consumer concerns
about the returns and features of our products or our financial
strength may cause existing customers to surrender policies or
withdraw assets, and diminish our ability to sell policies and attract
assets from new and existing customers, which would result in lower
sales and fee revenues.
These extraordinary economic and market conditions have materially and
adversely affected us. It is difficult to predict how long the current economic
and market conditions will continue, whether the financial markets will continue
to deteriorate and which aspects of our products and/or business will be
adversely affected. However, the lack of credit, lack of confidence in the
financial sector, increased volatility in the financial markets and reduced
business activity are likely to continue to materially and adversely affect our
business, financial condition and results of operations.
Our investment portfolio is subject to several risks that may diminish the
value of our invested assets and negatively impact our profitability, our
financial condition, our liquidity and our ability to continue to comply
with the financial covenants under our Second Amended Credit Facility.
The value of our investment portfolio is subject to numerous factors, which
are difficult to predict, and are often beyond our control. These factors
include, but are not limited to, the following:
o Changes in interest rates and interest rate spreads can reduce the
value of our investments as further discussed in the risk factor
entitled "Changing interest rates may adversely affect our results of
operations".
o Changes in patterns of relative liquidity in the capital markets for
various asset classes.
o Changes in the ability of issuers to make timely repayments on
actively managed fixed maturity investments can reduce the value of
our investments. This risk is significantly greater with respect to
below-investment grade securities, which comprised 9.1 percent of our
actively managed fixed maturity investments as of December 31, 2008.
o Changes in the estimated timing of receipt of cash flows. For example,
our structured security investments, which comprised 22 percent of our
actively managed fixed maturity investments at December 31, 2008, are
subject to risks relating to variable prepayment on the assets
underlying such securities, such as mortgage loans. When structured
securities prepay faster than expected, investment income may be
adversely affected due to the acceleration of the amortization of
purchase premiums or the inability to reinvest at comparable yields in
lower interest rate environments.
o Changes in the relative risk premium required in the market for a
given level of risk.
We have recorded writedowns of fixed maturity investments, equity
securities and other invested assets as a result of conditions which caused us
to conclude a decline in the fair value of the investment was other than
temporary as follows (excluding any such amounts included in discontinued
operations): $162.3 million in 2008; $105.5 million in 2007 (including $73.7
million of writedowns of investments which were subsequently transferred
pursuant to a coinsurance agreement as further discussed in the note to the
consolidated financial statements entitled "Summary of Significant Accounting
Policies"); and $21.1 million in 2006. Our investment portfolio is subject to
the risks of further declines in realizable value. However, we attempt to
mitigate this risk through the diversification and active management of our
portfolio.
In the event of substantial product surrenders or policy claims, we may
choose to maintain highly liquid, and potentially lower-yielding, assets, or to
sell assets at a loss, thereby eroding the performance of our portfolio.
Because a substantial portion of our operating results are derived from
returns on our investment portfolio, significant losses in the portfolio may
have a direct and materially adverse impact on our results of operations. In
addition, losses on our investment portfolio could reduce the investment returns
that we are able to credit to our customers of certain products,
25
thereby impacting our sales and eroding our financial performance. Investment
losses may also reduce the capital of our insurance subsidiaries, which may
cause us to make additional capital contributions to those subsidiaries or may
limit the ability of the insurance subsidiaries to make dividend payments to the
holding company. In addition, future investment losses could cause us to be in
violation of the financial covenants under our Second Amended Credit Facility as
described in the first risk factor above.
Deteriorating financial performance of securities collateralized by
mortgage loans and commercial mortgage loans may lead to writedowns, which
could have a material adverse effect on our results of operations and
financial condition.
Changes in mortgage delinquency or recovery rates, declining real estate
prices, changes in credit or bond insurer credit ratings and the quality of
service provided by service providers on securities in our portfolios could lead
us to determine that writedowns are appropriate in the future.
The determination of the amount of realized investment losses recorded as
impairments of our investments is highly subjective and could have a
material adverse effect on our operating results and financial condition.
The determination of the amount of realized investment losses recorded as
impairments vary by investment type and is based upon our periodic evaluation
and assessment of known and inherent risks associated with the respective asset
class. Such evaluations and assessments are revised as conditions change and new
information becomes available. Management updates its evaluations regularly and
reflects changes in realized investment gains and losses from impairments in
operating results as such evaluations are revised. Our assessment of whether
unrealized losses are impairments requires significant judgment and future
events may occur, or additional information may become available, which may
necessitate future impairments of securities in our portfolio. Historical trends
may not be indicative of future impairments. For example, the cost of our fixed
maturity and equity securities is adjusted for impairments in value deemed to be
other than temporary in the period in which the determination is made. The
assessment of whether impairments have occurred is based on management's
case-by-case evaluation of the underlying reasons for the decline in fair value.
The determination of the fair value of our fixed maturity securities
results in unrealized net investment gains and losses and is highly
subjective and could materially impact our operating results and financial
condition.
In determining fair value, we generally utilize market transaction data for
the same or similar instruments. The degree of management judgment involved in
determining fair values is inversely related to the availability of market
observable information. The fair value of financial assets and financial
liabilities may differ from the amount actually received to sell an asset or the
amount paid to transfer a liability in an orderly transaction between market
participants at the measurement date. Moreover, the use of different valuation
assumptions may have a material effect on the fair values of the financial
assets and financial liabilities. As of December 31, 2008, our total unrealized
net investment losses were $3.0 billion.
Litigation and regulatory investigations are inherent in our business, may
harm our financial strength and reputation and negatively impact our
financial results.
Insurance companies historically have been subject to substantial
litigation. In addition to the traditional policy claims associated with their
businesses, insurance companies face policyholder suits and class action suits.
We also face significant risks related to regulatory investigations and actions.
The litigation and regulatory investigations we are, have been, or may become
subject to include matters related to sales or underwriting practices, payment
of contingent or other sales commissions, claim payments and procedures, product
design, product disclosure, administration, additional premium charges for
premiums paid on a periodic basis, calculation of cost of insurance charges,
changes to certain non-guaranteed policy features, denial or delay of benefits,
charging excessive or impermissible fees on products and recommending unsuitable
products to customers. Certain of the Company's insurance policies allow or
require us to make changes based on experience to certain non-guaranteed
elements such as cost of insurance charges, expense loads, credited interest
rates and policyholder bonuses. The Company intends to make changes to certain
non-guaranteed elements in the future. In some instances in the past, such
action has resulted in litigation and similar litigation may arise in the
future. The Company's exposure, if any, arising from any such action cannot
presently be determined. Our pending legal and regulatory actions include
matters that are specific to us, as well as matters faced by other insurance
companies. State insurance departments focus on sales and claims payment
practices and product issues in their market conduct examinations. Negotiated
settlements of class action and other lawsuits have had a material adverse
effect on the business, financial condition and results of operations of our
insurance companies. We are, in the ordinary course of our business, a plaintiff
or defendant in actions arising out of our insurance business, including class
actions and reinsurance disputes, and, from time to time, we are also
26
involved in various governmental and administrative proceedings and
investigations and inquiries such as information requests, subpoenas and books
and record examinations, from state, federal and other authorities. The ultimate
outcome of these lawsuits and investigations, however, cannot be predicted with
certainty. In the event of an unfavorable outcome in one or more of these
matters, the ultimate liability may be in excess of liabilities we have
established and could have a material adverse effect on our business, financial
condition, results of operations or cash flows. We could also suffer significant
reputational harm as a result of such litigation, regulatory action or
investigation which could have a material adverse effect on our business,
financial condition, results of operations or cash flows.
For a description of current legal proceedings, see the note to the
consolidated financial statements entitled "Commitments and Contingencies".
The limited historical claims experience on our long-term care products
could negatively impact our operations if our estimates prove wrong and we
have not adequately set premium rates.
In setting premium rates, we consider historical claims information and
other factors, but we cannot predict future claims with certainty. This is
particularly applicable to our long-term care insurance products, for which we
(as well as other companies selling these products) have relatively limited
historical claims experience. Long-term care products tend to have fewer claims
than other health products such as Medicare supplement, but when claims are
incurred, they tend to be much higher in dollar amount and longer in duration.
Also, long-term care claims are incurred much later in the life of the policy
than most other supplemental health products. As a result of these traits, it is
difficult to appropriately price this product. For our long-term care insurance,
actual persistency in later policy durations that is higher than our persistency
assumptions could have a negative impact on profitability. If these policies
remain inforce longer than we assumed, then we could be required to make greater
benefit payments than anticipated when the products were priced. Mortality is a
critical factor influencing the length of time a claimant receives long-term
care benefits. Mortality continues to improve for the general population, and
life expectancy has increased. Improvements in actual mortality trends relative
to assumptions may adversely affect our profitability.
Our Bankers Life segment has offered long-term care insurance since 1985.
Recently, the claims experience on our Bankers Life long-term care blocks has
generally been higher than our pricing expectations and, the persistency of
these policies has been higher than our pricing expectations which may result in
higher benefit ratios in the future.
After the transfer of Senior Health to an independent trust, we continue to
hold long-term care business acquired through previous acquisitions. The
premiums collected from this block totaled $33.7 million in 2008. The experience
on this acquired block has generally been worse than the acquired companies'
original pricing expectations. We have received regulatory approvals for
numerous premium rate increases in recent years pertaining to these blocks. Even
with these rate increases, this block experienced benefit ratios of 169.6
percent in 2008, 192.4 percent in 2007 and 224.4 percent in 2006. If future
claims experience proves to be worse than anticipated as our long-term care
blocks continue to age, our financial results could be adversely affected. In
addition, such rate increases may cause existing policyholders to allow their
policies to lapse.
The results of operations of our insurance business will decline if our
premium rates are not adequate or if we are unable to obtain regulatory
approval to increase rates.
We set the premium rates on our health insurance policies based on facts
and circumstances known at the time we issue the policies and on assumptions
about numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, maintenance costs to
administer the policies and the interest rate earned on our investment of
premiums. In setting premium rates, we consider historical claims information,
industry statistics, the rates of our competitors and other factors, but we
cannot predict with certainty the future actual claims on our products. If our
actual claims experience proves to be less favorable than we assumed and we are
unable to raise our premium rates to the extent necessary to offset the
unfavorable claims experience, our financial results will be adversely affected.
We review the adequacy of our premium rates regularly and file proposed
rate increases on our health insurance products when we believe existing premium
rates are too low. It is possible that we will not be able to obtain approval
for premium rate increases from currently pending requests or from future
requests. If we are unable to raise our premium rates because we fail to obtain
approval in one or more states, our financial results will be adversely
affected. Moreover, in some instances, our ability to exit unprofitable lines of
business is limited by the guaranteed renewal feature of the policy. Due to this
feature, we cannot exit such business without regulatory approval, and
accordingly, we may be required to continue to service those products at a loss
for an extended period of time. Most of our long-term care business is
guaranteed renewable,
27
and, if necessary rate increases are not approved, we would be required to
recognize a loss and establish a premium deficiency reserve. During 2008, the
financial statements of three of our subsidiaries prepared in accordance with
statutory accounting practices prescribed or permitted by regulatory authorities
reflected the establishment of asset adequacy or premium deficiency reserves
primarily related to long-term care and annuity policies. Total asset adequacy
or premium deficiency reserves for Washington National, Conseco Insurance
Company and Bankers Conseco Life were $53.3 million, $20.0 million and $19.5
million, respectively, at December 31, 2008. Due to differences between
statutory and GAAP insurance liabilities, we were not required to recognize a
similar premium deficiency reserve in our consolidated financial statements
prepared in accordance with GAAP. The determination of the need for and amount
of asset adequacy reserves is subject to numerous actuarial assumptions,
including the Company's ability to change nonguaranteed elements related to
certain products consistent with contract provisions.
If, however, we are successful in obtaining regulatory approval to raise
premium rates, the increased premium rates may reduce the volume of our new
sales and cause existing policyholders to allow their policies to lapse. This
could result in a significantly higher ratio of claim costs to premiums if
healthier policyholders who get coverage elsewhere allow their policies to
lapse, while policies of less healthy policyholders continue inforce. This would
reduce our premium income and profitability in future periods.
Most of our supplemental health policies allow us to increase premium rates
when warranted by our actual claims experience. These rate increases must be
approved by the applicable state insurance departments, and we are required to
submit actuarial claims data to support the need for such rate increases. The
re-rate application and approval process on supplemental health products is a
normal recurring part of our business operations and reasonable rate increases
are typically approved by the state departments as long as they are supported by
actual claims experience and are not unusually large in either dollar amount or
percentage increase. For policy types on which rate increases are a normal
recurring event, our estimates of insurance liabilities assume we will be able
to raise rates if experience on the blocks warrants such increases in the
future.
The benefit ratio for our long-term care products included in the Conseco
Insurance Group segment has increased in recent periods and was 169.6 percent
during 2008. We will have to continue to raise rates or take other actions with
respect to some of these policies or our financial results will be adversely
affected.
As a result of higher persistency and resultant higher claims 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 have been seeking
approval from regulatory authorities for rate increases on portions of this
business. Many of the rate increases have been approved by regulators and
implemented. However, it is possible that we will not be able to obtain approval
for all or a portion of the premium rate increases from currently pending
requests or future requests. If we are unable to obtain these rate increases,
the profitability of these policies and the performance of this block of
business will be adversely affected. In addition, such rate increases may reduce
the volume of our new sales and cause existing policyholders to allow their
policies to lapse, resulting in reduced profitability.
We have implemented and will continue to implement from time to time and
when actuarially justified, premium rate increases in our long-term care
business. In some cases, we offer policyholders the opportunity to reduce their
coverage amounts or accept non-forfeiture benefits as alternatives to increasing
their premium rates. The financial impact of our rate increase actions could be
adversely affected by policyholder anti-selection, meaning that policyholders
who are less likely to incur claims may lapse their policies or reduce their
benefits, while policyholders who are more likely to incur claims may maintain
full coverage and accept their rate increase.
We have identified a material weakness in our internal control over
financial reporting, and our business and stock price may be adversely
affected if we have not adequately addressed the weakness or if we have
other material weaknesses or significant deficiencies in our internal
controls over financial reporting.
We did not maintain effective controls over the accounting and disclosure
of insurance policy benefits and the liabilities for some of our insurance
products. We previously identified a material weakness in internal controls over
the actuarial reporting processes related to the design of controls to ensure
the completeness and accuracy of certain inforce policies in our Bankers Life
segment, Conseco Insurance Group segment, and the long-term care business
reflected in discontinued operations. Remediation efforts to enhance controls
over the actuarial reporting process continued in 2008 and the control
deficiencies in the actuarial reporting process related to the design of
controls over the completeness and accuracy of certain inforce policies in our
Bankers Life and long-term care business reflected in discontinued operations
were remediated, and the new controls were determined to be effective. However,
a material weakness relating to the actuarial
28
reporting process in our Conseco Insurance Group segment continued to exist as
of December 31, 2008.
These control deficiencies resulted in adjustments to insurance policy
benefits and the liabilities for insurance products in the consolidated
financial statements for the years ended December 31, 2006, December 31, 2007
and December 31, 2008. If we cannot produce reliable financial reports,
investors could lose confidence in our reported financial information, the
market price of our stock could decline significantly, we may be unable to
obtain additional financing to operate and expand our business, and our business
and financial condition could be harmed. In addition, we face the risk that,
notwithstanding our efforts to date to identify and remedy all material errors
in those financial statements, we may discover other errors in the future and
that the cost of identifying and remedying the errors and remediating our
material weakness in internal controls will be high and have a material adverse
effect on our financial condition and results of operation. See Item 9A of this
annual report for additional information.
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 NOLs.
As of December 31, 2008, we had approximately $4.8 billion of federal tax
NOLs and $1.2 billion of capital loss carryforwards, resulting in a gross
deferred tax asset of approximately $2.1 billion, expiring in years 2009 through
2028. The timing and manner in which Conseco will be able to utilize some of its
NOLs 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 NOLs 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 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 2009 will be
approximately $662 million (including $520 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
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 NOLs to offset future
taxable income and that new limitation would apply to all of our NOLs (as
compared to our current limitation which only applies to a portion of our
carryforwards). 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 5.4 percent), and the
new annual restriction could effectively eliminate our ability to use a
substantial portion of our NOLs to offset future taxable income. The writedown
of our deferred tax assets that would occur in the event of an ownership change
for purposes of Section 382 would likely cause us to breach the debt to equity
covenant of our Second Amended Credit Facility. We regularly monitor ownership
change (as calculated for purposes of Section 382) and, as of December 31, 2008,
we were below the 50 percent ownership change level that would trigger further
impairment of our ability to utilize our NOLs. In January 2009, the Company's
Board of Directors adopted a Section 382 Rights Plan (the "Rights Plan") which
is designed to protect shareholder value by preserving the value of our NOLs.
See the "Income Taxes" footnote to our financial statements contained herein for
additional information regarding the Rights Plan, our tax loss carryforwards and
other tax matters.
The value of our deferred tax asset may be impaired to the extent our
future profits are less than we have projected; and such impairment may
have a material adverse effect on our results of operations and our
financial condition.
As of December 31, 2008, we had deferred tax assets of $2.1 billion. During
2008, we increased the deferred tax valuation allowance by $856.2 million. The
$856.2 million increase to our valuation allowance during 2008 included
increases of: (i) $452 million of deferred tax assets related to Senior Health,
which was transferred to an independent trust during 2008; (ii) $298 million
related to our reassessment of the recovery of our deferred tax assets in
accordance with GAAP, following the additional losses incurred as a result of
the transaction to transfer Senior Health to an independent trust; (iii) $60
million related to the recognition of additional realized investment losses for
which we are unlikely to receive any tax benefit; and (iv) $45 million related
to the projected additional future expense following the modifications to our
Second Amended Credit Facility as described in the note to these consolidated
financial statements entitled "Subsequent Events." Our income tax expense
includes deferred income taxes arising from temporary differences between the
financial reporting and tax bases of assets and liabilities, capital loss
carryforwards and NOLs. We evaluate the realizability of our deferred income tax
assets and assess the need for a valuation allowance on an ongoing basis. In
evaluating our deferred income tax
29
assets, we consider whether it is more likely than not that the deferred income
tax assets will be realized. The ultimate realization of our deferred income tax
assets depends upon generating sufficient future taxable income during the
periods in which our temporary differences become deductible and before our
capital loss carryforwards and NOLs expire. This assessment requires significant
judgment. However, recovery is dependent on achieving such projections and
failure to do so would result in an increase in the valuation allowance in a
future period. Any future increase in the valuation allowance would result in
additional income tax expense and reduce shareholders' equity, and such an
increase could have a material adverse effect upon our earnings in the future.
Concentration of our investment portfolios in any particular sector of the
economy or type of asset may have an adverse effect on our financial
position or results of operations.
The concentration of our investment portfolios in any particular industry,
group of related industries, asset classes (such as residential mortgage-backed
securities and other asset-backed securities), or geographic area could have an
adverse effect on its value and performance and, consequently, on our results of
operations and financial position. While Conseco seeks to mitigate this risk by
having a broadly diversified portfolio, events or developments that have a
negative impact on any particular industry, group of related industries or
geographic area may have an adverse effect on the investment portfolios to the
extent that the portfolios are concentrated.
Our business is subject to extensive regulation, which limits our operating
flexibility and could result in our insurance subsidiaries being placed
under regulatory control or otherwise negatively impact our financial
results.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate. Our insurance subsidiaries are subject
to state insurance laws that establish supervisory agencies. Such agencies have
broad administrative powers including the power to:
o grant and revoke business licenses;
o regulate and supervise sales practices and market conduct;
o establish guaranty associations;
o license agents;
o approve policy forms;
o approve premium rates for some lines of business such as long-term
care and Medicare supplement;
o establish reserve requirements;
o prescribe the form and content of required financial statements and
reports;
o determine the reasonableness and adequacy of statutory capital and
surplus;
o perform financial, market conduct and other examinations;
o define acceptable accounting principles; and
o regulate the types and amounts of permitted investments.
The regulations issued by state insurance agencies can be complex and subject to
differing interpretations. If a state insurance regulatory agency determines
that one of our insurance company subsidiaries is not in compliance with
applicable regulations, the subsidiary is subject to various potential
administrative remedies including, without limitation, monetary penalties,
restrictions on the subsidiary's ability to do business in that state and a
return of a portion of policyholder premiums. In addition, regulatory action or
investigations could cause us to suffer significant reputational harm, which
could have an adverse effect on our business, financial condition and results of
operations.
Our insurance subsidiaries are also subject to RBC requirements. These
requirements were designed to evaluate the adequacy of statutory capital and
surplus in relation to investment and insurance risks associated with asset
quality, mortality and morbidity, asset and liability matching and other
business factors. The requirements are used by states as an early warning tool
to discover companies that may be weakly-capitalized for the purpose of
initiating regulatory action. Generally, if an insurer's RBC falls below
specified levels, the insurer is subject to different degrees of regulatory
action depending upon the magnitude of the deficiency. The 2008 statutory annual
statements filed with the state insurance regulators of each of our insurance
subsidiaries reflected total adjusted capital in excess of the levels subjecting
the subsidiaries to any regulatory action.
30
Our reserves for future insurance policy benefits and claims may prove to
be inadequate, requiring us to increase liabilities which results in
reduced net income and shareholders' equity.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and standard actuarial tables of
mortality, morbidity, lapse rates, investment experience and expense levels. For
our health insurance business, we establish an active life reserve, a liability
for due and unpaid claims, claims in the course of settlement, incurred but not
reported claims, and a reserve for the present value of amounts on incurred
claims not yet due. We establish reserves based on assumptions and estimates of
factors either established at the fresh-start date for business inforce then or
considered when we set premium rates for business written after that date.
Many factors can affect these reserves and liabilities, such as economic
and social conditions, inflation, hospital and pharmaceutical costs, changes in
life expectancy, regulatory actions, changes in doctrines of legal liability and
extra-contractual damage awards. Therefore, the reserves and liabilities we
establish are necessarily based on estimates, assumptions, industry data and
prior years' statistics. It is possible that actual claims will materially
exceed our reserves and have a material adverse effect on our results of
operations and financial condition. We have incurred significant losses beyond
our estimates as a result of actual claim costs and persistency of our long-term
care business included in our Bankers Life and Conseco Insurance Group segments.
The benefit ratios for our long-term care products in our Bankers Life segment
were 107.6 percent, 102.0 percent and 94.5 percent in 2008, 2007 and 2006,
respectively. The benefit ratios for our long-term care products in our Conseco
Insurance Group segment were 169.6 percent, 192.4 percent and 224.4 percent in
2008, 2007 and 2006, respectively. Our financial performance depends
significantly upon the extent to which our actual claims experience and future
expenses are consistent with the assumptions we used in setting our reserves. If
our assumptions with respect to future claims are incorrect, and our reserves
prove to be insufficient to cover our actual losses and expenses, we would be
required to increase our liabilities, and our financial results could be
adversely affected.
We may be required to accelerate the amortization of the cost of policies
produced or the value of policies inforce at the Effective Date.
Cost of policies produced represent the costs that vary with, and are
primarily related to, producing new insurance business. The value of policies
inforce at the Effective Date represents the value assigned to the right to
receive future cash flows from contracts existing at September 10, 2003. The
balances of these accounts are amortized over the expected lives of the
underlying insurance contracts. Management, on an ongoing basis, tests these
accounts recorded on our balance sheet to determine if these amounts are
recoverable under current assumptions. In addition, we regularly review the
estimates and assumptions underlying these accounts for those products for which
we amortize the cost of policies produced or the value of insurance inforce at
the Effective Date in proportion to gross profits or gross margins. If facts and
circumstances change, these tests and reviews could lead to reduction in the
balance of those accounts that could have an adverse effect on the results of
our operations and our financial condition.
Our operating results will suffer if policyholder surrender levels differ
significantly from our assumptions.
Surrenders of our annuities and life insurance products can result in
losses and decreased revenues if surrender levels differ significantly from
assumed levels. At December 31, 2008, approximately 20 percent of our total
insurance liabilities, or approximately $4.8 billion, could be surrendered by
the policyholder without penalty. The surrender charges that are imposed on our
fixed rate annuities typically decline during a penalty period, which ranges
from five to twelve years after the date the policy is issued. Surrenders and
redemptions could require us to dispose of assets earlier than we had planned,
possibly at a loss. Moreover, surrenders and redemptions require faster
amortization of either the acquisition costs or the commissions associated with
the original sale of a product, thus reducing our net income. We believe
policyholders are generally more likely to surrender their policies if they
believe the issuer is having financial difficulties, or if they are able to
reinvest the policy's value at a higher rate of return in an alternative
insurance or investment product.
Changing interest rates may adversely affect our results of operations.
Our profitability is affected by fluctuating interest rates. While we
monitor the interest rate environment and, in some cases, employ hedging
strategies to mitigate such impact, our financial results could be adversely
affected by changes in interest rates. Our spread-based insurance and annuity
business is subject to several inherent risks arising from movements in interest
rates, especially if we fail to anticipate or respond to such movements. First,
interest rate changes can cause compression of our net spread between interest
earned on investments and interest credited to customer deposits. Our ability to
adjust for such a compression is limited by the guaranteed minimum rates that we
must credit to policyholders on certain products, as well as the terms on most
of our other products that limit reductions in the crediting rates to
pre-established
31
intervals. As of December 31, 2008, approximately 41 percent of our insurance
liabilities were subject to interest rates that may be reset annually; 40
percent had a fixed explicit interest rate for the duration of the contract; 14
percent had credited rates that approximate the income we earn; and the
remainder had no explicit interest rates. Second, if interest rate changes
produce an unanticipated increase in surrenders of our spread-based products, we
may be forced to sell invested assets at a loss in order to fund such
surrenders. Third, the profits from many non-spread-based insurance products,
such as long-term care policies, can be adversely affected when interest rates
decline because we may be unable to reinvest the cash from premiums received at
the interest rates anticipated when we sold the policies. Finally, changes in
interest rates can have significant effects on the market value and performance
of our investments in general and specifically on the performance of our
structured securities portfolio, including collateralized mortgage obligations,
as a result of changes in the prepayment rate of the loans underlying such
securities. We employ asset/liability strategies that are designed to mitigate
the effects of interest rate changes on our profitability but do not currently
extensively employ derivative instruments for this purpose. We may not be
successful in implementing these strategies and achieving adequate investment
spreads.
We use computer models to simulate our cash flows expected from existing
business under various interest rate scenarios. These simulations help us
measure the potential gain or loss in fair value of our interest-sensitive
financial instruments. With such estimates, we seek to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, exposure to
interest rate risk is minimized because a change in the value of assets should
be largely offset by a change in the value of liabilities. At December 31, 2008,
the duration of our fixed maturity investments (as modified to reflect
prepayments and potential calls) was approximately 7.6 years, and the duration
of our insurance liabilities was approximately 7.8 years. We estimate that our
fixed maturity securities and short-term investments, net of corresponding
changes in insurance acquisition costs, would decline in fair value by
approximately $185 million if interest rates were to increase by 10 percent from
rates as of December 31, 2008. This compares to a decline in fair value of $490
million based on amounts and rates at December 31, 2007. The calculations
involved in our computer simulations incorporate numerous assumptions, require
significant estimates and assume an immediate change in interest rates without
any management reaction to such change. Consequently, potential changes in the
values of our financial instruments indicated by the simulations will likely be
different from the actual changes experienced under given interest rate
scenarios, and the differences may be material. Because we actively manage our
investments and liabilities, our net exposure to interest rates can vary over
time.
General market conditions affect investments and investment income.
The performance of our investment portfolio depends in part upon the level
of and changes in interest rates, risk spreads, real estate values, market
volatility, the performance of the economy in general, the performance of the
specific obligors included in our portfolio and other factors that are beyond
our control. Changes in these factors can affect our net investment income in
any period, and such changes can be substantial.
Financial market conditions can also affect our realized and unrealized
investment gains (losses). During periods of rising interest rates, the fair
values of our investments will typically decline. Conversely, during periods of
falling interest rates, the fair values of our investments will typically rise.
Our results of operations may be negatively impacted if our initiatives to
restructure our insurance operations are unsuccessful or if our planned
conversions result in valuation differences.
Our Conseco Insurance Group segment has experienced decreases in premium
revenues and new annualized premiums in recent years as well as expense levels
that exceed product pricing expense assumptions. We have implemented several
initiatives to improve operating results, including: (i) focusing sales efforts
on higher margin products; (ii) reducing operating expenses by eliminating or
reducing marketing costs of certain products; (iii) streamlining administrative
procedures and reducing personnel; and (iv) increasing retention rates on our
more profitable blocks of inforce business. Many of our initiatives address
issues resulting from the substantial number of acquisitions of our Predecessor.
Between 1982 and 1997, our Predecessor completed 19 transactions involving the
acquisitions of 44 separate insurance companies. Our efforts involve
improvements to our policy administration procedures and significant systems
conversions, such as the elimination of duplicate processing systems for similar
business. These initiatives may result in unforeseen expenses, complications or
delays, and may be inadequate to address all issues. Some of these initiatives
have only recently begun to be executed, and may not ultimately be successfully
completed. While our future operating performance depends greatly on the success
of these efforts, even if we successfully implement these measures, they alone
may not sufficiently improve our results of operations.
32
Conversions to new systems can result in valuation differences between the
prior system and the new system. We have recognized such differences in the
past. Our planned conversions could result in future valuation adjustments, and
there can be no assurance that these adjustments will not have a material
adverse effect on future earnings.
Our financial position may be negatively impacted if we are unable to
achieve our goals for 2009.
We have identified a number of goals for 2009, including maintaining strong
growth at Bankers Life, improving earnings stability and reducing volatility and
reducing our enterprise exposure to long-term care business. The most consistent
components of our operations in recent years have been Bankers Life and Colonial
Penn, and the continued growth and profitability of those businesses is critical
to our overall results. The failure to achieve these and our other goals for
2009 could have a material adverse effect on our results of operations,
financial condition and the price of our common stock.
A failure to improve the financial strength ratings of our insurance
subsidiaries or a decline from the current ratings could cause us to
experience decreased sales, increased agent attrition and increased
policyholder lapses and redemptions.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. Agents,
insurance brokers and marketing companies who market our products, and
prospective policyholders view ratings as an important factor in evaluating an
insurer's products. This is especially true for annuity, interest-sensitive life
insurance and long-term care products. The current financial strength ratings of
our primary insurance subsidiaries from A.M. Best, S&P and Moody's are "B
(Fair)," "BB-" and "Ba2," respectively. A.M. Best has sixteen possible ratings.
There are six ratings above our "B" rating and nine ratings that are below our
rating. S&P has twenty-one possible ratings. There are twelve ratings above our
"BB-" rating and eight ratings that are below our rating. Moody's has twenty-one
possible ratings. There are eleven ratings above our "Ba2" rating and nine
ratings that are below our rating. Most of our competitors have higher financial
strength ratings and, to be competitive over the long term, we believe it is
critical to achieve improved ratings.
If we fail to achieve ratings upgrades from A.M. Best or if our ratings are
further downgraded, we may experience declining sales of certain of our
insurance products, defections of our independent and career sales force, and
increased policies being redeemed or allowed to lapse. These events would
adversely affect our financial results, which could then lead to ratings
downgrades.
Competition from companies that have greater market share, higher ratings,
greater financial resources and stronger brand recognition, may impair our
ability to retain existing customers and sales representatives, attract new
customers and sales representatives and maintain or improve our financial
results.
The supplemental health insurance, annuity and individual life insurance
markets are highly competitive. Competitors include other life and accident and
health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
Our principal competitors vary by product line. Our main competitors for
agent sold long-term care insurance products include Genworth Financial, John
Hancock Financial Services and MetLife. Our main competitors for agent sold
Medicare supplement insurance products include United HealthCare, Blue Cross and
Blue Shield Plans, Mutual of Omaha and United American.
In some of our product lines, such as life insurance and fixed annuities,
we have a relatively small market share. Even in some of the lines in which we
are one of the top five writers, our market share is relatively small. For
example, while our Bankers Life segment ranked fourth in annualized premiums of
individual long-term care insurance in 2007 with a market share of approximately
5.4 percent, the top three writers of individual long-term care insurance had
annualized premiums with a combined market share of approximately 57 percent
during the period. In addition, while our Bankers Life segment was ranked fourth
in direct premiums earned for individual Medicare supplement insurance in 2007
with a market share of 3.8 percent, the top writer of individual Medicare
supplement insurance had direct premiums with a market share of 15.5 percent
during the period.
Virtually all of our major competitors have higher financial strength
ratings than we do. Many of our competitors are larger companies that have
greater capital, technological and marketing resources and have access to
capital at a lower cost. Recent industry consolidation, including business
combinations among insurance and other financial services companies, has
resulted in larger competitors with even greater financial resources.
Furthermore, changes in federal law have narrowed the historical separation
between banks and insurance companies, enabling traditional banking institutions
to enter the insurance
33
and annuity markets and further increase competition. This increased competition
may harm our ability to maintain or improve our profitability.
In addition, because the actual cost of products is unknown when they are
sold, we are subject to competitors who may sell a product at a price that does
not cover its actual cost. Accordingly, if we do not also lower our prices for
similar products, we may lose market share to these competitors. If we lower our
prices to maintain market share, our profitability will decline.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among insurance and financial
services companies for sales representatives. We compete for sales
representatives primarily on the basis of our financial position, financial
strength ratings, support services, compensation, products and product features.
Our competitiveness for such agents also depends upon the relationships we
develop with these agents. Our Predecessor's bankruptcy continues to be an
adverse factor in developing relationships with certain agents. If we are unable
to attract and retain sufficient numbers of sales representatives to sell our
products, our ability to compete and our revenues and profitability would
suffer.
Volatility in the securities markets, and other economic factors, may
adversely affect our business, particularly our sales of certain life
insurance products and annuities.
Fluctuations in the securities markets and other economic factors may
adversely affect sales and/or policy surrenders of our annuities and life
insurance policies. For example, volatility in the equity markets may deter
potential purchasers from investing in equity-indexed annuities and may cause
current policyholders to surrender their policies for the cash value or to
reduce their investments. In addition, significant or unusual volatility in the
general level of interest rates could negatively impact sales and/or lapse rates
on certain types of insurance products.
Federal and state legislation could adversely affect the financial
performance of our insurance operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and pending legislative proposals concerning
healthcare reform contain features that could severely limit, or eliminate, our
ability to vary pricing terms or apply medical underwriting standards to
individuals, thereby potentially increasing our benefit ratios and adversely
impacting our financial results. In particular, Medicare reform could affect our
ability to price or sell our products or profitably maintain our blocks in
force. For example, the Medicare Advantage program provides incentives for
health plans to offer managed care plans to seniors. The growth of managed care
plans under this program could decrease sales of the traditional Medicare
supplement products we sell.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards in all long-term care policies, including:
guaranteed premium rates; protection against inflation; limitations on waiting
periods for pre-existing conditions; setting standards for sales practices for
long-term care insurance; and guaranteed consumer access to information about
insurers, including information regarding lapse and replacement rates for
policies and the percentage of claims denied. Enactment of any proposal that
would limit the amount we can charge for our products, such as guaranteed
premium rates, or that would increase the benefits we must pay, such as
limitations on waiting periods, or that would otherwise increase the costs of
our business, could adversely affect our financial results.
Tax law changes could adversely affect our insurance product sales and
profitability.
We sell deferred annuities and some forms of life insurance that are
attractive, in part, because policyholders generally are not subject to United
States Federal income tax on increases in policy values until some form of
distribution is made. Congress has enacted legislation to lower marginal tax
rates, to reduce the federal estate tax gradually over a ten-year period (with
total elimination of the federal estate tax in 2010) and to increase
contributions that may be made to individual retirement accounts and 401(k)
accounts. While these tax law changes are scheduled to expire at the beginning
of 2011 absent future congressional action, they could in the interim diminish
the appeal of our annuity and life insurance products because the benefit of tax
deferral is lessened when tax rates are lower and because fewer people may
purchase these products when they can contribute more to individual retirement
accounts and 401(k) accounts. Additionally, Congress has considered, from time
to time, other possible changes to U.S. tax laws, including elimination of the
tax deferral on the accretion of value within certain annuities and life
insurance products. Such a change would make these products less attractive to
prospective purchasers and therefore would likely cause our sales of these
products to decline.
34
We face risk with respect to our reinsurance agreements.
We transfer exposure to certain risks to others through reinsurance
arrangements. Under these arrangements, other insurers assume a portion of our
losses and expenses associated with reported and unreported claims in exchange
for a portion of policy premiums. The availability, amount and cost of
reinsurance depend on general market conditions and may vary significantly. As
of December 31, 2008, our reinsurance receivables totaled $3.3 billion. Our
ceded life insurance inforce totaled $13.8 billion. Our nine largest reinsurers
accounted for 88 percent of our ceded life insurance inforce. We face credit
risk with respect to reinsurance. When we obtain reinsurance, we are still
liable for those transferred risks if the reinsurer cannot meet its obligations.
Therefore, the inability of our reinsurers to meet their financial obligations
may require us to increase liabilities, thereby reducing our net income and
shareholders' equity.
Our insurance subsidiaries may be required to pay assessments to fund other
companies' policyholder losses or liabilities and this may negatively
impact our financial results.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments up to certain
prescribed limits to fund policyholder losses or liabilities of other insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Although past assessments have not been material, if there were a
number of large insolvencies, future assessments could be material and could
have a material adverse effect on our operating results and financial position.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2. PROPERTIES.
Our headquarters and the administrative operations of our Conseco Insurance
Group segment are located on a Company-owned 117-acre corporate campus in
Carmel, Indiana, immediately north of Indianapolis. The six buildings on the
campus contain approximately 626,000 square feet of space and house Conseco's
executive offices and certain administrative operations of its subsidiaries. In
May 2007, we entered into a listing agreement for the sale/lease of one of these
buildings (approximately 100,000 square feet). Management believes that our
remaining office space is adequate for our needs.
Our Bankers Life segment is primarily administered from a facility in
downtown Chicago, Illinois. Bankers Life has approximately 222,000 square feet
leased under an agreement which expires in 2018. In addition, Bankers Life
leases approximately 114,000 square feet of space in its former location, the
Merchandise Mart. Approximately 75 percent of that space is subleased through
November 2013, the early termination date of the lease. We also lease 241 sales
offices in various states totaling approximately 710,000 square feet. These
leases are short-term in length, with remaining lease terms expiring between
2009 and 2015.
Our Colonial Penn segment is administered from a Company-owned office
building in Philadelphia, Pennsylvania with approximately 127,000 square feet.
We occupy approximately 60 percent of this space, with the remainder leased to
tenants.
ITEM 3. LEGAL PROCEEDINGS.
Information required for Item 3 is incorporated by reference to the
discussion under the heading "Legal Proceedings" in note 9 "Commitments and
Contingencies" to our consolidated financial statements included in Item 8 of
this Form 10-K.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
35
Executive Officers of the Registrant
Officer Positions with Conseco, Principal
Name and Age (a) Since Occupation and Business Experience (b)
---------------- ----- --------------------------------------
C. James Prieur, 57................................ 2006 Since September 2006, chief executive officer. From April 1999 until
September 2006, president and chief operating officer of Sun Life
Financial, Inc. and chief operating officer of its principal
subsidiary, Sun Life Assurance Company.
Edward J. Bonach, 55............................... 2007 Since May 2007, executive vice president and chief financial officer.
From 2002 until 2007, Mr. Bonach served as chief financial officer
of National Life Group.
Russell M. Bostick, 52............................. 2005 Since August 2008, executive vice president of technology and
operations. From 2005 until August 2008, executive vice president and
chief information officer. From 1998 until 2005, chief technology
officer of Chase Insurance and its predecessors.
Eric R. Johnson, 48................................ 1997 Since September 2003, president and chief executive officer of 40|86
Advisors, Conseco's wholly-owned registered investment advisor. Mr.
Johnson has held various investment management positions since joining
Conseco in 1997.
John R. Kline, 51.................................. 1990 Since July 2002, senior vice president and chief accounting officer.
Mr. Kline has served in various accounting and finance capacities
with Conseco since 1990.
Susan L. Menzel, 43................................ 2005 Since May 2005, executive vice president, human resources. From 2004
to May 2005, senior vice president, human resources of APAC Customer
Services. From 1997 to 2004, vice president, human resources of Sears
Roebuck.
Christopher J. Nickele, 52......................... 2005 Since October 2005, executive vice president, product management.
From 2002 until September 2005, vice president - product development
of Lincoln National Corporation.
Scott R. Perry, 46................................. 2001 Since 2006, president of Bankers Life. Employed in various capacities
for Bankers Life since 2001.
Steven M. Stecher, 48.............................. 2004 Since August 2008, president of Conseco Insurance Group. From January
2007 until August 2008, executive vice president, operations. From
August 2004 until January 2007, executive vice president of Conseco
Insurance Group. From 2003 until May 2004 chief information officer
of Orix Financial Services. From 1997 until 2002, Mr. Stecher held
several executive positions with ING Americas, including chief
information officer, vice president of strategic marketing and head of
shared services.
Matthew J. Zimpfer, 41............................. 2008 Since June 2008, executive vice president and general counsel. Mr.
Zimpfer has held various legal positions since joining Conseco in
1998.
Mr. Kline served as an officer of our Predecessor company, which filed a
bankruptcy petition on December 17, 2002.
36
- --------------------
(a) The executive officers serve as such at the discretion of the Board of
Directors and are elected annually.
(b) Business experience is given for at least the last five years.
PART II
-------
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES.
MARKET INFORMATION
The following table sets forth the ranges of high and low sales prices per
share for our common stock on the New York Stock Exchange for the quarterly
periods beginning January 1, 2007. There have been no dividends paid or declared
on our common stock during this period.
Period Market price
------------------
High Low
---- ---
2007:
First Quarter........................................... $20.46 $16.56
Second Quarter.......................................... 21.25 17.25
Third Quarter........................................... 21.02 13.25
Fourth Quarter.......................................... 16.26 12.05
2008:
First Quarter........................................... $12.64 $8.71
Second Quarter.......................................... 12.34 9.62
Third Quarter........................................... 10.16 3.06
Fourth Quarter.......................................... 5.21 1.31
As of February 19, 2009, there were approximately 55,700 holders of the
outstanding shares of common stock, including individual participants in
securities position listings.
37
PERFORMANCE GRAPH
The Performance Graph below compares Conseco's cumulative total shareholder
return on its common stock for the period from December 31, 2003 through
December 31, 2008 with the cumulative total return of the Standard & Poor's 500
Composite Stock Price Index (the "S&P 500 Index") and the Dow Jones Life
Insurance Index. The comparison for each of the periods assumes that $100 was
invested on December 31, 2003 in each of Conseco common stock, the stocks
included in the S&P 500 Index and the stocks included in the Dow Jones Life
Insurance Index and that all dividends were reinvested. The stock performance
shown in this graph represents past performance and should not be considered an
indication of future performance of Conseco's common stock.
COMPARISON OF CUMULATIVE TOTAL RETURN
AMONG CONSECO, S&P 500 INDEX AND DOW JONES LIFE INSURANCE INDEX
[GRAPHIC OMITTED]
Cumulative Total Returns 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08
-------- -------- -------- -------- -------- --------
DJ Life Insurance Index $ 100 $ 121 $ 148 $ 167 $ 178 $ 88
S&P 500 Index $ 100 $ 111 $ 116 $ 135 $ 142 $ 90
Conseco, Inc. $ 100 $ 92 $ 106 $ 92 $ 58 $ 24
DIVIDENDS
The Company does not anticipate declaring or paying cash dividends on its
common stock in the foreseeable future, and is currently limited in doing so
pursuant to our debt agreements. Please refer to "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations -
Liquidity of the Holding Companies" for further discussion of these
restrictions.
38
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)
October 1 through
October 31........ 10,648 $3.74 - $262.8
November 1 through
November 30....... - - - 262.8
December 1 through
December 31....... 918 3.39 - 262.8
----- -------
Total................. 11,566 3.71 - 262.8
====== =======
<FN>
- ------------
(a) The Company purchased these shares 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>
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes information, as of December 31, 2008,
relating to our common stock that may be issued under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan.
Number of securities
remaining available for
Number of securities Weighted-average future issuance under
to be issued upon exercise exercise price of equity compensation
of outstanding options, outstanding options, plans (excluding securities
warrants or rights warrants or rights reflected in first column)
------------------ ------------------ --------------------------
Equity compensation plans
approved by security holders...... 5,864,451 $16.94 1,153,732
Equity compensation plans not
approved by security holders...... - - -
--------- ------ ---------
Total................................. 5,864,451 $16.94 1,153,732
========= ====== =========
39
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
Years ended December 31,
-----------------------------------------------------
2008 2007 2006 2005 2004
---- ---- ---- ---- ----
(Amounts in millions, except per share data)
STATEMENT OF OPERATIONS DATA (a)
Insurance policy income................................. $3,253.6 $2,895.7 $2,696.4 $2,620.9 $2,611.2
Net investment income................................... 1,178.8 1,369.8 1,350.8 1,222.8 1,178.8
Net realized investment gains (losses) ................. (262.4) (158.0) (46.6) (3.3) 36.7
Total revenues.......................................... 4,189.7 4,131.3 4,019.8 3,865.1 3,848.2
Interest expense........................................ 97.8 117.3 73.5 58.3 79.5
Total benefits and expenses............................. 4,177.3 4,141.3 3,853.1 3,459.4 3,470.3
Income (loss) before income taxes, minority
interest, discontinued operations and
cumulative effect of accounting change................ 12.4 (10.0) 166.7 405.7 377.9
Income tax expense...................................... 416.4 64.0 61.0 144.1 132.5
Income (loss) before discontinued operations............ (404.0) (74.0) 105.7 261.6 245.4
Discontinued operations, net of income taxes............ (722.7) (105.9) .3 51.1 44.3
Net income (loss)....................................... (1,126.7) (179.9) 106.0 312.7 289.7
Preferred stock dividends .............................. - 14.1 38.0 38.0 65.5
Net income (loss) applicable to common stock............ (1,126.7) (194.0) 68.0 274.7 224.2
PER SHARE DATA
Income (loss) before discontinued operations, basic..... $(2.19) $ (.51) $ .45 $ 1.48 $ 1.36
Income (loss) before discontinued operations, diluted... (2.19) (.51) .45 1.41 1.31
Net income, basic....................................... (6.10) (1.12) .45 1.82 1.70
Net income, diluted..................................... (6.10) (1.12) .45 1.69 1.59
Book value per common share outstanding................. 8.76 22.94 26.50 25.27 21.34
Weighted average shares outstanding for
basic earnings........................................ 184.7 173.4 151.7 151.2 132.3
Weighted average shares outstanding for
diluted earnings...................................... 184.7 173.4 152.5 185.0 155.9
Shares outstanding at period-end........................ 184.8 184.7 152.2 151.5 151.1
BALANCE SHEET DATA - AT PERIOD END (a)
Total investments....................................... $18,647.5 $21,324.5 $23,768.8 $23,424.6 $22,169.5
Total assets............................................ 28,769.7 33,971.2 33,593.1 32,886.8 31,478.0
Corporate notes payable................................. 1,328.7 1,193.7 1,000.8 851.5 768.0
Total liabilities....................................... 27,150.5 29,735.3 28,893.0 28,389.5 27,586.1
Shareholders' equity.................................... 1,619.2 4,235.9 4,700.1 4,497.3 3,891.9
STATUTORY DATA(b) - AT PERIOD END
Statutory capital and surplus........................... $1,311.5 $1,336.2 $1,554.5 $1,603.8 $1,510.0
Asset valuation reserve ("AVR")......................... 55.0 161.3 179.1 142.7 117.0
Total statutory capital and surplus and AVR............. 1,366.5 1,497.5 1,733.6 1,746.5 1,627.0
<FN>
- --------------------
(a) As a result of the Transfer, as further discussed in the note to the
consolidated financial statements entitled "Transfer of Senior Health
Insurance Company of Pennsylvania to an Independent Trust", a
substantial portion of our long-term care business is presented as
discontinued operations in our consolidated financial statements and
prior periods have been restated to conform with the current year
presentation.
(b) We have derived the statutory data from statements filed by our
insurance subsidiaries with regulatory authorities which are prepared
in accordance with statutory accounting principles, which vary in
certain respects from GAAP, and include amounts related to our
discontinued operations in 2007, 2006, 2005 and 2004.
</FN>
40
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at December 31, 2008, and the consolidated results of operations for the years
ended December 31, 2008, 2007 and 2006 and, where appropriate, factors that may
affect future financial performance. Please read this discussion in conjunction
with the consolidated financial statements and notes included in this Form 10-K.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Our statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the SEC, press
releases, presentations by Conseco or its management or oral statements)
relative to markets for Conseco's products and trends in Conseco's operations or
financial results, as well as other statements, contain forward-looking
statements within the meaning of the federal securities laws and the Private
Securities Litigation Reform Act of 1995. Forward-looking statements typically
are identified by the use of terms such as "anticipate," "believe," "plan,"
"estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" in Item 1A provide examples
of risks, uncertainties and events that could cause our actual results to differ
materially from the expectations expressed in our forward-looking statements.
Assumptions and other important factors that could cause our actual results to
differ materially from those anticipated in our forward-looking statements
include, among other things:
o 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
and the cost of doing so;
o our ability to continue to satisfy the financial ratio and balance
requirements and other covenants of our debt agreements;
o our ability to generate sufficient liquidity to meet our debt service
obligations and other cash needs;
o our ability to obtain adequate and timely rate increases on our
supplemental health products, including our long-term care business;
o the receipt of required regulatory approvals for dividend and surplus
debenture interest payments from our insurance subsidiaries;
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 assets 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
41
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 complete the remediation of the material weakness in
internal controls over our actuarial reporting process and to maintain
effective controls over financial reporting;
o our ability to continue to recruit and retain productive agents and
distribution partners and customer response to new products,
distribution channels and marketing initiatives;
o our ability to achieve 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 regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, such as the
payment of dividends and surplus debenture interest to us, regulation
of financial services affecting (among other things) bank sales and
underwriting of insurance products, regulation of the sale,
underwriting and pricing of products, and health care regulation
affecting health insurance products; and
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products.
Other factors and assumptions not identified above are also relevant to the
forward-looking statements, and if they prove incorrect, could also cause actual
results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, 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; and corporate operations, which
consists of holding company activities and certain noninsurance company
businesses that are not part of our other segments. Prior to the fourth quarter
of 2008, we had a fourth segment comprised of other business in run-off. The
other business in run-off segment had included blocks of business that we no
longer market or underwrite and were managed separately from our other
businesses. Such segment had consisted of: (i) long-term care insurance sold in
prior years through independent agents; and (ii) major medical insurance. As a
result of the Transfer, as further discussed in the note to the consolidated
financial statements entitled "Transfer of Senior Health Insurance Company of
Pennsylvania to an Independent Trust", a substantial portion of the long-term
care business in the other business in run-off segment is presented as
discontinued operations in our consolidated financial statements. Accordingly,
we have restated all prior year segment disclosures to conform to management's
current view of the Company's operating segments. Our segments are described
below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company, 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 approximately 5,500
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.
42
o Colonial Penn, which consists of the business of Colonial Penn,
markets primarily graded benefit and simplified issue life insurance
directly to customers through television advertising, direct mail, the
internet and telemarketing. Colonial Penn markets its products under
its own brand name.
o 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
approximately 400 IMOs that represent over 2,400 independent producing
agents, including approximately 575 from PMA. 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. This
segment also includes blocks of long-term care and other health
business of these companies that we no longer market or underwrite.
For the year ended December 31, 2008, net loss applicable to common stock
totaled $1,126.7 million, or $6.10 per diluted share.
Our major goals for 2009 include:
o Managing capital and liquidity to maintain compliance with debt
covenants.
o Maintaining strong growth at Bankers Life.
o Continuing to improve the focus and profitability mix of sales at
Conseco Insurance Group.
o Improving earnings stability and reducing volatility.
o Completing the remediation project relating to our material weakness
in internal controls.
o Continuing to reduce our enterprise exposure to long-term care
business.
o Improving profitability of existing lines of business or disposing of
underperforming blocks of business.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Management has made estimates in the past
that we believed to be appropriate but were subsequently revised to reflect
actual experience. If our future experience differs materially from these
estimates and assumptions, our results of operations and financial condition
could be affected.
We base our estimates on historical experience and other assumptions that
we believe are reasonable under the circumstances. We continually evaluate the
information used to make these estimates as our business and the economic
environment change. The use of estimates is pervasive throughout our financial
statements. The accounting policies and estimates we consider most critical are
summarized below. Additional information on our accounting policies is included
in the note to our consolidated financial statements entitled "Summary of
Significant Accounting Policies".
Investments
At December 31, 2008, the carrying value of our investment portfolio was
$18.6 billion.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments. We consider anticipated prepayments on
structured securities when we estimate yields on such securities. When actual
prepayments differ from our estimates, the adjustment to yield is recognized as
investment income (loss).
We regularly evaluate our investments for possible impairment based on
current economic conditions, credit loss
43
experience and other investee-specific circumstances and developments. When we
conclude that a decline in a security's net realizable value is other than
temporary, the decline is recognized as a realized loss and the cost basis of
the security is reduced to its estimated fair value. During the year ended
December 31, 2008, writedowns of investments included: (i) $162.3 million of
writedowns of investments for other than temporary declines in fair value; and
(ii) $380.5 million of writedowns of investments (classified as discontinued
operations - which were transferred to an independent trust as further discussed
in the note to the consolidated financial statements entitled "Transfer of
Senior Health Insurance Company of Pennsylvania to an Independent Trust") 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.
Our evaluation of investments for impairment requires significant
judgments, including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) the assessment
of whether any decline in estimated fair value is other than temporary.
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 risk premium or
interest rates; (iv) the near-term prospects for improvement in the issuer
and/or its industry; (v) our view of the investment's rating and whether the
investment is investment-grade and/or has been downgraded since its purchase;
(vi) whether the issuer is current on all payments in accordance with the
contractual terms of the investment and is expected to meet all of its
obligations under the terms of the investment; (vii) our ability and intent to
hold the investment for a period of time sufficient to allow for any anticipated
recovery; and (viii) the underlying current and prospective asset and enterprise
values of the issuer and the extent to which our investment may be affected by
changes in such values. At December 31, 2008, our net accumulated other
comprehensive income (loss) included gross unrealized losses on fixed maturity
securities of $3.2 billion, which we consider to be temporary declines in
estimated fair value.
When the cost basis of a security is written down to fair value due to an
other than temporary decline, we review the circumstances of that particular
investment in relation to other investments in our portfolio. If such
circumstances exist with respect to other investments, those investments may
also be written down to fair value. Future events may occur, or additional or
updated information may become available, which may necessitate future realized
losses of securities in our portfolio. If new information becomes available or
the financial condition of the investee changes, our judgments may change
resulting in the recognition of a realized investment loss at that time.
Significant realized losses on our investments could have a material adverse
effect on our earnings in future periods.
As defined in Statement of Financial Accounting Standards No. 157 "Fair
Value Measurements" ("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 and separate account assets, 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.
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
44
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) 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.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Based on historical performance,
risk of default by the borrower is significantly greater for below-investment
grade securities and in many cases, severity of loss is relatively greater as
such securities are generally unsecured and often subordinated to other
indebtedness of the issuer. Also, issuers of below-investment grade securities
usually have higher levels of debt and may be more financially leveraged hence,
all other things being equal, more sensitive to adverse economic conditions,
such as recession or increasing interest rates. The Company attempts to reduce
the overall risk related to its investment in below-investment grade securities,
as in all investments, through careful credit analysis, strict investment policy
guidelines, and diversification by issuer and/or guarantor and by industry.
Our fixed maturity investments are generally purchased in the context of a
long-term strategy to fund insurance liabilities, so we do not generally seek to
purchase and sell such securities to generate short-term realized gains. In
certain circumstances, including those in which securities are selling at prices
which exceed our view of their current fair value, and it is possible to
reinvest the proceeds to better meet our long-term asset-liability objectives,
we may sell certain securities. During 2008, we sold $.8 billion of fixed
maturity investments which resulted in gross investment losses (before income
taxes) of $177.3 million. We sell securities at a loss for a number of reasons
including, but not limited to: (i) changes in the investment environment; (ii)
expectation that the market value could deteriorate further; (iii) desire to
reduce our exposure to an issuer or an industry; (iv) changes in credit quality;
or (v) changes in expected liability cash flows.
We generally seek to balance the duration and cash flows of our invested
assets with the estimated duration and cash flows of benefit payments arising
from contract liabilities. These efforts may cause us to sell investments before
their maturity date and could result in the realization of net realized
investment gains (losses). When the estimated durations of assets and
liabilities are similar, exposure to interest rate risk is minimized because a
change in the value of assets should be largely offset by a change in the value
of liabilities. In certain circumstances, a mismatch of the durations or related
cash flows of invested assets and insurance liabilities could have a significant
impact on our results of operations and financial position. See "-- Quantitative
and Qualitative Disclosures About Market Risks" for additional discussion of the
duration of our invested assets and insurance liabilities.
For more information on our investment portfolio and our critical
accounting policies related to investments, see the note to our consolidated
financial statements entitled "Investments".
Value of Policies Inforce at the Effective Date and Cost of Policies
Produced
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of our Predecessor's cost of policies
purchased and cost of policies produced as of the Effective Date and replaced
them with the value of policies inforce at the Effective Date.
45
The value assigned to the right to receive future cash flows from contracts
existing at the Effective Date is referred to as the value of policies inforce
at the Effective Date. We also defer renewal commissions paid in excess of
ultimate commission levels related to the existing policies in this account. The
balance of this account is amortized, evaluated for recovery, and adjusted for
the impact of unrealized gains (losses) in the same manner as the cost of
policies produced described below. We expect to amortize approximately 14
percent of the December 31, 2008 balance of value of policies inforce in 2009,
12 percent in 2010, 11 percent in 2011, 9 percent in 2012 and 7 percent in 2013.
The cost of policies produced are those costs that vary with, and are
primarily related to, producing new insurance business in the period after
September 10, 2003. For universal life or investment products, we amortize these
costs using the interest rate credited to the underlying policy in relation to
the estimated gross profits. For other products, we amortize these costs using
the projected investment earnings rate in relation to future anticipated premium
revenue. The value of policies inforce and the cost of policies produced are
collectively referred to as "insurance acquisition costs."
Insurance acquisition costs are amortized to expense over the lives of the
underlying policies in relation to future anticipated premiums or gross profits.
The insurance acquisition costs for policies other than universal life and
investment-type products are amortized with interest (using the projected
investment earnings rate) over the estimated premium-paying period of the
policies, in a manner which recognizes amortization expense in proportion to
each year's premium income. The insurance acquisition costs for universal life
and investment-type products are amortized with interest (using the interest
rate credited to the underlying policy) in proportion to estimated gross
profits. The interest, mortality, morbidity and persistency assumptions used to
amortize insurance acquisition costs are consistent with those assumptions used
to estimate liabilities for insurance products. For universal life and
investment-type products, these assumptions are reviewed on a regular basis.
When actual profits or our current best estimates of future profits are
different from previous estimates, we adjust cumulative amortization of
insurance acquisition costs to maintain amortization expense as a constant
percentage of gross profits over the entire life of the policies.
During the fourth quarter of 2008, we were required to accelerate the
amortization of insurance acquisition costs related to a block of equity-indexed
annuities. This block of business experienced higher than anticipated surrenders
during the year. These annuities also have a market value adjustment ("MVA")
feature, which effectively reduced (or in some cases, eliminated) the charges
paid upon surrender in the fourth quarter of 2008 as the 10-year treasury rate
dropped. The impact of both the historical experience and the projected
increased surrender activity and higher MVA benefits has reduced our
expectations on the profitability of this block to approximately break-even. We
recognized additional amortization of approximately $5 million related to the
actual and expected future changes in the experience of this block. We continue
to hold insurance acquisition costs of approximately $80 million related to
these products, which we determined are recoverable. Results for this block are
expected to exhibit increased volatility in the future, because almost all of
the difference between our assumptions and actual experience will be reflected
in earnings in the period such differences occur.
During the fourth quarter of 2008, a detailed analysis was performed on a
universal life block of business that led to the changes in our assumptions of
future mortality, surrenders, premium persistency, expenses and investment
income. We recognized additional amortization expense of approximately $8
million to reflect changes in our estimates of future policyholder assumptions
on our universal life business, net of planned increases to associated
policyholder charges.
During 2007, we were required to accelerate the amortization of insurance
acquisition costs related to our universal life products because the prior
balance was not recoverable by the value of future estimated gross profits on
this block. This additional amortization was necessary so that our insurance
acquisition costs would not exceed the value of future estimated gross profits
and is expected to continue to be recognized in subsequent periods. Because our
insurance acquisition costs are now equal to the value of future estimated gross
profits, this block is expected to generate break-even earnings in the future.
We continue to hold insurance acquisition costs of approximately $140 million
related to these products, which we determined are recoverable by the value of
estimated gross profits. In addition, results for this block are expected to
exhibit increased volatility in the future, because the entire difference
between our assumptions and actual experience is expected to be reflected in
earnings in the period such differences occur.
During the fourth quarter of 2007, we recognized additional amortization
expense of $14.8 million to reflect changes in our estimates of future mortality
rates on our universal life business, net of planned increases to associated
policyholder charges.
During the fourth quarter of 2006, we recognized additional amortization
expense of $7.8 million to reflect a change in an actuarial assumption related
to a block of interest-sensitive life insurance policies based on a change in
management's
46
intent on the administration of such policies. The policies affected by the
adjustments described above were issued through a subsidiary prior to its
acquisition by Conseco in 1996.
During the first quarter of 2006, we made certain adjustments to our
assumptions of expected future profits for the annuity and universal life blocks
of business in this segment related to investment returns, lapse rates, the cost
of options underlying our equity-indexed products and other refinements. We
recognized additional amortization expense of $12.4 million in 2006 due to these
changes. This increase to amortization expense was offset by a reduction to
insurance policy benefit expense of $11.5 million, to reflect the effect of the
changes in these assumptions on the calculation of certain insurance
liabilities, such as the liability to purchase future options underlying our
equity-indexed products.
When lapses of our insurance products exceed levels assumed in determining
the amortization of insurance intangibles, we adjust amortization to reflect the
change in future premiums or estimated gross profits resulting from the
unexpected lapses. We recognized additional amortization expense of $7.9 million
during the first six months of 2006 as a result of higher than expected lapses
of our Medicare supplement products. We believe the unexpected lapses were
primarily related to premium rate increases and competition from companies
offering Medicare Advantage products. During the first nine months of 2006, we
changed our estimates of the future gross profits of certain universal life
products, which under certain circumstances are eligible for interest bonuses in
addition to the declared base rate. These interest bonuses are not required in
the current crediting rate environment and our estimates of future gross profits
have been changed to reflect the discontinuance of the bonus. We reduced
amortization expense by $4.0 million during the first six months of 2006 as a
result of this change. There have been no other significant changes to
assumptions used to amortize insurance acquisition costs during 2008, 2007 or
2006. Revisions to assumptions in future periods could have a significant
adverse or favorable effect on our results of operations and financial position.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization of insurance acquisition
costs to reflect the change in estimated gross profits from the products due to
the gain or loss realized and the effect on future investment yields. We
decreased amortization expense for such changes by $21.5 million, $35.7 million
and $10.1 million during the years ended December 31, 2008, 2007 and 2006,
respectively. We also adjust insurance acquisition costs for the change in
amortization that would have been recorded if actively managed fixed maturity
securities had been sold at their stated aggregate fair value and the proceeds
reinvested at current yields. We include the impact of this adjustment in
accumulated other comprehensive income (loss) within shareholders' equity. We
limit the total adjustment related to unrealized losses to the total of the
costs capitalized plus interest (or the total value of policies inforce
recognized at the Effective Date plus interest with respect to the value of
policies inforce at the Effective Date) related to insurance policies issued in
a particular year (or policies inforce at the Effective Date with respect to the
value of policies inforce at the Effective Date). The investment environment
during the fourth quarter of 2008 resulted in significant net unrealized losses
in our actively managed fixed maturity investment portfolio. The total
adjustment to accumulated other comprehensive income related to the change in
the cost of policies produced for the negative amortization that would have been
recorded if actively managed fixed maturity securities had been sold at their
stated aggregate fair value would have resulted in the balance of the cost of
policies produced exceeding the total of costs capitalized plus interest for
annuity blocks of business issued in certain years. Accordingly, the adjustment
made to the cost of policies produced and accumulated other comprehensive income
was reduced by $206 million. The total pre-tax impact of such adjustments on
accumulated other comprehensive income (loss) was an increase of $265.8 million
at December 31, 2008.
At December 31, 2008, the balance of insurance acquisition costs was $3.3
billion. The recoverability of this amount is dependent on the future
profitability of the related business. Each year, we evaluate the recoverability
of the unamortized balance of insurance acquisition costs. These evaluations are
performed to determine whether estimates of the present value of future cash
flows, in combination with the related liability for insurance products, will
support the unamortized balance. These future cash flows are based on our best
estimate of future premium income, less benefits and expenses. The present value
of these cash flows, plus the related balance of liabilities for insurance
products, is then compared with the unamortized balance of insurance acquisition
costs. In the event of a deficiency, such amount would be charged to
amortization expense. The determination of future cash flows involves
significant judgment. Revisions to the assumptions which determine such cash
flows could have a significant adverse effect on our results of operations and
financial position.
47
The table presented below summarizes our estimates of cumulative
adjustments to insurance acquisition costs resulting from hypothetical revisions
to certain assumptions. Although such hypothetical revisions are not currently
required or anticipated, we believe they could occur based on past variances in
experience and our expectations of the ranges of future experience that could
reasonably occur. We have assumed that revisions to assumptions resulting in the
adjustments summarized below would occur equally among policy types, ages and
durations within each product classification. Any actual adjustment would be
dependent on the specific policies affected and, therefore, may differ from the
estimates summarized below. In addition, the impact of actual adjustments would
reflect the net effect of all changes in assumptions during the period.
Estimated adjustment to
income before
income taxes based on
Change in assumptions revisions to certain assumptions
--------------------------------
(dollars in millions)
Universal life-type products (a):
5% increase to assumed mortality.................................. $ (80.5)
5% decrease to assumed mortality.................................. 103.3
15% increase to assumed expenses.................................. (22.1)
15% decrease to assumed expenses.................................. 22.1
10 basis point decrease to assumed spread......................... (21.5)
10 basis point increase to assumed spread......................... 21.2
10% increase to assumed lapses.................................... (7.3)
10% decrease to assumed lapses.................................... 7.8
Investment-type products:
20% increase to assumed surrenders................................ (33.0)
20% decrease to assumed surrenders................................ 44.7
15% increase to assumed expenses.................................. (3.8)
15% decrease to assumed expenses.................................. 4.0
10 basis point decrease to assumed spread......................... (21.9)
10 basis point increase to assumed spread......................... 21.9
Other than universal life and investment-type products (b):
5% increase to assumed morbidity.................................. (305.0)
50 basis point decrease to investment earnings rate............... (231.5)
15% increase to assumed expenses.................................. (13.9)
10% decrease to assumed lapses.................................... (27.4)
<FN>
- --------------------
(a) A significant portion of our universal life-type products inforce are
in loss recognition status. A favorable change in experience on such
blocks may slow down future amortization; however, the current period
adjustment to insurance acquisition costs would be small. This causes
the downside sensitivities above to be lower in magnitude than the
upside results.
(b) We have excluded the effect of reasonably likely changes in mortality,
lapse, surrender and expense assumptions for policies other than
universal life and investment-type products. Our estimates indicate
such changes would not result in any portion of the $2.2 billion
balance of unamortized insurance acquisition costs related to these
policies being unrecoverable.
</FN>
Accounting for marketing and reinsurance agreements with Coventry
Prescription Drug Benefit
The MMA provided for the introduction of a PDP product. In order to offer
this product to our current and potential future policyholders without investing
in management and infrastructure, we entered into a national distribution
agreement with Coventry to use our career and independent agents to distribute
Coventry's prescription drug plan, Advantra Rx. We receive a fee based on the
premiums collected on plans sold through our distribution channels. In addition,
Conseco has a quota-share reinsurance agreement with Coventry for Conseco
enrollees that provides Conseco with 50 percent of net premiums and related
policy benefits subject to a risk corridor. The Part D program was effective
January 1, 2006.
48
The following describes how we account for and report our PDP business:
Our accounting for the national distribution agreement
o We recognize distribution and licensing fee income from Coventry based
upon negotiated percentages of collected premiums on the underlying
Medicare Part D contracts. This fee income is recognized over the
calendar year term as premiums are collected.
o We also pay commissions to our agents who sell the plans on behalf of
Coventry. These payments are deferred and amortized over the remaining
term of the initial enrollment period (the one-year life of the
initial policy).
Our accounting for the quota-share agreement
o We recognize premium revenue evenly over the period of the underlying
Medicare Part D contracts.
o We recognize policyholder benefits and ceding commission expense as
incurred.
o We recognize risk-share premium adjustments consistent with Coventry's
risk-share agreement with the Centers for Medicare and Medicaid
Services.
The following summarizes the pre-tax income (loss) of the PDP business
(dollars in millions):
2008 2007 2006
---- ---- ----
Insurance policy income................................ $67.1 $70.8 $74.4
Fee revenue and other.................................. 2.6 2.4 5.3
----- ----- -----
Total revenues....................................... 69.7 73.2 79.7
----- ----- -----
Insurance policy benefits.............................. 62.3 57.2 59.6
Commission expense..................................... 6.0 6.4 8.7
Other operating expenses............................... 2.1 1.0 6.5
----- ----- -----
Total expense........................................ 70.4 64.6 74.8
----- ----- -----
Pre-tax income (loss)................................ $ (.7) $ 8.6 $ 4.9
===== ===== =====
Private-Fee-For-Service
Conseco expanded its strategic alliance with Coventry by entering into a
national distribution agreement under which our career agents began distributing
Coventry's PFFS plan, beginning January 1, 2007. The Advantra Freedom product is
a Medicare Advantage plan designed to provide seniors with more choices and
better coverage at lower cost than original Medicare and Medicare Advantage
plans offered through HMOs. Under the agreement, we receive a fee based on the
number of PFFS plans sold through our distribution channels. In addition,
Conseco has a quota-share reinsurance agreement with Coventry for Conseco
enrollees that provides Conseco with a specified percentage of the net premiums
and related profits.
We receive distribution fees from Coventry and we pay sales commissions to
our agents for these enrollments. In addition, we receive a specified percentage
of the income (loss) related to this business pursuant to a quota-share
agreement with Coventry.
49
The following summarizes our accounting and reporting practices for the
PFFS business.
Our accounting for the distribution agreement
o We receive distribution income from Coventry and other parties based
on a fixed fee per PFFS contract. This income is deferred and
recognized over the remaining calendar year term of the initial
enrollment period.
o We also pay commissions to our agents who sell the plans on behalf of
Coventry and other parties. These payments are deferred and amortized
over the remaining term of the initial enrollment period (the one-year
life of the initial policy).
Our accounting for the quota-share agreement
o We recognize revenue evenly over the period of the underlying PFFS
contracts.
o We recognize policyholder benefits and ceding commission expense as
incurred.
The following summarizes the pre-tax income (loss) of the PFFS business
(dollars in millions):
2008 2007
---- ----
Insurance policy income............................ $229.0 $100.8
Fee revenue and other.............................. 8.3 8.6
------ ------
Total revenues................................. 237.3 109.4
------ ------
Insurance policy benefits.......................... 221.8 82.7
Commission expense................................. 8.0 4.2
Other operating expenses........................... 12.7 8.8
------ ------
Total expense.................................. 242.5 95.7
------ ------
Pre-tax income (loss).............................. $ (5.2) $ 13.7
====== ======
Large Group Private-Fee-For-Service Blocks
During 2007 and 2008, Conseco entered into three quota-share reinsurance
agreements with Coventry related to the PFFS business written by Coventry under
certain group policies. Conseco receives a specified percentage of the net
premiums and related profits associated with this business as long as the ceded
revenue margin is less than or equal to five percent. Conseco receives a
specified percentage of the net premiums and related profits on the ceded margin
in excess of five percent. In order to reduce the required statutory capital
associated with the assumption of this business, Conseco terminated two group
policy quota-share agreements as of December 31, 2008 and will terminate the
last agreement on June 30, 2009. The following summarizes the premiums assumed,
related expenses and pre-tax income of this business (dollars in millions):
2008 2007
---- ----
Premiums assumed................................... $313.5 $99.8
------ -----
Policy benefits.................................... 301.1 91.2
Commission expense................................. 12.0 4.1
------ -----
Total expenses................................. 313.1 95.3
------ -----
Pre-tax income..................................... $ .4 $ 4.5
====== =====
50
Income Taxes
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.
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 December 31, 2008, we
have incurred a cumulative loss over the evaluation period, resulting from the
substantial loss during 2008 primarily related to the transfer of Senior Health
to an independent trust as described in the note to these consolidated financial
statements entitled "Transfer of Senior Health Insurance Company of Pennsylvania
to an Independent Trust". 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 December 31, 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. 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.
At December 31, 2008, our valuation allowance for our net deferred tax
assets was $1.2 billion, 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 December 31, 2008, we believe
that we will, more likely than not, recover $2.1 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 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 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 similar 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
51
Section 382 of the Code. Section 382 imposes limitations on a corporation's
ability to use its NOLs when the company undergoes an ownership change. Because
the Company underwent an ownership change pursuant to its reorganization, this
limitation applies to the Company. Any losses that are subject to the Section
382 limitation will only be utilized by the Company up to approximately $142
million per year with any unused amounts carried forward to the following year.
Absent an additional ownership charge, our Section 382 limitation for 2009 will
be approximately $662 million (including $520 million of unused amounts carried
forward from prior years).
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets because we believed that the realization of such
net deferred income tax assets in future periods was uncertain. During 2006, we
concluded that it was no longer necessary to hold certain portions of the
previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $260.0 million in 2006. However, we are required to
continue to hold a valuation allowance of $1.2 billion at December 31, 2008
because we have determined that it is more likely than not that a portion of our
deferred tax assets will not be realized. This determination was made by
evaluating each component of the deferred tax asset and assessing the effects of
limitations or interpretations on the value of such component to be fully
recognized in the future.
Changes in our valuation allowance are summarized as follows (dollars in
millions):
Balance at December 31, 2005............................................. $1,043.8
Expiration of NOL and capital loss carryforwards....................... (6.0)
Release of valuation allowance (a)..................................... (260.0)
--------
Balance at December 31, 2006............................................. 777.8
Increase in 2007....................................................... 68.0
Expiration of capital loss carryforwards............................... (157.6)
Write-off of certain state NOLs (recovery is remote)................... (15.3)
--------
Balance at December 31, 2007............................................. 672.9
Increase in 2008....................................................... 856.2 (b)
Expiration of capital loss carryforwards............................... (209.7)
Write-off of capital loss carryforwards related to Senior Health....... (133.2)
Write-off of certain NOLs related to Senior Health..................... (5.5)
--------
Balance at December 31, 2008............................................. $1,180.7
========
<FN>
- --------------------
(a) There is a corresponding increase to additional paid-in capital.
(b) The $856.2 million increase to our valuation allowance during 2008
included increases of: (i) $452 million of deferred tax assets related
to Senior Health, which was transferred to an independent trust during
2008; (ii) $298 million related to our reassessment of the recovery of
our deferred tax assets in accordance with GAAP, following the
additional losses incurred as a result of the transaction to transfer
Senior Health to an independent trust; (iii) $60 million related to
the recognition of additional realized investment losses for which we
are unlikely to receive any tax benefit; and (iv) $45 million related
to the projected additional future expense following the modifications
to our Second Amended Credit Facility as described in the note to
these consolidated financial statements entitled "Subsequent Events."
</FN>
52
As of December 31, 2008, we had $4.8 billion of federal NOLs and $1.2
billion of capital loss carryforwards, which expire as follows (dollars in
millions):
Net operating
loss carryforwards(a) Total loss carryforwards
--------------------- Capital loss Total loss ---------------------------------------
Year of expiration Life Non-life carryforwards carryforwards Subject to ss.382 Not subject to ss.382
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
2009....... $ - $ - $ 86.2 $ 86.2 $ - $ 86.2
2010....... - .1 - .1 .1 -
2011....... - .1 - .1 .1 -
2012....... - - 63.6 63.6 - 63.6
2013....... - - 1,010.1 1,010.1 - 1,010.1
2017....... 12.2 - - 12.2 12.2 -
2018....... 2,152.4 (a) - - 2,152.4 38.1 2,114.3
2021....... 29.6 - - 29.6 - 29.6
2022....... 207.9 - - 207.9 - 207.9
2023....... - 2,073.7 (a) - 2,073.7 71.1 2,002.6
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 1.6 - 1.6 - 1.6
2027....... - 188.4 - 188.4 - 188.4
2028....... - .9 - .9 - .9
-------- -------- -------- -------- ------- --------
Total...... $2,402.1 $2,386.8 $1,159.9 $5,948.8 $ 121.6 $5,827.2
======== ======== ======== ======== ======= ========
<FN>
- --------------------
(a) The allocation of the NOLs summarized above assumes the IRS does not
take an adverse position in the future regarding the tax position we
plan to take in our tax returns with respect to the allocation of
cancellation of indebtedness income. If the IRS disagrees with the tax
position we plan to take with respect to the allocation of
cancellation of indebtedness income, and their position prevails,
approximately $631 million of the NOLs expiring in 2018 would be
characterized as non-life NOLs.
</FN>
The Company adopted FASB Interpretation No. 48 "Accounting for Uncertainty
in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48") on
January 1, 2007, which resulted in a $6 million increase to additional paid-in
capital. As of January 1, 2007 and December 31, 2007, the amount of unrecognized
tax benefits was not significant. While it is expected that the amount of
unrecognized tax benefits will change in the next twelve months, the Company
does not expect the change to have a significant impact on its results of
operations.
As more fully discussed below, the Company's interpretation of the tax law,
as it relates to the application of the cancellation of indebtedness income to
its NOLs, is an uncertain tax position. Since all other life NOLs must be
utilized prior to this portion of the NOL, it has not yet been utilized nor is
it expected to be utilized within the next twelve months. As a result, an
uncertain tax position has not yet been taken on the Company's tax return.
Although FIN 48 allowed a change in accounting, the Company has chosen to
continue its past accounting policy of classifying interest and penalties as
income tax expense in the consolidated statement of operations. No such amounts
were recognized in 2008 or 2007. The liability for accrued interest and
penalties was not significant at December 31, 2008 or December 31, 2007.
Tax years 2005 through 2007 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 2005 through 2007
based on the individual state statutes of limitation.
The following paragraphs describe an open matter related to the
classification of our NOLs.
In July 2006, the Joint Committee of Taxation accepted the audit and the
settlement which characterized $2.1 billion of the tax losses on our
Predecessor's investment in Conseco Finance Corp. as life company losses and the
remaining amount as non-life losses prior to the application of the cancellation
of indebtedness attribute reductions described below. As a result
53
of the approval of the settlement, we concluded it was appropriate to reduce our
valuation allowance by $260 million in the second quarter of 2006, which was
accounted for as an addition to paid-in capital.
The Code provides that any income realized as a result of the cancellation
of indebtedness in bankruptcy (cancellation of debt income or "CODI") must
reduce NOLs. We realized an estimated $2.5 billion of CODI when we emerged from
bankruptcy. Pursuant to the Company's interpretation of the tax law, the CODI
reductions were all used to reduce non-life NOLs. However, if the IRS were to
disagree with our interpretation and ultimately prevail, we believe
approximately $631 million of NOLs classified as life company NOLs would be
re-characterized as non-life NOLs and subject to the 35% limitation discussed
above. Such a re-characterization would also extend the year of expiration as
life company NOLs expire after 15 years whereas non-life NOLs expire after 20
years. The Company does not expect the IRS to consider this issue for a number
of years.
The Company adopted Statement of Financial Accounting Standards No. 123R
"Accounting for Stock-Based Compensation" in calendar year 2006. Pursuant to
this accounting rule, the Company is precluded from recognizing the tax benefits
of any tax windfall upon the exercise of a stock option or the vesting of
restricted stock unless such deduction resulted in actual cash savings to the
Company. Because of the Company's NOLs, no cash savings have occurred. NOL
carryforwards of $1.9 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital if realized.
Liabilities for Insurance Products
At December 31, 2008, the total balance of our liabilities for insurance
products was $24.2 billion. These liabilities are generally payable over an
extended period of time and the profitability of the related products is
dependent on the pricing of the products and other factors. Differences between
our expectations when we sold these products and our actual experience could
result in future losses.
We calculate and maintain reserves for the future payment of claims to our
policyholders based on actuarial assumptions. For all our insurance products, we
establish an active life reserve, a liability for due and unpaid claims, claims
in the course of settlement and incurred but not reported claims. In addition,
for our supplemental health insurance business, we establish a reserve for the
present value of amounts not yet due on claims. Many factors can affect these
reserves and liabilities, such as economic and social conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal liability and
extra-contractual damage awards. Therefore, our reserves and liabilities are
necessarily based on numerous estimates and assumptions as well as historical
experience. Establishing reserves is an uncertain process, and it is possible
that actual claims will materially exceed our reserves and have a material
adverse effect on our results of operations and financial condition. We have
incurred significant losses beyond our estimates as a result of actual claim
costs and persistency of our long-term care business of Senior Health and
Washington National. Our financial results depend significantly upon the extent
to which our actual claims experience is consistent with the assumptions we used
in determining our reserves and pricing our products. If our assumptions with
respect to future claims are incorrect, and our reserves are insufficient to
cover our actual losses and expenses, we would be required to increase our
liabilities, which would negatively affect our operating results.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and standard actuarial tables, of
mortality, morbidity, lapse rates, investment experience and expense levels.
Accounting for Long-term Care Premium Rate Increases
Many of our long-term care policies were subject to premium rate increases
in 2006 and 2007. In some cases, these premium rate increases were reasonably
consistent with the assumptions we used to value the particular block of
business at the fresh-start date. With respect to the 2006 premium rate
increases, some of our policyholders were provided an option to cease paying
their premiums and receive a non-forfeiture option in the form of a paid-up
policy with limited benefits. In addition, our policyholders could choose to
reduce their coverage amounts and premiums in the same proportion, when
permitted by our contracts or as required by regulators. The following describes
how we account for these premium rate increases and related policyholder
options:
o Premium rate increases - 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
54
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.
o Benefit reductions - If there is a premium rate increase on one of our
long-term care policies, a policyholder may choose reduced coverage
with a proportionate reduction in premium, when permitted by our
contracts. This option does not require additional underwriting.
Benefit reductions are treated as a partial lapse of coverage, and the
balance of our reserves and deferred insurance acquisition costs is
reduced in proportion to the reduced coverage.
o Non-forfeiture benefits offered in conjunction with a rate increase -
In some cases, non-forfeiture benefits are offered to policyholders
who wish to lapse their policies at the time of a significant rate
increase. In these cases, exercise of this option is treated as an
extinguishment of the original contract and issuance of a new
contract. The balance of our reserves and deferred insurance
acquisition costs are released, and a reserve for the new contract is
established.
o Florida Order - In 2004, the Florida Office of Insurance Regulation
issued an order to Washington National regarding its home health care
business in Florida. The order required Washington National to offer a
choice of three alternatives to holders of home health care policies
in Florida subject to premium rate increases as follows:
o retention of their current policy with a rate increase of 50
percent in the first year and actuarially justified increases
in subsequent years;
o receipt of a replacement policy with reduced benefits and a
rate increase in the first year of 25 percent and no more than
15 percent in subsequent years; or
o receipt of a paid-up policy, allowing the holder to file
future claims up to 100 percent of the amount of premiums paid
since the inception of the policy.
Reserves for all three groups of policies under the order were
prospectively adjusted using the prospective revision methodology
described above, as these alternatives were required by the Florida
Office of Insurance Regulation. These policies had no insurance
acquisition costs established at the Effective Date.
Some of our policyholders may receive a non-forfeiture benefit if they cease
paying their premiums pursuant to their original contract (or pursuant to
changes made to their original contract as a result of a litigation settlement
made prior to the Effective Date or an order issued by the Florida Office of
Insurance Regulation). In these cases, exercise of this option is treated as the
exercise of a policy benefit, and the reserve for premium paying benefits is
reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect
the election of this benefit.
Liabilities for Loss Contingencies Related to Lawsuits and Our Guarantees
of Bank Loans and Related Interest Loans
We are involved on an ongoing basis in arbitrations and lawsuits, including
purported class actions. The ultimate outcome of these legal matters cannot be
predicted with certainty. We recognize an estimated loss from these loss
contingencies when we believe it is probable that a loss has been incurred and
the amount of the loss can be reasonably estimated. However, it is difficult to
measure the actual loss that might be incurred related to litigation. The
ultimate outcome of these lawsuits could have a significant impact on our
results of operations and financial position.
In conjunction with our bankruptcy reorganization in 2003, $481.3 million
principal amount of bank loans made to certain former directors and employees to
enable them to purchase common stock of our Predecessor were transferred to the
Company. These loans had been guaranteed by our Predecessor. We received all
rights to collect the balances due pursuant to the original terms of these
loans. In addition, we hold loans to participants for interest on the loans. The
loans and the interest loans are collectively referred to as the "D&O loans." We
regularly evaluate the collectibility of these loans in light of the credit
worthiness of the participants and the current status of various legal actions
we have taken to collect the D&O loans. At December 31, 2008, we have estimated
that approximately $10.0 million of the D&O loan balance (which is included in
other assets) is collectible (net of the costs of collection). An allowance has
been established to reduce the total D&O loan balance to the amount we estimated
was recoverable.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in connection with our bankruptcy
reorganization in
55
2003, the former holders of TOPrS (issued by our Predecessor's subsidiary trusts
and eliminated in our reorganization) who did not opt out of the bankruptcy
settlement will be entitled to receive 45 percent of any proceeds from the
collection of certain D&O loans in an aggregate amount not to exceed $30
million. As of December 31, 2008, we had paid $19.3 million to the former
holders of TOPrS and we have established a liability of $4.3 million (which is
included in other liabilities), representing our estimate of the additional
amount which will be paid to the former holders of TOPrS pursuant to the
settlement.
RESULTS OF OPERATIONS:
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; and corporate operations, which
consists of holding company activities and certain noninsurance businesses.
Please read this discussion in conjunction with the consolidated financial
statements and notes included in this Form 10-K.
The following tables and narratives summarize the operating results of our
segments (dollars in millions):
2008 2007 2006
---- ---- ----
Income (loss) before net realized investment gains (losses), net of related
amortization and income taxes (a non-GAAP measure) (a):
Bankers Life....................................................... $ 171.5 $ 241.8 $265.3
Colonial Penn...................................................... 25.2 18.1 21.6
Conseco Insurance Group............................................ 121.3 (26.3) (3.0)
Corporate operations............................................... (64.7) (121.3) (80.7)
------- ------- ------
253.3 112.3 203.2
------- ------- ------
Net realized investment gains (losses), net of related amortization:
Bankers Life....................................................... (100.9) (17.4) (16.3)
Colonial Penn...................................................... (1.6) (.2) .2
Conseco Insurance Group............................................ (87.6) (98.5) (20.0)
Corporate operations............................................... (50.8) (6.2) (.4)
------- ------- ------
(240.9) (122.3) (36.5)
------- ------- ------
Income (loss) before income taxes:
Bankers Life....................................................... 70.6 224.4 249.0
Colonial Penn...................................................... 23.6 17.9 21.8
Conseco Insurance Group............................................ 33.7 (124.8) (23.0)
Corporate operations............................................... (115.5) (127.5) (81.1)
------- ------- ------
Income (loss) before income taxes................................. $ 12.4 $ (10.0) $166.7
======= ======= ======
<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
</FN>
56
131"), excluding realized investment gains (losses) because we believe
that this performance measure is a better indicator of the ongoing
businesses and trends in our business. Our investment focus is on
investment income to support our liabilities for insurance products as
opposed to the generation of realized investment gains (losses), and a
long-term focus is necessary to maintain profitability over the life
of the business. Realized investment gains (losses) depend on market
conditions and do not necessarily relate to decisions regarding the
underlying business of our segments. However, "income (loss) before
net realized investment gains (losses), net of related amortization,
and before income taxes" does not replace "income (loss) before income
taxes" as a measure of overall profitability. We may experience
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.
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.
57
Bankers Life (dollars in millions)
2008 2007 2006
---- ---- ----
Premium collections:
Annuities........................................................... $ 1,224.1 $ 885.5 $ 997.5
Supplemental health................................................. 1,887.0 1,546.1 1,308.3
Life................................................................ 209.4 200.0 184.2
--------- -------- --------
Total collections................................................. $ 3,320.5 $2,631.6 $2,490.0
========= ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based................................................. $ 252.9 $ 281.6 $ 271.8
Equity-indexed.................................................. 1,203.0 787.4 500.2
Deposit based................................................... 4,464.3 4,507.4 4,435.4
Health.............................................................. 3,880.5 3,569.7 3,310.2
Life:
Interest sensitive.............................................. 385.9 364.2 341.5
Non-interest sensitive.......................................... 357.8 299.1 246.7
--------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded........................... $10,544.4 $9,809.4 $9,105.8
========= ======== ========
Revenues:
Insurance policy income............................................. $ 2,109.9 $1,780.0 $1,545.5
Net investment income:
General account invested assets................................... 617.1 578.7 513.3
Equity-indexed products........................................... (49.4) (10.6) 12.3
Other special-purpose portfolios.................................. (9.5) 4.2 -
Fee revenue and other income........................................ 11.0 12.0 6.0
--------- -------- --------
Total revenues.................................................. 2,679.1 2,364.3 2,077.1
--------- -------- --------
Expenses:
Insurance policy benefits........................................... 1,879.9 1,480.6 1,216.2
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than equity-indexed products..................... 175.7 180.9 173.6
Equity-indexed products........................................... 34.8 23.2 20.8
Amortization related to operations.................................. 234.8 264.0 241.0
Interest expense on investment borrowings........................... - - .1
Other operating costs and expenses.................................. 182.4 173.8 160.1
--------- -------- --------
Total benefits and expenses..................................... 2,507.6 2,122.5 1,811.8
--------- -------- --------
Income before net realized investment losses,
net of related amortization and income taxes........................ 171.5 241.8 265.3
--------- -------- --------
Net realized investment losses.................................... (116.7) (19.9) (19.5)
Amortization related to net realized investment losses............ 15.8 2.5 3.2
--------- -------- --------
Net realized investment losses,
net of related amortization................................. (100.9) (17.4) (16.3)
--------- -------- --------
Income before income taxes............................................... $ 70.6 $ 224.4 $ 249.0
========= ======== ========
(continued)
58
(continued from previous page)
2008 2007 2006
---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits.......................................... $1,709.4 $1,298.0 $1,058.8
Benefit ratio (a).................................................. 91.3% 84.4% 79.9%
Medicare supplement:
Insurance policy benefits.......................................... $452.3 $433.3 $436.6
Benefit ratio (a).................................................. 70.8% 67.2% 66.6%
PDP and PFFS:
Insurance policy benefits.......................................... $585.1 $231.1 $59.6
Benefit ratio (a).................................................. 96.0% 85.1% 80.0%
Long-term care:
Insurance policy benefits.......................................... $672.0 $633.6 $562.6
Benefit ratio (a).................................................. 107.6% 102.0% 94.5%
Interest-adjusted benefit ratio (b)................................ 74.0% 70.8% 64.9%
<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 $210.1 million, $193.8 million and $175.9 million in
2008, 2007 and 2006, respectively.
</FN>
59
Total premium collections were $3,320.5 million in 2008, up 26 percent from
2007, and $2,631.6 million in 2007, up 5.7 percent from 2006. Premium
collections include $614.0 million, $277.8 million and $76.7 million in 2008,
2007, and 2006, respectively, of premiums collected pursuant to the quota-share
agreements with Coventry described above under "Accounting for marketing and
reinsurance 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
$10.5 billion in 2008, up 7.5 percent from 2007, and $9.8 billion in 2007, up
7.7 percent from 2006. 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 $609.6 million, $271.4 million
and $74.4 million in 2008, 2007 and 2006, respectively, of premium income from
the quota-share agreements with Coventry described above under "Accounting for
marketing and reinsurance agreements with Coventry".
Net investment income on general account invested assets (which excludes
income on policyholder accounts) increased 6.6 percent, to $617.1 million, in
2008 and 13 percent, to $578.7 million, in 2007. The average balance of general
account invested assets was $10.6 billion, $10.0 billion and $9.2 billion in
2008, 2007 and 2006, respectively. The average yield on these assets was 5.83
percent in 2008, 5.79 percent in 2007 and 5.59 percent in 2006. 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 $(67.0) million, $(11.2) million and $12.3 million
in 2008, 2007 and 2006, respectively. Net investment income related to
equity-indexed products also includes income (loss) on trading securities which
are held to act as hedges for embedded derivates related to equity-indexed
products. Such trading account income (loss) was $17.6 million and $.6 million
in 2008 and 2007, respectively. There was no such trading account income in
2006. 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 2008 were affected by a reduction to earnings of $21.0
million 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 agent deferred compensation plan, and as a
result, are accounted for outside the plan and are recorded in the consolidated
balance sheet as other invested assets. Changes in the cash surrender value
(which approximates net realizable value) of the COLI assets are recorded as net
investment income (loss) and totaled $(9.5) million and $1.5 million in 2008 and
2007, respectively. We also recognized a death benefit of $2.7 million under the
COLI in 2007.
Fee revenue and other income was $11.0 million in 2008, compared to $12.0
million in 2007 and $6.0 million in 2006. We recognized fee income of $10.9
million, $11.0 million and $5.3 million in 2008, 2007 and 2006, respectively,
pursuant to the agreements described above under "Accounting for marketing and
reinsurance agreements with Coventry".
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
The Medicare supplement business consists of both individual and group
policies. Government regulations generally require us to attain and maintain a
ratio of total benefits incurred to total premiums earned (excluding changes in
policy benefit reserves), after three years from the original issuance of the
policy and over the lifetime of the policy, of not less than 65 percent on
individual products and not less than 75 percent on group products, as
determined in accordance with statutory
60
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 $.5 million, $3.7 million and $9.8 million in
2008, 2007 and 2006, respectively. Excluding the effects of prior year claim
reserve redundancies, our benefit ratios would have been 70.8 percent, 67.8
percent and 68.3 percent in 2008, 2007 and 2006, respectively. We experienced an
increase in the number of incurred claims in 2008.
The insurance policy benefits on our PDP and PFFS business result from our
quota-share reinsurance agreements with Coventry as described above under
"Accounting for marketing and 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 a specified percentage of the
business written by Coventry under two large group policies. During 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. One group policy reinsurance agreement was terminated on December
31, 2008, and the other group policy reinsurance agreement will be terminated on
June 30, 2009.
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 107.6 percent, 102.0 percent and 94.5 percent in
2008, 2007 and 2006, respectively. The interest-adjusted benefit ratio on this
business was 74.0 percent, 70.8 percent and 64.9 percent in 2008, 2007 and 2006,
respectively. Since the insurance product liabilities we establish for long-term
care business are subject to significant estimates, the ultimate claim liability
we incur for a particular period is likely to be different than our initial
estimate. Our insurance policy benefits reflected reserve deficiencies from
prior years of $6.0 million, $7.4 million and $.5 million in 2008, 2007 and
2006, respectively. Excluding the effects of prior year claim reserve
deficiencies, our benefit ratios would have been 106.7 percent, 100.8 percent
and 94.4 percent in 2008, 2007 and 2006, respectively. We experienced an
increase in the number of incurred claims in 2008 and 2007.
As a result of higher persistency in our long-term care block in the
Bankers Life segment than assumed in the original pricing, our premium rates
were too low. Accordingly, we began a program in 2006 to seek approval from
regulatory authorities for rate increases on approximately 65 percent of this
block. As an alternative to the rate increase, policyholders were offered the
option: (i) to reduce their benefits to maintain their previous premium rates;
or (ii) to choose a nonforfeiture benefit equal to the sum of accumulated
premiums paid less claims received. We have received all expected regulatory
approvals and have implemented 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 December 31, 2008, all such
filings had been submitted for regulatory approval, and approximately 65 percent
of the rate increases had been approved by regulators and implemented. Remaining
approvals and implementations are expected to occur over the next three to nine
months. Finally, an additional rate increase on the 65 percent of the block that
received an increase in 2006 was filed in the third quarter of 2008. As of
December 31, 2008, approximately 65 percent of the rate increases had been
approved by regulators and implemented. The remaining approvals and
implementations of this rate increase are expected to occur by the end of 2009.
During the fourth quarter of 2007, we recognized additional insurance
policy benefits of $6.7 million to reflect changes in our estimates of future
surrender and premium persistency rates on our universal life insurance block of
business.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $175.7 million, $180.9 million and $173.6
million in 2008, 2007 and 2006, respectively. The weighted average crediting
rates for these products were 3.6 percent, 3.7 percent and 3.6 percent in 2008,
2007 and 2006, respectively.
Amounts added to equity-indexed products based on change in value of the
indices fluctuated with the corresponding related investment income accounts
described above.
61
Amortization related to operations includes amortization of the value of
policies inforce at the Effective Date and the cost of policies produced
(collectively referred to as "amortization of insurance acquisition costs").
Insurance acquisition costs are generally amortized either: (i) in relation to
the estimated gross profits for universal life and investment-type products; or
(ii) in relation to actual and expected premium revenue for other products. In
addition, for universal life and investment-type products, we are required to
adjust the total amortization recorded to date through the statement of
operations if actual experience or other evidence suggests that earlier
estimates of future gross profits should be revised. Accordingly, amortization
for universal life and investment-type products is dependent on the profits
realized during the period and on our expectation of future profits. For other
products, we amortize insurance acquisition costs in relation to actual and
expected premium revenue, and amortization is only adjusted if expected premium
revenue changes or if we determine the balance of these costs is not recoverable
from future profits. Bankers Life's amortization expense was $234.8 million,
$264.0 million and $241.0 million in 2008, 2007 and 2006, respectively. During
the first six months of 2008, 2007 and 2006, we experienced higher lapses than
we anticipated on our Medicare supplement products. These lapses reduced our
estimates of future expected premium income and, accordingly, we recognized
additional amortization expense of $12.2 million in the first half of 2008,
$25.4 million in the first half of 2007 and $7.9 million in the first half of
2006. We believe such increases were partially related to competition from
Medicare Advantage products.
Other operating costs and expenses in our Bankers Life segment were $182.4
million in 2008, up 5.0 percent from 2007 and were $173.8 million in 2007, up
8.6 percent from 2006. 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):
2008 2007 2006
---- ---- ----
Expenses related to the marketing and quota-share
agreements with Coventry............................................ $ 40.8 $ 24.5 $ 15.2
Commission expense..................................................... 20.5 20.8 20.7
Other operating expenses............................................... 121.1 128.5 124.2
------ ------ ------
Total............................................................... $182.4 $173.8 $160.1
====== ====== ======
Net realized investment losses fluctuated each period. During 2008, net
realized investment losses in this segment included $31.1 million of net losses
from the sales of investments (primarily fixed maturities), and $85.6 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During 2007, net realized investment losses
in this segment included $4.6 million of net losses from the sales of
investments (primarily fixed maturities), and $15.3 million of writedowns of
investments resulting from declines in fair values that we concluded were other
than temporary. During 2006, net realized investment losses in this segment
included $15.1 million of net losses from the sales of investments (primarily
fixed maturities), and $4.4 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary.
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 $15.8 million, $2.5 million and
$3.2 million in 2008, 2007 and 2006, respectively.
62
Colonial Penn (dollars in millions)
2008 2007 2006
---- ---- ----
Premium collections:
Life................................................................. $174.1 $113.7 $ 97.2
Supplemental health.................................................. 8.9 10.4 12.0
------ ------ -------
Total collections.................................................. $183.0 $124.1 $109.2
====== ====== ======
Average liabilities for insurance products:
Annuities-mortality based............................................ $ 85.9 $ 88.7 $ 90.8
Health............................................................... 20.7 22.9 25.6
Life:
Interest sensitive............................................... 25.0 25.9 27.6
Non-interest sensitive........................................... 562.9 558.9 553.6
------ ------ ------
Total average liabilities for insurance
products, net of reinsurance ceded........................... $694.5 $696.4 $697.6
====== ====== ======
Revenues:
Insurance policy income.............................................. $184.8 $125.8 $112.1
Net investment income:
General account invested assets.................................... 40.1 37.8 38.2
Trading account income related to reinsurer accounts............... (.5) (.2) (4.3)
Change in value of embedded derivative related
to a modified coinsurance agreement.............................. - .2 4.3
Fee revenue and other income......................................... 1.8 .7 .6
------ ------ ------
Total revenues................................................... 226.2 164.3 150.9
------ ------ ------
Expenses:
Insurance policy benefits............................................ 138.2 101.0 95.1
Amounts added to annuity and interest-sensitive life product
account balances................................................. 1.2 1.2 1.3
Amortization related to operations................................... 32.0 20.3 17.3
Other operating costs and expenses................................... 29.6 23.7 15.6
------ ------ ------
Total benefits and expenses...................................... 201.0 146.2 129.3
------ ------ ------
Income before net realized investment gains (losses) and
income taxes......................................................... 25.2 18.1 21.6
Net realized investment gains (losses)............................. (1.6) (.2) .2
------ ------ ------
Income before income taxes................................................ $ 23.6 $ 17.9 $ 21.8
====== ====== ======
Reinsurance recapture: In the fourth quarter of 2007, we completed the
recapture of a block of traditional life insurance inforce that had been ceded
under a coinsurance agreement with REALIC. The recapture of this block resulted
in a $2.8 million gain accounted for as a reduction to insurance policy
benefits.
Total premium collections increased 47 percent, to $183.0 million, in 2008
and 14 percent, to $124.1 million, in 2007. See "Premium Collections" for
further analysis of Colonial Penn's premium collections.
Average liabilities for insurance products, net of reinsurance ceded, did
not fluctuate significantly during the three years ended December 31, 2008.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage
63
and fees and other charges assessed on other policies. The increase in 2008
reflects: (i) the recapture of the modified coinsurance agreement in the fourth
quarter of 2007; and (ii) the growth in this segment. See "Premium Collections"
for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) did not fluctuate significantly
during the three years ended December 31, 2008. The average balance of general
account invested assets was $676.0 million in 2008, $660.6 million in 2007 and
$688.5 million in 2006. The average yield on these assets was 5.94 percent in
2008, 5.72 percent in 2007 and 5.55 percent in 2006.
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 derivative related to a modified coinsurance
agreement is described in the note to our consolidated financial statements
entitled "Summary of Significant Accounting Policies - 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 (as further discussed below
under insurance policy benefits), 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. Insurance policy benefits were reduced
by $2.8 million in 2007 as a result of completing the aforementioned recapture
of a block of traditional life insurance in force that had been ceded in 2002 to
REALIC. In the transaction, which had an effective date of October 1, 2007,
Colonial Penn paid REALIC a recapture fee of $63 million. Colonial Penn
recaptured 100 percent of the liability for the future benefits previously
ceded, and will recognize profits from the block as they emerge over time.
Colonial Penn already administered the policies that were recaptured.
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.
Amortization was negatively impacted in 2008 by a $1.3 million adjustment that
is not expected to recur.
Other operating costs and expenses in our Colonial Penn segment increased
25 percent, to $29.6 million, in 2008 as compared to 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. Other operating
costs and expenses in our Colonial Penn segment increased 52 percent, to $23.7
million, in 2007 as compared to 2006 primarily due to the initial marketing
costs associated with a pilot program involving the distribution of Coventry's
PFFS plan through our direct response distribution channel. Such pilot program
was discontinued in 2008. Excluding these costs, other operating costs and
expenses were comparable in 2007 and 2006.
Net realized investment gains (losses) fluctuated each period. During 2008,
net realized investment losses in this segment included $.1 million of net gains
from the sales of investments (primarily fixed maturities), net of $1.7 million
of writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During 2007, net realized investment gains
in this segment included $.4 million of net gains from the sales of investments
(primarily fixed maturities), net of $.6 million of writedowns of investments
resulting from declines in fair values that we concluded were other than
temporary. During 2006, net realized investment gains in this segment included
$.4 million of net gains from the sales of investments (primarily fixed
maturities), net of $.2 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary.
64
Conseco Insurance Group (dollars in millions)
2008 2007 2006
---- ---- ----
Premium collections:
Annuities........................................................... $ 129.8 $ 368.6 $ 433.3
Supplemental health................................................. 621.8 633.4 655.8
Life................................................................ 269.8 287.3 314.6
-------- --------- ---------
Total collections................................................. $1,021.4 $ 1,289.3 $ 1,403.7
======== ========= =========
Average liabilities for insurance products:
Annuities:
Mortality based................................................... $ 220.7 $ 230.3 $ 241.2
Equity-indexed.................................................... 891.0 1,435.3 1,376.4
Deposit based..................................................... 752.6 2,337.7 3,150.8
Separate accounts................................................. 23.6 28.4 29.3
Health.............................................................. 2,993.1 2,927.5 2,899.4
Life:
Interest sensitive................................................ 2,945.5 3,045.5 3,061.2
Non-interest sensitive............................................ 1,393.8 1,380.2 1,416.8
-------- --------- ---------
Total average liabilities for insurance products,
net of reinsurance ceded...................................... $9,220.3 $11,384.9 $12,175.1
======== ========= =========
Revenues:
Insurance policy income............................................. $ 958.9 $ 989.9 $ 1,038.8
Net investment income:
General account invested assets................................... 592.7 727.6 723.5
Equity-indexed products........................................... (28.4) (1.3) 26.0
Trading account income related to policyholder and
reinsurer accounts.............................................. (18.5) 1.4 6.9
Change in value of embedded derivatives related to
modified coinsurance agreements................................. 6.7 1.4 .8
Other trading accounts............................................ - (12.8) -
Fee revenue and other income........................................ 1.7 1.0 1.4
-------- --------- ---------
Total revenues.................................................... 1,513.1 1,707.2 1,797.4
-------- --------- ---------
Expenses:
Insurance policy benefits........................................... 820.9 850.9 862.9
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products.............................. 153.6 217.4 251.9
Equity-indexed products........................................... 8.2 60.7 55.8
Amortization related to operations.................................. 122.6 178.2 175.1
Interest expense on investment borrowings........................... 22.4 17.6 .8
Costs related to a litigation settlement............................ - 32.2 165.8
Loss related to an annuity coinsurance transaction.................. - 76.5 -
Other operating costs and expenses.................................. 264.1 300.0 288.1
-------- --------- ---------
Total benefits and expenses....................................... 1,391.8 1,733.5 1,800.4
-------- --------- ---------
Income (loss) before net realized investment losses,
net of related amortization and income taxes........................ 121.3 (26.3) (3.0)
-------- --------- ---------
Net realized investment losses.................................... (93.3) (131.7) (26.9)
Amortization related to net realized investment losses............ 5.7 33.2 6.9
-------- --------- ---------
Net realized investment losses,
net of related amortization................................... (87.6) (98.5) (20.0)
-------- --------- ---------
Income (loss) before income taxes........................................ $ 33.7 $ (124.8) $ (23.0)
======== ========= =========
(continued)
65
(continued from previous page)
2008 2007 2006
---- ---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits.......................................... $494.3 $514.9 $538.7
Benefit ratio (a).................................................. 79.8% 80.4% 80.5%
Medicare supplement:
Insurance policy benefits.......................................... $139.8 $156.4 $158.9
Benefit ratio (a).................................................. 68.4% 67.6% 61.9%
Specified disease:
Insurance policy benefits.......................................... $285.4 $279.4 $277.1
Benefit ratio (a).................................................. 77.1% 77.8% 77.4%
Interest-adjusted benefit ratio (b)................................ 43.3% 44.7% 45.4%
Long-term care:
Insurance policy benefits.......................................... $58.7 $72.5 $91.2
Benefit ratio (a).................................................. 169.6% 192.4% 224.4%
Interest-adjusted benefit ratio (b)................................ 93.5% 128.5% 171.3%
Other:
Insurance policy benefits.......................................... $10.4 $6.6 $11.5
Benefit ratio (a).................................................. 100.5% 54.2% 80.6%
<FN>
- --------------------
(a) We calculate benefit ratios by dividing the related product's
insurance policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for Conseco Insurance Group's specified disease and 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 specified disease and 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 these products, 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 $125.2 million, $118.9 million and $114.7 million in
2008, 2007 and 2006, respectively. The investment income earned on the
accumulated assets backing the long-term care reserves was $26.3
million, $24.1 million and $21.6 million in 2008, 2007 and 2006,
respectively.
</FN>
Annuity coinsurance agreement. 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 subsidiaries with REALIC. The
66
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, were 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 $1,021.4 million in 2008, down 21 percent
from 2007, and $1,289.3 million in 2007, down 8.1 percent from 2006. The
decrease in 2007 collected premiums was primarily due to lower equity-indexed
annuity sales as we changed the pricing of specific products and we no longer
emphasized the sale of certain products. See "Premium Collections" for further
analysis of fluctuations in premiums collected by product.
Average liabilities for insurance products, net of reinsurance ceded were
$9.2 billion in 2008, down 19 percent from 2007, and $11.4 billion in 2007, down
6.5 percent from 2006. The decreases in such liabilities were 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) decreased 19 percent, to $592.7
million, in 2008 and increased .6 percent, to $727.6 million, in 2007. The
average balance of general account invested assets decreased 17 percent in 2008,
to $10.1 billion, and 2.8 percent in 2007, to $12.2 billion. 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 5.89 percent in 2008, 5.97 percent in 2007 and 5.77 percent in
2006.
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 $(37.3) million, $2.7 million and $28.1 million in
2008, 2007 and 2006, 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 $8.9 million,
$(4.0) million and $(2.1) million in 2008, 2007 and 2006, 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.
Our results in 2008, were affected by a reduction to earnings of $4.4
million 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 held 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
67
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 "Summary of Significant Accounting Policies - Accounting for
Derivatives." We have transferred the specific block of investments related to
these agreements to our trading securities account, which we carry at estimated
fair value with changes in such value recognized as trading account income. The
change in the value of the embedded derivatives has largely been offset by the
change in value of the trading securities.
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 were $3.6 million, $(.2) million and $28.9 million in
2008, 2007 and 2006, respectively. Such fluctuations were 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 were 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 $2.5 million,
$1.0 million and $5.4 million in 2008, 2007 and 2006, respectively. Excluding
the effects of prior year claim reserve redundancies, our benefit ratios for the
Medicare supplement block would have been 69.6 percent, 68.0 percent and 64.1
percent in 2008, 2007 and 2006, 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 $64.6
million, $74.9 million and $97.6 million in 2008, 2007 and 2006, respectively.
Such decreases are 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 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 $85.0 million, $79.7 million and $80.8 million
in 2008, 2007 and 2006, respectively. The increase in the margin in 2008 is due
to a $12 million correction to insurance policy
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benefits resulting from our material control weakness remediation procedures.
The long-term care policies in this segment generally provide for indemnity
and non-indemnity benefits on a guaranteed renewable or non-cancellable basis.
The benefit ratio on our long-term care policies was 169.6 percent, 192.4
percent and 224.4 percent in 2008, 2007 and 2006, respectively. Benefit ratios
are calculated by dividing the product's insurance policy benefits by insurance
policy income. Since the insurance product liabilities we establish for
long-term care business are subject to significant estimates, the ultimate claim
liability we incur for a particular period is likely to be different than our
initial estimate. Our insurance policy benefits reflected reserve deficiencies
from prior years of $1.1 million, $6.3 million and $12.8 million in 2008, 2007
and 2006, respectively. Excluding the effects of prior year claim reserve
deficiencies, our benefit ratios would have been 166.6 percent, 175.7 percent
and 192.5 percent in 2008, 2007 and 2006, respectively. These ratios reflect the
level of incurred claims experienced in recent periods, adverse development on
claims incurred in prior periods and decreases in policy income. The prior
period deficiencies have resulted from the impact of paid claim experience being
different than prior estimates, changes in actuarial assumptions and refinements
to claimant data used to determine claim reserves.
The net cash flows from long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in benefits will be partially offset
by investment income earned on the assets which have accumulated. The
interest-adjusted benefit ratio for long-term care products is calculated by
dividing the insurance product's insurance policy benefits less interest income
on the accumulated assets backing the insurance liabilities by insurance policy
income. The interest-adjusted benefit ratio on this business was 93.5 percent,
128.5 percent and 171.3 percent in 2008, 2007 and 2006, respectively. Excluding
the effects of prior year claim reserve deficiencies, our interest-adjusted
benefit ratios would have been 90.4 percent, 111.9 percent and 139.8 percent in
2008, 2007 and 2006, respectively.
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. 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.
On July 1, 2004, the Florida Office of Insurance Regulation issued an order
impacting approximately 4,800 home health care policies issued in Florida by our
subsidiary, Washington National, and its predecessor companies. Pursuant to the
Order, Washington National offered the following three alternatives to holders
of these policies subject to rate increases as follows:
o retention of their current policy with a rate increase of 50 percent
in the first year and actuarially justified increases in subsequent
years (which is also the default election for policyholders who failed
to make an election by 30 days prior to the anniversary date of their
policies) ("option one");
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15 percent
in subsequent years ("option two"); or
o receipt of a paid-up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy ("option three").
Policyholders selecting option one or option two are entitled to receive a
contingent non-forfeiture benefit if their policy subsequently lapses. In
addition, policyholders could change their initial election any time up to 30
days prior to the anniversary date of their policies. We began to implement
premium adjustments with respect to policyholder elections in the fourth quarter
of 2005 and the implementation of these premium adjustments was completed in
2007. We did not make any adjustments to the insurance liabilities when these
elections were made. Reserves for all three groups of policies under the order
were prospectively adjusted using the prospective revision methodology described
in the "Critical Accounting Policies - Accounting for Long-term Care Premium
Rate Increases" in "Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations".
69
The order also requires Washington National to pursue a similar course of
action with respect to home health care policies in other states, subject to
such actions being justified based on the experience of the business and
approval by the other state insurance departments. If we are unsuccessful in
obtaining rate increases or other forms of relief in those states, or if the
policy changes approved by the Florida Office of Insurance Regulation prove
inadequate, our future results of operations could be adversely affected.
The benefit ratios on Conseco Insurance Group's other products are subject
to fluctuations due to the smaller size of these blocks of business.
During the fourth quarter of 2007, we recognized additional insurance
policy benefits of $2.0 million to increase our insurance product liabilities.
This increase primarily affects our best estimate of the costs associated with
enhancing certain benefits related to a block of excess interest whole life
policies in response to various issues in how the policies had been
administered. We recognized additional insurance policy benefits of $8.0 million
during the fourth quarter of 2006 based on our prior estimate of the enhanced
benefits associated with these same policies and administrative issues. The
policies affected by the adjustments described above were issued through a
subsidiary prior to its acquisition by Conseco in 1997.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $153.6 million, $217.4 million and $251.9
million in 2008, 2007 and 2006, respectively. The decrease was primarily due to
a smaller block of annuity business inforce due to: (i) lapses exceeding new
sales in recent periods; and (ii) the completion of the annuity coinsurance
agreement discussed above. The weighted average crediting rates for these
products were 4.2 percent, 4.1 percent and 4.1 percent in 2008, 2007 and 2006,
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. In addition,
in 2006, we reduced such amounts by $8.5 million to reflect a change in the
assumptions for the cost of options underlying our equity-indexed products as
described below under amortization related to operations. Such decreases were
partially offset by a $4.7 million increase in amortization of insurance
acquisition costs related to the assumption changes.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs are generally amortized either:
(i) in relation to the estimated gross profits for universal life and
investment-type products; or (ii) in relation to actual and expected premium
revenue for other products. In addition, for universal life and investment-type
products, we are required to adjust the total amortization recorded to date
through the statement of operations if actual experience or other evidence
suggests that earlier estimates of future gross profits should be revised.
Accordingly, amortization for universal life and investment-type products is
dependent on the profits realized during the period and on our expectation of
future profits. For other products, we amortize insurance acquisition costs in
relation to actual and expected premium revenue, and amortization is only
adjusted if expected premium revenue changes or if we determine the balance of
these costs is not recoverable from future profits. Lapse rates on our Medicare
supplement products have impacted our estimates of future expected premium
income and, accordingly, we recognized increased (decreased) amortization
expense of $(5.5) million, $(3.9) million and $7.1 million in 2008, 2007 and
2006, respectively. The assumptions we use to estimate our future gross profits
and premiums involve significant judgment. A revision to our current assumptions
could result in increases or decreases to amortization expense in future
periods. The decrease in amortization expense in 2008, as compared to 2007, was
primarily a result of the coinsurance agreement discussed above.
During the fourth quarter of 2008, we were required to accelerate the
amortization of insurance acquisition costs related to a block of equity-indexed
annuities. This block of business experienced higher than anticipated surrenders
during the year. These annuities also have a MVA feature, which effectively
reduced (or in some cases, eliminated) the charges paid upon surrender in the
fourth quarter of 2008 as the 10-year treasury rate dropped. The impact of both
the historical experience and the projected increased surrender activity and
higher MVA benefits has reduced our expectations on the profitability of this
block to approximately break-even. We recognized additional amortization of
approximately $5 million related to the actual and expected future changes in
the experience of this block. This increase to amortization expense was offset
by a reduction to the insurance policy option benefit reserve. We continue to
hold insurance acquisition costs of approximately $80 million related to these
products, which we determined are recoverable. Results for this block are
expected to exhibit increased volatility in the future, because almost all of
the difference between our assumptions and actual experience will be reflected
in earnings in the period such differences occur.
During the fourth quarter of 2008, a detailed analysis was performed on a
universal life block of business that led to
70
the changes in our assumptions of future mortality, surrenders, premium
persistency, expenses and investment income. We recognized additional
amortization expense of approximately $8 million to reflect changes in our
estimates of future policyholder assumptions on our universal life business, net
of planned increases to associated policyholder charges.
During 2007, we were required to accelerate the amortization of insurance
acquisition costs related to our universal life products because the prior
balance was not recoverable by the value of future estimated gross profits on
this block. This additional amortization was necessary so that our insurance
acquisition costs would not exceed the value of future estimated gross profits
and is expected to continue to be recognized in subsequent periods. Because our
insurance acquisition costs are now equal to the value of future estimated gross
profits, this block is expected to generate break-even earnings in the future.
In addition, results for this block are expected to exhibit increased volatility
in the future, because the entire difference between our assumptions and actual
experience is expected to be reflected in earnings in the period such
differences occur.
During the fourth quarter of 2007, we recognized additional amortization
expense of $14.8 million to reflect changes in our estimates of future mortality
rates on our universal life business, net of planned increases to associated
policyholder charges.
During the fourth quarter of 2006, we recognized additional amortization
expense of $7.8 million to reflect a change in an actuarial assumption related
to a block of interest-sensitive life insurance policies based on a change in
management's intent on the administration of such policies. The policies
affected by the adjustments described above were issued through a subsidiary
prior to its acquisition by Conseco in 1996.
During the first quarter of 2006, we made certain adjustments to our
assumptions of expected future profits for the annuity and universal life blocks
of business in this segment related to investment returns, lapse rates, the cost
of options underlying our equity-indexed products and other refinements. We
recognized additional amortization expense of $12.4 million in the first quarter
of 2006 due to these changes. This increase to amortization expense was offset
by a reduction to insurance policy benefit expense of $11.5 million, to reflect
the effect of the changes in these assumptions on the calculation of certain
insurance liabilities, such as the liability to purchase future options
underlying our equity-indexed products. Also, during the second quarter of 2006,
we changed our estimates of the future gross profits of certain universal life
products, which under certain circumstances are eligible for interest bonuses in
addition to the declared base rate. These interest bonuses are not required in
the current crediting rate environment and our estimates of future gross profits
have been changed to reflect the discontinuance of the bonus. We reduced
amortization expense by $4.0 million during the second quarter of 2006 as a
result of this change.
Interest expense on investment borrowings includes $21.9 million and $16.7
million of interest expense on collateralized borrowings in 2008 and 2007,
respectively, as further described in the note to the consolidated financial
statements entitled "Summary of Significant Accounting Policies - Investment
Borrowings".
Costs related to a litigation settlement include legal fees and estimated
amounts related to a settlement during 2006 in the class action case referred to
as In Re Conseco Life Insurance Company Cost of Insurance Litigation. The costs
related to the litigation settlement recognized in 2007 represent changes to our
initial estimates based on the ultimate cost of the settlement, including the
effect of the 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 "Commitments and
Contingencies". A portion of the legal and other costs related to this
litigation were incurred by the Corporate Operations segment to defend the
non-insurance company allegations made in such lawsuits.
Loss related to an annuity coinsurance transaction resulted from the
completion of a transaction to coinsure 100 percent of most of the older inforce
equity-indexed annuity and fixed annuity business of three of our insurance
subsidiaries with REALIC as further discussed above under annuity coinsurance
transaction.
Other operating costs and expenses were $264.1 million, $300.0 million and
$288.1 million in 2008, 2007 and 2006, respectively. Other operating costs and
expenses include commission expense of $79.2 million, $82.2 million and $90.6
million in 2008, 2007 and 2006, respectively. During 2007, the Company
recognized expenses of $7.3 million related to the decision to abandon certain
software that will not be used consistent with our current business plan and
$3.7 million of costs related to other operational initiatives and consolidation
activities. The decrease in expenses in 2008 is also due to lower litigation
expenses and lower sales and marketing costs.
Net realized investment gains (losses) fluctuate each period. During 2008,
net realized investment losses included
71
$33.0 million of net losses from the sales of investments (primarily fixed
maturities), and $60.3 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. During
2007, net realized investment losses in this segment included: (i) $43.6 million
from the sales of investments (primarily fixed maturities); (ii) $14.4 million
of writedowns of investments resulting from declines in fair values that we
concluded were other than temporary; and (iii) $73.7 million of writedowns of
investments (which were subsequently transferred pursuant to a coinsurance
agreement as further discussed in the note to the consolidated financial
statements entitled "Summary of Significant Accounting Policies - Reinsurance")
as a result of our intent not to hold such investments for a period of time
sufficient to allow for any anticipated recovery in value. The net investment
losses realized on sales of investments in 2007 were primarily recognized on
securities collateralized by sub prime residential mortgage loans. We decided to
sell these securities given our concerns regarding the effect future adverse
developments could have on the future value of these securities. For further
information on our sub prime holdings, refer to the caption entitled "Other
Investments" in the "Investments" section of Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations. During
2006, net realized investment losses included $10.4 million of net losses from
the sales of investments (primarily fixed maturities), and $16.5 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary.
Amortization related to net realized investment gains (losses) is the
increase or decrease in the amortization of insurance acquisition costs which
results from realized investment gains or losses. When we sell securities which
back our universal life and investment-type products at a gain (loss) and
reinvest the proceeds at a different yield (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 $5.7 million, $33.2 million and
$6.9 million in 2008, 2007 and 2006, respectively.
Corporate Operations (dollars in millions)
2008 2007 2006
---- ---- ----
Corporate operations:
Interest expense on corporate debt................................... $ (59.2) $ (72.3) $(52.9)
Net investment income................................................ 4.9 6.6 4.6
Fee revenue and other income......................................... 4.7 9.8 10.9
Net operating results of variable interest entity.................... 7.2 9.2 4.9
Costs related to a litigation settlement............................. - (32.2) (8.9)
Other operating costs and expenses................................... (43.5) (42.4) (38.6)
Gain (loss) on extinguishment of debt................................ 21.2 - (.7)
------- ------- ------
Loss before net realized investment losses
and income taxes................................................ (64.7) (121.3) (80.7)
Net realized investment losses....................................... (50.8) (6.2) (.4)
------- ------- ------
Loss before income taxes........................................... $(115.5) $(127.5) $(81.1)
======= ======= ======
Interest expense on corporate debt has been impacted by: (i) the repayment
or amendment of the Company's credit facilities in 2007 and 2006; (ii) the
issuance in 2008 of a $125.0 million Senior Note; (iii) borrowings in 2008
pursuant to our revolving credit facility; and (iv) the repurchase of $37.0
million par value of our Debentures. These transactions are further discussed in
the note to the consolidated financial statements entitled "Notes Payable -
Direct Corporate Obligations". Our average corporate debt outstanding was
$1,219.3 million, $1,111.8 million and $864.3 million in 2008, 2007 and 2006,
respectively. The average interest rate on our debt was 4.6 percent, 6.2 percent
and 5.7 percent in 2008, 2007 and 2006, respectively.
Net investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income and
fluctuated along with the change in the amount of invested assets in this
segment.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. In 2007, our wholly owned investment management
subsidiary recognized performance-based fees of $2.4 million resulting from the
liquidation of two portfolios that were
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managed by the subsidiary. Excluding such performance-based fees, fee revenue
and other income has decreased primarily as a result of a decrease in the market
value of investments managed for others, upon which these fees are based.
Net operating results of variable interest entity represent the operating
results of a variable interest entity ("VIE"). The VIE is consolidated in
accordance with Financial Accounting Standards Board Interpretation No. 46
"Consolidation of Variable Interest Entities", revised December 2003. Although
we do not control this entity, we consolidate it because we are the primary
beneficiary. This entity was established to issue securities and use the
proceeds to invest in loans and other permitted assets.
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 "Commitments and Contingencies" 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 2008, we
recognized a $9.6 million charge related to the consolidation of our Chicago
facilities. In 2006, other operating costs and expenses are net of a recovery of
$3.0 million related to our evaluation of the collectibility of the D&O loans.
Gain (loss) on extinguishment of debt of $21.2 million in 2008 resulted
from the repurchase of $37.0 million par value of Debentures for $15.3 million
plus accrued interest. The $(.7) million loss in 2006 resulted from the
write-off of certain issuance costs and other costs incurred related to the
Second Amended Credit Facility.
Net realized investment losses often fluctuate each period. During 2008,
net realized investment losses included $36.1 million from the sale of
investments ($14.1 million of such losses were recognized by a VIE) and $14.7
million of writedowns ($10.8 million of such writedowns were recognized by a
VIE) due to other-than-temporary declines in value on certain securities. During
2007, net realized investment losses in this segment included $4.7 million from
the sale of investments (primarily fixed maturities) and $1.5 million of
writedowns due to other-than-temporary declines in value on certain securities.
During 2006, net realized investment losses in this segment included $.4 million
from the sale of investments.
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 from A.M. Best,
S&P and Moody's are
73
"B (Fair)", "BB-" and "Ba2", respectively. For a description of these ratings
and additional information on our ratings, see "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations --
Liquidity for Insurance Operations."
We set premium rates on our health insurance policies based on facts and
circumstances known at the time we issue the policies using assumptions about
numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. We also consider historical claims information,
industry statistics, the rates of our competitors and other factors. If our
actual claims experience is less favorable than we anticipated and we are unable
to raise our premium rates, our financial results may be adversely affected. We
generally cannot raise our health insurance premiums in any state until we
obtain the approval of the state insurance regulator. We review the adequacy of
our premium rates regularly and file for 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.
74
Total premiums collections were as follows:
Bankers Life (dollars in millions)
2008 2007 2006
---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year).......................................... $ 522.8 $ 437.4 $ 276.5
-------- -------- --------
Other fixed (first-year)............................................. 697.8 445.3 718.1
Other fixed (renewal)................................................ 3.5 2.8 2.9
-------- -------- --------
Subtotal - other fixed annuities................................... 701.3 448.1 721.0
-------- -------- --------
Total annuities.................................................... 1,224.1 885.5 997.5
-------- -------- --------
Supplemental health:
Medicare supplement (first-year)..................................... 81.3 82.5 97.8
Medicare supplement (renewal)........................................ 555.3 553.6 531.3
-------- -------- --------
Subtotal - Medicare supplement..................................... 636.6 636.1 629.1
-------- -------- --------
Long-term care (first-year).......................................... 42.7 47.0 51.2
Long-term care (renewal)............................................. 583.0 575.4 541.2
-------- -------- --------
Subtotal - long-term care.......................................... 625.7 622.4 592.4
-------- -------- --------
PDP and PFFS (first year)............................................ 353.3 206.4 76.7
PDP and PFFS (renewal)............................................... 260.7 71.4 -
-------- -------- --------
Subtotal - PDP and PFFS............................................ 614.0 277.8 76.7
-------- -------- --------
Other health (first-year)............................................ 2.1 .9 1.0
Other health (renewal)............................................... 8.6 8.9 9.1
-------- -------- --------
Subtotal - other health............................................ 10.7 9.8 10.1
-------- -------- --------
Total supplemental health.......................................... 1,887.0 1,546.1 1,308.3
-------- -------- --------
Life insurance:
First-year........................................................... 80.7 89.2 90.3
Renewal.............................................................. 128.7 110.8 93.9
-------- -------- --------
Total life insurance............................................... 209.4 200.0 184.2
-------- -------- --------
Collections on insurance products:
Total first-year premium collections on insurance
products.......................................................... 1,780.7 1,308.7 1,311.6
Total renewal premium collections on insurance
products........................................................... 1,539.8 1,322.9 1,178.4
-------- -------- --------
Total collections on insurance products............................ $3,320.5 $2,631.6 $2,490.0
======== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections in this
segment increased 38 percent, to $1,224.1 million, in 2008 and decreased 11
percent to $885.5 million, in 2007. Premium collections from our equity-indexed
products were favorably impacted in 2007 and the first half of 2008 by the
general stock market performance made these products attractive to certain
customers. Premium collections from our equity-indexed products declined in the
second half of 2008 due to declines in the stock market. Premium collections
from our fixed annuity products increased sharply in the last half of 2008, due
to volatility in the financial markets which made these products more attractive
to customers.
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
75
on the overall level of sales, the length of time the business remains inforce,
investment yields, claims experience and expense management.
Collected premiums on Medicare supplement policies in the Bankers Life
segment increased .1 percent, to $636.6 million, in 2008 and 1.1 percent, to
$636.1 million, in 2007. The increase in premium collections of our Medicare
supplement products in 2007 was primarily due to higher persistency, partially
offset by lower new sales.
Premiums collected on Bankers Life's long-term care policies increased .5
percent, to $625.7 million, in 2008 and 5.1 percent, to $622.4 million, in 2007.
The increase in premium collections of our long-term care products in 2007 was
primarily due to higher premiums associated with the policies that were impacted
by the rate increases which became effective in 2007 and 2006.
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. These
agreements are described in "Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations - Critical Accounting
Policies".
Other health products relate to collected premiums on other health products
which we no longer actively market.
Life products in this segment are sold primarily to the senior market
through our career agents. Life premiums collected in this segment increased 4.7
percent, to $209.4 million, in 2008 and 8.6 percent, to $200.0 million, in 2007.
Collected premiums have been impacted by an increased focus on life products.
Colonial Penn (dollars in millions)
2008 2007 2006
---- ---- ----
Premiums collected by product:
Life insurance:
First-year........................................................... $ 35.0 $ 28.7 $ 22.9
Renewal.............................................................. 139.1 85.0 74.3
------ ------ ------
Total life insurance............................................... 174.1 113.7 97.2
------ ------ ------
Supplemental health (all of which are renewal premiums):
Medicare supplement.................................................. 8.1 9.4 10.9
Other health......................................................... .8 1.0 1.1
------ -------- ------
Total supplemental health.......................................... 8.9 10.4 12.0
------ ------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products........................................................... 35.0 28.7 22.9
Total renewal premium collections on insurance
products........................................................... 148.0 95.4 86.3
------ ------ ------
Total collections on insurance products............................ $183.0 $124.1 $109.2
====== ====== ======
Life products in this segment are sold primarily to the senior market. Life
premiums collected in this segment increased 53 percent, to $174.1 million, in
2008 and 17 percent, to $113.7 million, in 2007. Graded benefit life products
sold through our direct response marketing channel accounted for $168.5 million,
$108.8 million and $92.3 million of collected premiums in 2008, 2007 and 2006,
respectively. Collected premiums have been impacted by: (i) the recapture in the
fourth quarter of 2007 of a block of traditional life insurance inforce that had
been ceded in 2002 to REALIC; and (ii) an increased investment in marketing
activities in 2008.
Supplemental health products include Medicare supplement and other
insurance products. Our profits on
76
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)
2008 2007 2006
---- ---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)......................................... $ 116.1 $ 336.4 $ 369.4
Equity-indexed (renewal)............................................ 7.6 8.2 9.1
-------- -------- --------
Subtotal - equity-indexed annuities............................... 123.7 344.6 378.5
-------- -------- --------
Other fixed (first-year)............................................ 3.8 18.0 46.1
Other fixed (renewal)............................................... 2.3 6.0 8.7
-------- -------- --------
Subtotal - other fixed annuities.................................. 6.1 24.0 54.8
-------- -------- --------
Total annuities................................................... 129.8 368.6 433.3
-------- -------- --------
Supplemental health:
Medicare supplement (first-year).................................... 9.6 19.4 30.6
Medicare supplement (renewal)....................................... 194.2 206.5 213.6
-------- -------- --------
Subtotal - Medicare supplement.................................... 203.8 225.9 244.2
-------- -------- --------
Specified disease (first-year)...................................... 39.4 31.4 28.1
Specified disease (renewal)......................................... 335.2 327.8 329.6
-------- -------- --------
Subtotal - specified disease...................................... 374.6 359.2 357.7
-------- -------- --------
Long-term care (all of which are renewal)........................... 33.7 36.7 39.4
-------- -------- --------
Other health (first-year)........................................... .1 .3 -
Other health (renewal).............................................. 9.6 11.3 14.5
-------- -------- --------
Subtotal - other health........................................... 9.7 11.6 14.5
-------- -------- --------
Total supplemental health......................................... 621.8 633.4 655.8
-------- -------- --------
Life insurance:
First-year.......................................................... 4.3 4.7 6.7
Renewal............................................................. 265.5 282.6 307.9
-------- -------- --------
Total life insurance.............................................. 269.8 287.3 314.6
-------- -------- --------
Collections on insurance products:
Total first-year premium collections on
insurance products............................................... 173.3 410.2 480.9
Total renewal premium collections on
insurance products................................................ 848.1 879.1 922.8
-------- -------- --------
Total collections on insurance products........................... $1,021.4 $1,289.3 $1,403.7
======== ======== ========
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity collected
premiums in this segment decreased 65 percent, to $129.8 million, in 2008 and 15
percent, to $368.6 million, in 2007.
Total collected premiums for these products decreased 64 percent, to $123.7
million, in 2008 and 9.0 percent, to $344.6 million, in 2007. During 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.
Annuity premiums on fixed products decreased 75 percent, to $6.1 million,
in 2008 primarily due to a focus on the sale of more profitable products and
decreased 56 percent, to $24.0 million, in 2007. The increase in short-term
interest rates in 2007 resulted in lower first-year fixed annuity sales as
certain other competing products had become attractive.
77
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease, long-term care 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 9.8 percent, to $203.8 million, in 2008 and 7.5 percent,
to $225.9 million, 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 4.3 percent, to
$374.6 million, in 2008 and .4 percent, to $359.2 million, in 2007. Such
increases reflect higher new sales in each year and a slight improvement in
persistency in 2008.
The long-term care premiums in this segment relate to blocks of business
that we no longer market or underwrite. As a result, we expect this segment's
long-term care premiums to continue to decline, reflecting additional policy
lapses in the future, partially offset by premium rate increases.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected decreased 6.1
percent, to $269.8 million, in 2008 and 8.7 percent, to $287.3 million, in 2007.
INVESTMENTS
Our investment strategy is to: (i) maintain a predominately
investment-grade fixed income portfolio; (ii) provide liquidity to meet our cash
obligations to policyholders and others; and (iii) generate stable and
predictable investment income through active investment management. Consistent
with this strategy, investments in fixed maturity securities, mortgage loans and
policy loans made up 95 percent of our $18.6 billion investment portfolio at
December 31, 2008. The remainder of the invested assets was trading securities,
equity securities and other invested assets.
The following table summarizes the composition of our investment portfolio
as of December 31, 2008 (dollars in millions):
Carrying Percent of
value total investments
----- -----------------
Actively managed fixed maturities............................................... $15,277.0 82%
Equity securities............................................................... 32.4 -
Mortgage loans.................................................................. 2,159.4 12
Policy loans.................................................................... 363.5 2
Trading securities.............................................................. 326.5 2
Securities lending collateral................................................... 393.7 2
Partnership investments......................................................... 23.1 -
Other invested assets........................................................... 71.9 -
--------- ---
Total investments............................................................ $18,647.5 100%
========= ===
Insurance statutes regulate the types of investments that our insurance
subsidiaries are permitted to make and limit the amount of funds that may be
used for any one type of investment. In light of these statutes and regulations
and our business and investment strategy, we generally seek to invest in United
States government and government-agency securities and corporate securities
rated investment grade by established nationally recognized rating organizations
or in securities of comparable investment quality, if not rated.
78
The following table summarizes the carrying value of our actively managed
fixed maturity securities by category as of December 31, 2008 (dollars in
millions):
Percent of
Gross gross
Percent of unrealized unrealized
Carrying value fixed maturities losses losses
-------------- ---------------- ------ ------
Collateralized mortgage obligations........... $2,438.1 16.0% $ (533.7) 16.8%
Utilities..................................... 1,428.0 9.3 (194.2) 6.1
Energy/pipelines.............................. 1,323.0 8.7 (258.4) 8.2
Food/beverage................................. 1,069.2 7.0 (118.5) 3.7
Banks......................................... 820.3 5.4 (219.0) 6.9
Healthcare/pharmaceuticals.................... 808.5 5.3 (84.0) 2.7
Insurance..................................... 716.1 4.7 (228.7) 7.2
Cable/media................................... 589.4 3.9 (123.0) 3.9
Commercial mortgage-backed securities......... 567.2 3.7 (265.7) 8.4
Real estate/REITs............................. 462.6 3.0 (211.5) 6.7
Telecom....................................... 460.6 3.0 (63.0) 2.0
Brokerage..................................... 432.6 2.8 (78.0) 2.5
Capital goods................................. 403.0 2.6 (44.4) 1.4
States and political subdivisions............. 382.6 2.5 (53.8) 1.7
Aerospace/defense............................. 365.0 2.4 (11.7) .4
Transportation................................ 357.5 2.3 (41.3) 1.3
Building materials............................ 278.5 1.8 (103.0) 3.2
Technology.................................... 242.2 1.6 (41.4) 1.3
Asset-backed securities....................... 203.7 1.3 (87.6) 2.8
Consumer products............................. 179.1 1.2 (26.6) .8
Other......................................... 1,749.8 11.5 (380.3) 12.0
--------- ----- --------- -----
Total actively managed fixed maturities.... $15,277.0 100.0% $(3,167.8) 100.0%
========= ===== ========= =====
Our fixed maturity securities consist predominantly of publicly traded
securities. We classify securities issued in the Rule 144A market as publicly
traded. Securities not publicly traded comprise approximately 13 percent of our
total fixed maturity securities portfolio.
Fair Value of Investments
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 and separate account assets, 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.
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.
79
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) 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. Substantially all of our Level 2
fixed maturity securities and separate account assets were valued from
independent pricing services. 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. The number of prices obtained is
dependent on the Company's analysis of such prices as further described below.
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 are non-binding and represent an exit price, but assumptions used to
establish the fair value may not be observable and therefore represent Level 3
inputs. Approximately 5 percent and 1 percent of our Level 3 fixed maturity
securities were valued using broker quotes or independent pricing services,
respectively. The remaining Level 3 fixed maturity 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.
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. As a result of
such procedures, the Company may conclude
80
the prices received from third parties are not reflective of current market
conditions. In those instances, we may request additional pricing quotes or
apply internally developed valuations. However, the number of instances is
insignificant and the aggregate change in value of such investments is not
materially different from the original prices received.
The categorization of the fair value measurements of our investments priced
by independent pricing services was based upon the Company's judgment of the
inputs or methodologies used by the independent pricing services to value
different asset classes. Such inputs include: benchmark yields, reported trades,
broker dealer quotes, issuer spreads, benchmark securities, bids, offers and
reference data. The Company categorizes such fair value measurements based upon
asset classes and the underlying observable or unobservable inputs used to value
such investments.
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.
The categorization of fair value measurements, by input level, for our
fixed maturity securities, equity securities, trading securities, certain other
invested assets and assets held in separate accounts at December 31, 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........ $74.9 $13,326.0 $1,876.1 $15,277.0
Equity securities........................ - - 32.4 32.4
Trading securities....................... 8.8 315.0 2.7 326.5
Securities lending collateral............ - 170.3 48.1 218.4
Other invested assets.................... - 55.9 (a) 2.3 (b) 58.2
Assets held in separate accounts......... - 18.2 - 18.2
<FN>
- -------------
(a) Includes corporate-owned life insurance and derivatives.
(b) Includes equity-like holdings in special-purpose entities.
</FN>
81
The following table presents 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 year ended December 31, 2008 (dollars in millions):
Actively Securities Other
managed fixed Equity Trading lending invested
maturities securities securities collateral assets
---------- ---------- ---------- ---------- ------
Assets:
Beginning balance as of
December 31, 2007............................. $1,753.3 $34.5 $11.8 $105.7 $ 4.3
Purchases, sales, issuances and
settlements, net.............................. 465.4 (3.0) (6.3) (18.7) (1.4)
Total realized and unrealized gains (losses):
Included in net loss.......................... (18.9) - (2.3) - .9
Included in other comprehensive
income (loss)............................... (247.9) .9 - (2.6) (1.5)
Transfers in and/or (out) of Level 3 (a)........ (75.8) - (.5) (36.3) -
-------- ----- ----- ------ ------
Ending balance as of December 31, 2008............ $1,876.1 $32.4 $ 2.7 $ 48.1 $ 2.3
======== ===== ===== ====== =====
Amount of total gains (losses) for the year
ended December 31, 2008 included in
our net loss relating to assets and
liabilities still held as of the reporting
date............................................ $(5.6) $ - $ - $ - $.9
===== ===== ===== ===== ===
<FN>
- -----------
(a) Net transfers out of Level 3 are reported as having occurred at the
beginning of the period.
</FN>
At December 31, 2008, 80 percent of our Level 3 actively managed fixed
maturities were investment grade and 91 percent of our Level 3 actively managed
fixed maturities consisted of corporate securities.
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 and purchases and
settlements of derivative instruments.
We review the fair value hierarchy classifications each reporting period.
Transfers in and/or (out) of Level 3 in 2008 were primarily due to changes in
the observability of the valuation attributes resulting 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.
82
The Securities Valuation Office ("SVO") of the NAIC evaluates fixed
maturity investments for regulatory reporting purposes and assigns securities to
one of six investment categories called "NAIC Designations". The NAIC ratings
are similar to the rating agency descriptions of the Nationally Recognized
Statistical Rating Organization ("NRSROs"). NAIC designations of "1" or "2"
include fixed maturities generally rated investment grade (rated "Baa3" or
higher by Moody's or rated "BBB-" or higher by S&P and Fitch Ratings ("Fitch"))
NAIC Designations of "3" through "6" are referred to as below investment grade
(which generally are rated "Ba1" or lower by Moody's or rated "BB+" or lower by
S&P and Fitch). As a result of time lags between the funding of investments, the
finalization of legal documents and the completion of the SVO filing process,
our fixed maturities generally include securities that have not yet been rated
by the SVO as of each balance sheet date. Pending receipt of the SVO ratings,
the classification of these securities by NAIC Designation is based on the
expected ratings as determined by the Company. References to investment grade or
below investment grade are based on NAIC Designations. The following table sets
forth fixed maturity investments at December 31, 2008, classified by NAIC
Designation and the equivalent NRSRO rating (dollars in millions):
Estimated fair value
--------------------------
Percent of
NRSRO equivalent Amortized fixed
NAIC rating rating cost Amount maturities
- ----------- ------ ---- ------ ----------
1........................................... AAA/AA/A $ 9,609.2 $ 8,510.0 56%
2........................................... BBB 6,683.5 5,375.1 35
--------- --------- --
Investment grade........................ 16,292.7 13,885.1 91
--------- --------- ---
3........................................... BB 1,395.0 992.4 7
4........................................... B 498.7 339.5 2
5........................................... CCC and lower 73.0 45.6 -
6........................................... In or near default 16.9 14.4 -
--------- --------- ---
Below-investment grade (a).............. 1,983.6 1,391.9 9
--------- --------- ---
Total fixed maturity securities...... $18,276.3 $15,277.0 100%
========= ========= ===
<FN>
- ---------
(a) Below-investment grade fixed maturity securities with an amortized
cost of $379.2 million and an estimated fair value of $261.7 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. Refer to the note to the consolidated financial statements
entitled "Investment in a Variable Interest Entity" concerning the
Company's investment in the VIE. At December 31, 2008, our total
investment in the VIE was $83.8 million. Our investments in the VIE
were rated as follows: $25.2 million was rated NAIC 4, $56.7 million
was rated NAIC 6 and $1.9 million was not rated as it was an
equity-type security.
</FN>
The following table summarizes investment yields earned over the past three
years on the general account invested assets of our insurance subsidiaries.
General account investments exclude the value of options (dollars in millions).
2008 2007 2006
---- ---- ----
Weighted average general account invested assets as defined:
As reported........................................................ $19,597.9 $22,469.2 $21,718.7
Excluding unrealized appreciation
(depreciation) (a)............................................... 21,323.3 22,835.4 22,420.7
Net investment income on general account
invested assets........................................................ 1,249.9 1,344.1 1,275.0
Yields earned:
As reported........................................................ 6.38% 5.98% 5.87%
Excluding unrealized appreciation
(depreciation) (a)............................................... 5.86% 5.89% 5.69%
83
- --------------------
(a) Excludes the effect of reporting fixed maturities at fair value as
described in the note to our consolidated financial statements entitled
"Investments".
Although investment income is a significant component of total revenues,
the profitability of certain of our insurance products is determined primarily
by the spreads between the interest rates we earn and the rates we credit or
accrue to our insurance liabilities. At December 31, 2008 and 2007, the average
yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 6.0 percent and 6.0 percent, respectively, and the average
interest rate credited or accruing to our total insurance liabilities (excluding
interest rate bonuses for the first policy year only and excluding the effect of
credited rates attributable to variable or equity-indexed products) was 4.5
percent and 4.7 percent, respectively.
Actively Managed Fixed Maturities
Our actively managed fixed maturity portfolio at December 31, 2008,
included primarily debt securities of the United States government, public
utilities and other corporations, and structured securities. 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".
At December 31, 2008, our fixed maturity portfolio had $168.5 million of
unrealized gains and $3,167.8 million of unrealized losses, for a net unrealized
loss of $2,999.3 million. Estimated fair values of fixed maturity investments
were determined based on estimates from: (i) nationally recognized pricing
services (87 percent of the portfolio); (ii) broker-dealer market makers (1
percent of the portfolio); and (iii) internally developed methods (12 percent of
the portfolio).
At December 31, 2008, approximately 7.5 percent of our invested assets (9.1
percent of fixed maturity investments) were fixed maturities rated
below-investment grade. Our level of investments in below-investment-grade fixed
maturities could change if market conditions change. Below-investment grade
securities have different characteristics than investment grade corporate debt
securities. Based on historical performance, risk of default by the borrower is
significantly greater for below-investment grade securities and in many cases
severity of loss is relatively greater as such securities are generally
unsecured and often subordinated to other indebtedness of the issuer. Also,
issuers of below-investment grade securities usually have higher levels of debt
and may be more financially leveraged, hence, all other things being equal, more
sensitive to adverse economic conditions, such as recession or increasing
interest rates. The Company attempts to reduce the overall risk related to its
investment in below-investment grade securities, as in all investments, through
careful credit analysis, strict investment policy guidelines, and
diversification by issuer and/or guarantor and by industry. At December 31,
2008, our below-investment-grade fixed maturity investments had an amortized
cost of $1,983.6 million and an estimated fair value of $1,391.9 million.
We continually evaluate the creditworthiness of each issuer whose
securities we hold. We pay special attention to large investments and to those
securities whose market values have declined materially for reasons other than
changes in interest rates or other general market conditions. We evaluate the
realizable value of the investment, the specific condition of the issuer and the
issuer's ability to comply with the material terms of the security. We review
the recent operational results and financial position of the issuer, information
about its industry, information about factors affecting the issuer's performance
and other information. 40|86 Advisors employs experienced securities analysts in
a variety of specialty areas who compile and review such data. If evidence does
not exist to support a realizable value equal to or greater than the amortized
cost of the investment, and such decline in market value is determined to be
other than temporary, we reduce the amortized cost to its fair value, which
becomes the new cost basis. We report the amount of the reduction as a realized
loss. We recognize any recovery of such reductions as investment income over the
remaining life of the investment (but only to the extent our current valuations
indicate such amounts will ultimately be collected), or upon the repayment of
the investment. During 2008, we recognized net realized investment losses of
$262.4 million, which were comprised of: (i) $100.1 million of net losses from
the sales of investments (primarily fixed maturities); and (ii) $162.3 million
of writedowns of investments for other than temporary declines in fair value.
Our investment portfolio is subject to the risks of further declines in
realizable value. However, we attempt to mitigate this risk through the
diversification and active management of our portfolio.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we have both the ability and intent to hold securities with
unrealized losses until they mature or recover in value, we may sell securities
at a loss in the
84
future because of actual or expected changes in our view of the particular
investment, its industry, its type or the general investment environment. In
making investment decisions, we consider the impact on the capital and surplus
of the insurance company and the corresponding impact of the Company's ability
to maintain compliance with the financial covenants under the Second Amended
Credit Facility.
As of December 31, 2008, we had investments in substantive default (i.e.,
in default due to nonpayment of interest or principal) that had an estimated
fair value of $3.4 million. 40|86 Advisors employs experienced professionals to
manage non-performing and impaired investments. There were no other fixed
maturity investments about which we had serious doubts as to the recoverability
of the carrying value of the investment.
When a security defaults, our policy is to discontinue the accrual of
interest and eliminate all previous interest accruals, if we determine that such
amounts will not be ultimately realized in full. Investment income forgone due
to defaulted securities was $.9 million, nil and nil for the years ended
December 31, 2008, 2007 and 2006, respectively.
At December 31, 2008, fixed maturity investments included $3.4 billion of
structured securities (or 22 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 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. The
yield 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
2008.
85
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral at December 31, 2008 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 61.9 $ 49.8 $ 45.0
4 percent - 5 percent............................................................... 85.4 81.7 79.7
5 percent - 6 percent............................................................... 3,097.6 3,021.6 2,544.9
6 percent - 7 percent............................................................... 870.6 842.7 544.4
7 percent - 8 percent............................................................... 190.5 186.9 121.2
8 percent and above................................................................. 66.6 62.9 46.7
-------- -------- --------
Total structured securities.................................................. $4,372.6 $4,245.6 $3,381.9
======== ======== ========
The amortized cost and estimated fair value of structured securities at
December 31, 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..................... $1,525.9 $1,406.8 9.2%
Planned amortization classes, target amortization classes and
accretion-directed bonds............................................. 1,388.2 1,059.3 7.0
Commercial mortgage-backed securities................................... 832.2 567.2 3.7
Asset-backed securities................................................. 291.3 203.7 1.3
Collateralized debt obligations......................................... 134.3 96.6 .6
Other................................................................... 73.7 48.3 .3
-------- -------- ----
Total structured securities...................................... $4,245.6 $3,381.9 22.1%
======== ======== ====
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 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 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.
During 2008, we sold $.8 billion of fixed maturity investments which
resulted in gross investment losses (before income taxes) of $177.3 million. We
sell securities at a loss for a number of reasons including, but not limited to:
(i) changes in the investment environment; (ii) expectation that the market
value could deteriorate further; (iii) desire to reduce our exposure to an
issuer or an industry; (iv) changes in credit quality; or (v) changes in
expected liability cash flows. As discussed in the notes to our consolidated
financial statements, the realization of gains and losses affects the timing of
the amortization of insurance acquisition costs related to universal life and
investment products.
Other Investments
Our investment portfolio includes structured securities collateralized by
sub prime residential loans with a market
86
value of $58.2 million and a book value of $81.4 million at December 31, 2008.
These securities represent less than .3 percent of our consolidated investment
portfolio. Of these securities, $49.5 million (85 percent) were rated NAIC 1,
$8.2 million (14 percent) were rated NAIC 2 and $.5 million (1 percent) were
rated NAIC 3. Sub prime structured securities issued in 2006 and 2007 have
experienced higher delinquency and foreclosure rates than originally expected.
The Company's investment portfolio includes sub prime structured securities
collateralized by residential mortgage loans extended over several years,
primarily from 2003 to 2007. At December 31, 2008, we held no sub prime
securities collateralized by loans extended in 2006 and we held $5.8 million
extended in 2007.
At December 31, 2008, we held commercial mortgage loan investments with a
carrying value of $2,159.4 million (or 12 percent of total invested assets) and
a fair value of $2,122.1 million. The mortgage loan balance was primarily
comprised of commercial loans. Noncurrent commercial mortgage loans were
insignificant at December 31, 2008. During 2008, we recognized $5.8 million of
writedowns of commercial mortgage loans for other-than-temporary declines in
fair value and recognized losses of $22.1 million from the liquidation of
several delinquent commercial mortgage loans. Realized losses on commercial
mortgage loans were not significant in 2007 or 2006. Our allowance for loss on
mortgage loans was nil and $2.4 million at December 31, 2008 and 2007,
respectively. Approximately 7 percent, 7 percent, 7 percent, 6 percent , 6
percent and 6 percent of the mortgage loan balance were on properties located in
Indiana, California, Florida, Ohio, Minnesota, and Arizona, respectively. No
other state comprised greater than 5 percent of the mortgage loan balance.
The following table shows the distribution of our commercial mortgage loan
portfolio by property type as of December 31, 2008 (dollars in millions):
Number of Carrying
loans value
----- -----
Retail.......................................................................... 372 $ 905.5
Office building................................................................. 188 818.9
Industrial...................................................................... 75 316.8
Multi-family.................................................................... 39 100.7
Other........................................................................... 7 17.5
--- --------
Total commercial mortgage loans.............................................. 681 $2,159.4
=== ========
The following table shows our commercial mortgage loan portfolio by loan
size as of December 31, 2008 (dollars in millions):
Number Principal
of loans balance
-------- -------
Under $5 million................................................................ 566 $1,145.3
$5 million but less than $10 million............................................ 91 622.1
$10 million but less than $20 million........................................... 15 196.1
Over $20 million................................................................ 9 201.7
--- --------
Total commercial mortgage loans.............................................. 681 $2,165.2
=== ========
87
The following table summarizes the distribution of maturities of our
commercial mortgage loans as of December 31, 2008 (dollars in millions):
Number Principal
of loans balance
-------- -------
2009............................................................................ 25 $ 78.6
2010............................................................................ 6 3.2
2011............................................................................ 19 71.0
2012............................................................................ 24 54.9
2013............................................................................ 32 171.8
after 2013...................................................................... 575 1,785.7
--- --------
Total commercial mortgage loans.............................................. 681 $2,165.2
=== ========
At December 31, 2008, we held $326.5 million of trading securities. We
carry trading securities at estimated fair value; changes in fair value are
reflected in the statement of operations. Our trading securities are held to act
as hedges for embedded derivatives related to our equity-indexed annuity
products and certain modified coinsurance agreements. See the note to the
consolidated financial statements entitled "Summary of Significant Accounting
Policies - Accounting for Derivatives" for further discussion regarding the
embedded derivatives and the trading accounts. In addition, the trading account
includes investments backing the market strategies of our multibucket annuity
products.
Other invested assets also include options backing our equity-indexed
products, futures, credit default swaps, forward contracts and certain
nontraditional investments, including investments in limited partnerships,
promissory notes and real estate investments held for sale.
The Company participates in a securities lending program whereby certain
fixed maturity securities from our investment portfolio are loaned to third
parties via a lending agent for a short period of time. We maintain ownership of
the loaned securities. We require collateral equal to 102 percent of the market
value of the loaned securities. The collateral is invested by the lending agent
in accordance with our guidelines. The fair value of the loaned securities is
monitored on a daily basis with additional collateral obtained as necessary.
Under the terms of the securities lending program, the lending agent indemnifies
the Company against borrower defaults. As of December 31, 2008 and 2007, the
fair value of the loaned securities was $389.3 million and $450.3 million,
respectively. As of December 31, 2008 and 2007, the Company had received
collateral of $408.8 million and $460.4 million, respectively. Income generated
from the program, net of expenses is recorded as net investment income and
totaled $2.4 million, $1.3 million and $1.4 million in 2008, 2007 and 2006,
respectively.
CONSOLIDATED FINANCIAL CONDITION
Changes in the Consolidated Balance Sheet
Changes in our consolidated balance sheet between December 31, 2008 and
December 31, 2007, primarily reflect: (i) the Transfer; (ii) our net loss for
2008; and (iii) changes in the fair value of actively managed fixed maturity
securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At December 31, 2008, we decreased the
carrying value of such investments by $3.0 billion as a result of this fair
value adjustment.
88
Our capital structure as of December 31, 2008 and 2007 was as follows
(dollars in millions):
2008 2007
---- ----
Total capital:
Corporate notes payable....................................... $ 1,328.7 $1,193.7
Shareholders' equity:
Common stock............................................... 1.9 1.9
Additional paid-in capital................................. 4,076.0 4,068.6
Accumulated other comprehensive loss....................... (1,770.7) (273.3)
Retained earnings (accumulated deficit).................... (688.0) 438.7
--------- --------
Total shareholders' equity............................. 1,619.2 4,235.9
--------- --------
Total capital.......................................... $ 2,947.9 $5,429.6
========= ========
The following table summarizes certain financial ratios as of and for the
years ended December 31, 2008 and 2007:
2008 2007
---- ----
Book value per common share................................................................... $ 8.76 $22.94
Book value per common share, excluding accumulated other
comprehensive income (loss) (a)............................................................ 18.35 24.42
Ratio of earnings to fixed charges............................................................ 1.03X (b)
Ratio of earnings to fixed charges and preferred dividends.................................... 1.03X (c)
Debt to total capital ratios:
Corporate debt to total capital (d)...................................................... 45% 22%
Corporate debt to total capital, excluding accumulated other
comprehensive income (loss) (a)........................................................ 28% 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 $10.0 million less than fixed charges.
(c) For such ratio, earnings were $33.5 million less than fixed charges.
(d) Such ratio differs from the debt to total capitalization ratio
required by our Second Amended Credit Facility, primarily because the
credit agreement ratio excludes accumulated other comprehensive income
(loss) from total capital.
</FN>
89
Contractual Obligations
The Company's significant contractual obligations as of December 31, 2008,
were as follows (dollars in millions):
Payment due in
--------------------------------------------------------
Total 2009 2010-2011 2012-2013 Thereafter
----- ---- --------- --------- ----------
Insurance liabilities (a)............ $52,616.6 $3,643.1 $6,912.1 $6,326.3 $35,735.1
Notes payable (b).................... 1,679.3 165.9 490.8 1,022.6 -
Investment borrowings (c)............ 1,044.3 39.4 77.1 554.3 373.5
Postretirement plans (d)............. 176.6 3.9 8.1 9.3 155.3
Operating leases and certain other
contractual commitments (e)...... 222.8 46.2 61.3 41.0 74.3
--------- -------- -------- -------- ---------
Total............................ $55,739.6 $3,898.5 $7,549.4 $7,953.5 $36,338.2
========= ======== ======== ======== =========
<FN>
- --------------------
(a) These cash flows represent our estimates of the payments we expect to
make to our policyholders, without consideration of future premiums or
reinsurance recoveries. These estimates are based on numerous
assumptions (depending on the product type) related to mortality,
morbidity, lapses, withdrawals, future premiums, future deposits,
interest rates on investments, credited rates, expenses and other
factors which affect our future payments. The cash flows presented are
undiscounted for interest. As a result, total outflows for all years
exceed the corresponding liabilities of $24.2 billion included in our
consolidated balance sheet as of December 31, 2008. As such payments
are based on numerous assumptions, the actual payments may vary
significantly from the amounts shown.
In estimating the payments we expect to make to our policyholders, we
considered the following:
o For products such as immediate annuities and structured
settlement annuities without life contingencies, the payment
obligation is fixed and determinable based on the terms of the
policy.
o For products such as universal life, ordinary life, long-term
care, specified disease and fixed rate annuities, the future
payments are not due until the occurrence of an insurable
event (such as death or disability) or a triggering event
(such as a surrender or partial withdrawal). We estimated
these payments using actuarial models based on historical
experience and our expectation of the future payment patterns.
o For short-term insurance products such as Medicare supplement
insurance, the future payments relate only to amounts
necessary to settle all outstanding claims, including those
that have been incurred but not reported as of the balance
sheet date. We estimated these payments based on our
historical experience and our expectation of future payment
patterns.
o The average interest rate we assumed would be credited to our
total insurance liabilities (excluding interest rate bonuses
for the first policy year only and excluding the effect of
credited rates attributable to variable or equity-indexed
products) over the term of the contracts was 4.5 percent.
(b) Includes projected interest payments based on market rates, as
applicable, as of December 31, 2008 and reflects the modification to
the Second Amended Credit Facility. Refer to the notes to the
consolidated financial statements entitled "Notes Payable - Direct
Corporate Obligations" and "Subsequent Events" for additional
information on notes payable.
(c) These borrowings primarily represent: (i) the securities issued by a
VIE and include projected interest payments based on market rates, as
applicable, as of December 31, 2008; and (ii) collateralized
borrowings from the Federal Home Loan Bank of Indianapolis ("FHLBI").
(d) Includes benefits expected to be paid pursuant to our deferred
compensation plan and postretirement plans based on numerous actuarial
assumptions and interest credited at 6.03 percent.
(e) Refer to the notes to the consolidated financial statements entitled
"Commitments and Contingencies" for additional information on
operating leases and certain other contractual commitments.
</FN>
90
It is possible that the ultimate outcomes of various uncertainties could
affect our liquidity in future periods. For example, the following events could
have a material adverse effect on our cash flows:
o An adverse decision in pending or future litigation.
o An inability to obtain rate increases on certain of our insurance
products.
o Worse than anticipated claims experience.
o Lower than expected dividends and/or surplus debenture interest
payments from our insurance subsidiaries (resulting from inadequate
earnings or capital or regulatory requirements).
o An inability to meet and/or maintain the covenants in our Second
Amended Credit Facility.
o A significant increase in policy surrender levels.
o A significant increase in investment defaults.
o An inability of our reinsurers to meet their financial obligations.
While we seek to balance the duration and cash flows of our invested assets
with the estimated duration and cash flows of benefit payments arising from
contract liabilities, there could be significant variations in the timing of
such cash flows. Although we believe our current estimates properly project
future claim experience, if these estimates prove to be wrong, and our
experience worsens (as it did in some prior periods), our future liquidity could
be adversely affected.
Liquidity for Insurance Operations
Our insurance companies generally receive adequate cash flows from premium
collections and investment income to meet their obligations. Life insurance and
annuity liabilities are generally long-term in nature. Policyholders may,
however, withdraw funds or surrender their policies, subject to any applicable
penalty provisions. We seek to balance the duration of our invested assets with
the estimated duration of benefit payments arising from contract liabilities.
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 December 31, 2008, the carrying value of the FHLBI common stock was $22.5
million. Collateralized borrowings totaled $450.0 million as of December 31,
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 $504.6 million at December 31, 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 December 31, 2008
-------- ---- --------------------
$ 54.0 May 2012 Variable rate - 2.153%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 4.810%
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 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.
91
During 2008, the financial statements of three of our subsidiaries prepared
in accordance with statutory accounting practices prescribed or permitted by
regulatory authorities reflected the establishment of asset adequacy or premium
deficiency reserves primarily related to long-term care and annuity policies.
Total asset adequacy and premium deficiency reserves for Washington National,
Conseco Insurance Company and Bankers Conseco Life were $53.3 million, $20.0
million and $19.5 million, respectively at December 31, 2008. Due to differences
between statutory and GAAP insurance liabilities, we were not required to
recognize a similar premium deficiency reserve in our consolidated financial
statements prepared in accordance with GAAP. The determination of the need for
and amount of asset adequacy reserves is subject to numerous actuarial
assumptions, including the Company's ability to change nonguaranteed elements
related to certain products consistent with contract provisions.
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 March 4, 2009, A.M. Best downgraded the financial strength ratings of
our primary insurance subsidiaries to "B" from "B+" and such ratings have been
placed under review with negative implications. On November 20, 2008, A.M. Best
affirmed: (i) the financial strength ratings of "B+" of our primary insurance
subsidiaries; and (ii) the outlook was negative for our primary insurance
subsidiaries. On August 7, 2007, A.M. Best downgraded the financial strength
ratings of our primary insurance subsidiaries to "B+ (Good)" from "B++ (Good)".
The "B" rating is assigned to companies that have a fair ability, in A.M. Best's
opinion, to meet their current obligations to policyholders, but are financially
vulnerable to adverse changes in underwriting and economic conditions. A.M. Best
ratings for the industry currently range from "A++ (Superior)" to "F (In
Liquidation)" and some companies are not rated. An "A++" rating indicates a
superior ability to meet ongoing obligations to policyholders. A.M. Best has
sixteen possible ratings. There are six ratings above our "B" rating and nine
ratings that are below our rating.
On February 26, 2009, S&P downgraded the financial strength ratings of our
primary insurance subsidiaries to "BB-" from "BB+" and the outlook remained
negative for our primary insurance subsidiaries. On March 2, 2009, S&P placed
the financial strength ratings of our primary insurance subsidiaries on credit
watch with negative implications. A rating on credit watch with negative
implications highlights the potential direction of a rating focusing on
identifiable events and short-term trends that cause ratings to be placed under
special surveillance by S&P. A "negative" designation means that a rating may be
lowered. 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.
S&P has twenty-one possible ratings. There are twelve ratings above our "BB-"
rating and eight ratings that are below our rating.
On March 3, 2009, Moody's downgraded the financial strength ratings of our
primary insurance subsidiaries to "Ba2" from "Ba1" and the outlook remained
negative for our primary insurance subsidiaries. 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 "Ba2" offers questionable financial security and, often, the
ability of these companies to meet policyholders obligations may be very
moderate and thereby not well safeguarded in the future. Moody's has twenty-one
possible ratings. There are eleven ratings above our "Ba2" rating and nine
ratings that are below our rating.
Liquidity of the Holding Companies
We have significant indebtedness which will require over $165 million in
cash to service in 2009 (including the additional interest expense required
after the modification to our Second Amended Credit Facility described in the
note to the consolidated financial statements entitled "Subsequent Events").
Pursuant to our Second Amended Credit Facility, we must maintain certain
financial ratios. The levels of margin between the financial covenant
requirements and our financial status, both at year-end 2008 and the projected
levels during 2009, are relatively small and a failure to satisfy any of our
financial covenants at the end of a fiscal quarter would trigger a default under
our Second Amended Credit Facility. Achievement of our 2009 operating plan is a
critical factor in having sufficient income and liquidity to meet all of our
2009 debt service requirements and other holding company obligations and failure
to do so would have material adverse consequences for the Company. These items
are discussed further below.
92
As described below, we completed an amendment to our Second Amended Credit
Facility, which provides for, among other things: (i) additional margins between
our current financial status and certain financial covenant requirements through
June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new
restrictions on the ability of the Company to incur additional indebtedness; and
(iv) the ability of the lender to appoint a financial advisor at the Company's
expense.
At December 31, 2008, CNO, CDOC (our wholly owned subsidiary and a
guarantor under the Second Amended Credit Facility) and our other non-insurance
subsidiaries held unrestricted cash of $59.0 million. CNO 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. CNO and CDOC receive cash
from insurance subsidiaries, consisting of dividends and distributions, 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 CNO and
CDOC are 40|86 Advisors, which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives fees from the
insurance subsidiaries for providing administrative services. The agreements
between our insurance subsidiaries and Conseco Services, LLC and 40|86 Advisors,
respectively, were previously approved by the domestic insurance regulator for
each insurance company, and any payments thereunder do not require further
regulatory approval.
A deterioration in the financial condition, earnings or cash flow of the
material subsidiaries of CNO or CDOC for any reason could hinder such
subsidiaries' ability to pay cash dividends or other disbursements to CNO and/or
CDOC, which, in turn, would limit Conseco's ability to meet debt service
requirements and satisfy other financial obligations. In addition, we may choose
to retain capital in our insurance subsidiaries or to contribute additional
capital to our insurance subsidiaries to strengthen their surplus, and these
decisions could limit the amount available at our top tier insurance
subsidiaries to pay dividends to the holding companies. In the past, we have
made capital contributions to our insurance subsidiaries to meet debt covenants
and minimum capital levels required by certain regulators and it is possible we
will be required to do so in the future. Our holding companies made capital
contributions totaling $79.4 million to our insurance subsidiaries in 2008,
primarily in connection with the transfer of Senior Health. We currently do not
expect that contributions to our insurance subsidiaries will be required in
2009. If contributions were required, our holding companies would have limited
available capital for such contributions.
The following summarizes the legal ownership structure of Conseco's primary
subsidiaries at December 31, 2008:
[GRAPHIC OMITTED]
93
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 (excluded from
this calculation would be the $61.9 million of additional surplus recognized due
to the approval of a permitted practice by insurance regulators related to
certain deferred tax assets as further described below in this section
discussing actions we have taken to improve our capitalization and ratios). This
type of dividend is referred to as "ordinary dividends". Any dividends in excess
of these levels require the approval of the director or commissioner of the
applicable state insurance department. This type of dividend is referred to as
"extraordinary dividends". During 2008, our insurance subsidiaries paid
extraordinary dividends of $20.0 million to CDOC. Each of the direct insurance
subsidiaries of CDOC have negative earned surplus at December 31, 2008 as
summarized below (dollars in millions):
Earned
surplus
Subsidiary of CDOC (deficit) (a) Additional information
------------------ ------------- ----------------------
Conseco Life of Texas $(1,206.4) (b)
Washington National (1,111.3) (c)
Conseco Health (23.2) (d)
<FN>
- -----------
(a) As calculated pursuant to the state insurance department of each
company's domiciliary state.
(b) During 2008, Conseco Life of Texas transferred the ownership of Senior
Health, Washington National and Conseco Health to CDOC. As a result of
this transaction, the $1,574.7 million of accumulated unrealized
losses of Conseco Life of Texas' former subsidiaries were realized by
Conseco Life of Texas, reducing its earned surplus to $(1,206.4)
million at December 31, 2008, pursuant to the manner earned surplus is
calculated under the regulations of the Texas Department of Insurance.
(c) Pursuant to the regulations of the Illinois Division of Insurance, the
accumulated earnings and losses of Washington National's subsidiaries
are reflected in the earned surplus of Washington National. Conseco
Life, a subsidiary of Washington National, incurred aggregate costs in
excess of $265 million during the three years ended December 31, 2007
related to litigation regarding a change made in 2003 and 2004 in the
manner cost of insurance charges are calculated for certain life
insurance policies. In addition, significant dividend payments have
been made from Washington National and its subsidiaries in the past
which have increased its earned deficit, including payments made
following significant reductions in the business of Washington
National and its subsidiaries pursuant to a reinsurance transaction
completed in 2007.
(d) Based on our 2009 business plan, Conseco Health's 2009 earnings are
expected to result in a positive earned surplus balance later in the
year, enabling it to pay ordinary dividends. Such ordinary dividend
payments would be limited to the lesser of $12.9 million (10 percent
of its statutory surplus balance at December 31, 2008) or its positive
earned surplus balance.
</FN>
As described above, any current dividend payments from the subsidiaries of
CDOC would be considered extraordinary dividends and therefore require the
approval of the director or commissioner of the applicable state insurance
department. During 2009, we are expecting our insurance subsidiaries to pay
approximately $60.0 million of extraordinary dividends to CDOC ($25.0 million of
which has been approved by the Texas Department of Insurance for payment and
$35.0 million of which is expected to be approved by the Texas Department of
Insurance and paid later in 2009). In addition, we are expecting Conseco Life of
Texas to pay interest on surplus debentures of $44.5 million ($21.2 million of
which has been approved by the Texas Department of Insurance and $23.3 million
of which is expected to be approved by the Texas Department of Insurance and
paid later in 2009). Although we believe the dividends and surplus debenture
interest payments we are expecting to pay during 2009 are consistent with
payments that have been approved by insurance regulators in prior years, there
can be no assurance that such payments will be approved or that the financial
condition of our insurance subsidiaries will not change, making future approvals
less likely. Dividends and other payments from our non-insurance subsidiaries,
including 40|86 Advisors and Conseco Services, LLC, to CNO or CDOC do not
require approval by any regulatory authority or other third party. However,
insurance regulators may prohibit payments by our insurance subsidiaries to
parent companies if they determine that such payments could be adverse to our
policyholders or contractholders.
94
The insurance subsidiaries of CDOC receive funds to pay dividends from: (i)
the earnings of their direct businesses; (ii) tax sharing payments received from
subsidiaries (if applicable); and (iii) dividends received from subsidiaries (if
applicable). At December 31, 2008, these subsidiaries had negative or low levels
of earned surplus as summarized below (dollars in millions):
Earned
surplus
Subsidiary of CDOC (deficit) (a) Additional information
------------------ ------------- ----------------------
Subsidiaries of Conseco Life of Texas:
Bankers Life and Casualty Company $ (23.2) (b)
Colonial Penn (221.3) (c)
Subsidiaries of Washington National:
Conseco Insurance Company 7.4 (d)
Conseco Life (355.0) (e)
<FN>
- -----------
(a) As calculated pursuant to the state insurance department of each
company's domiciliary state.
(b) Based on our 2009 business plan, Bankers Life and Casualty Company's
earnings during 2009 are expected to result in a positive earned
surplus later in the year, enabling it to pay ordinary dividends. Such
ordinary dividend payments would be limited to the lesser of $57.2
million (10 percent of Bankers Life and Casualty Company's statutory
capital and surplus balance at December 31, 2008) or its positive
earned surplus balance.
(c) For tax planning purposes, Colonial Penn paid dividends to its parent
of $150 million during 2006. In addition, Colonial Penn issued a
surplus debenture to CDOC in exchange for $160 million of cash. The
2006 dividend payment reduced Colonial Penn's earned surplus by $150
million (even though total capital and surplus increased by $10
million after the issuance of the surplus debenture). In 2007,
Colonial Penn recaptured a block of traditional life business
previously ceded to an unaffiliated insurer in 2002. The Company's
earned surplus was reduced by $63 million as a result of the fee paid
to recapture this business.
(d) As of December 31, 2008, Conseco Insurance Company may pay ordinary
dividends of $7.4 million. Based on our 2009 business plan, Conseco
Insurance Company's 2009 earnings are expected to increase later in
the year enabling it to pay additional ordinary dividends. Such
ordinary dividend payments would be limited to the lesser of $18.7
million (Conseco Insurance Company's statutory net income for the year
ended December 31, 2008) or its positive earned surplus balance.
(e) We have no plans for Conseco Life to pay dividends to Washington
National at any time in the foreseeable future.
</FN>
In assessing Conseco's current financial position and operating plans for
the future, management made significant judgments and estimates with respect to
the potential financial and liquidity effects of Conseco's risks and
uncertainties, including but not limited to:
o the approval of dividend payments and surplus debenture interest
payments from our insurance subsidiaries by the director or
commissioner of the applicable state insurance departments;
o the potential adverse effects on Conseco's businesses from recent
downgrades or further downgrades by rating agencies;
o our ability to achieve our operating plan;
o the potential for continued declines in the bond and equity markets
and the potential for further significant recognition of
other-than-temporary impairments;
o the potential need to provide additional capital to our insurance
subsidiaries;
o our ability to continue to achieve compliance with our loan covenants
and the financial ratios we are required to maintain;
o the potential loss of key personnel that could impair our ability to
achieve our operating plan;
95
o the potential impact of an ownership change or a decrease in our
operating earnings on the valuation allowance related to our deferred
tax assets; and
o the potential impact on certain of Conseco's insurance subsidiaries if
regulators do not allow us to continue to recognize certain deferred
tax assets pursuant to permitted statutory accounting practices.
The following summarizes the projected sources and uses of cash of CDOC and
CNO during 2009 (dollars in millions):
From our operations From surplus From
or approved dividends debenture interest extraordinary
and surplus debenture payments requiring dividends
interest payments approval requiring approval Total
----------------- -------- ------------------ -----
Sources of holding company cash:
Dividends from our insurance subsidiaries:
Conseco Life of Texas........................ $ 25.0 $ - $20.0 $ 45.0
Washington National.......................... - - 5.0 5.0
Conseco Health............................... - - 10.0 10.0
Surplus debenture interest..................... 21.2 23.3 - 44.5
Administrative services fees................... 46.0 - - 46.0
Investment services fees....................... 24.0 - - 24.0
Amount received in conjunction with the
termination of commission financing
agreement with Conseco Insurance
Company...................................... 17.0 - - 17.0
Intercompany loan from a non-life subsidiary... 14.0 - - 14.0
------ ----- ----- ------
Total sources of cash expected to be available
to service our debt and other obligations.. 147.2 23.3 35.0 205.5
------ ----- ----- ------
Uses of holding company cash:
Debt service commitments of CNO and CDOC:
Estimated interest payments (b)................ 66.8 - - 66.8
Scheduled principal payments under
our secured credit agreement................. 10.0 - - 10.0
Repayment of amounts borrowed under
revolving credit facility maturing
on June 22, 2009............................. 55.0 - - 55.0
Fees to amend the Credit Facility.............. 9.1 - - 9.1
Scheduled principal payment under the
Senior Note payable to Senior Health......... 25.0 - - 25.0
Corporate expense and other.................... 32.2 - - 32.2
------ ----- ----- ------
Total expected uses of cash.................. 198.1 - - 198.1
------ ----- ----- ------
Net expected increase (decrease) in cash....... (50.9) $23.3 $35.0 7.4
===== =====
Cash balance, beginning of year (a)............ 59.0 59.0
------ ------
Expected cash balance, end of year (a)......... $ 8.1 $ 66.4
====== ======
<FN>
- ---------
(a) Includes cash balances of our other non-insurance subsidiaries, which
are available to CDOC or CNO.
(b) Includes additional interest expense required after the modification
to our Second Amended Credit Facility on March 30, 2009, as further
described below.
</FN>
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
96
bankruptcy laws.
In connection with the Transfer further discussed in the note to the
consolidated financial statements entitled "Transfer of Senior Health Insurance
Company of Pennsylvania to an Independent Trust", the Company issued a $125.0
million Senior Note due November 12, 2013 payable to Senior Health. The Senior
Note has a five-year maturity date; a 6 percent interest rate; and requires
annual principal payments of $25.0 million. Such amounts are expected to be
funded by the Company's operating activities. Conseco agreed that it would not
pay cash dividends on its common stock while any portion of the Senior Note
remained outstanding.
The Second Amended Credit Facility includes an $80.0 million revolving
credit facility that can be used for general corporate purposes and that will
mature on June 22, 2009. In October 2008, the Company borrowed $75.0 million
under the revolving credit facility. The Company also requested borrowings of
$5.0 million which were not funded. In December 2008, we repaid $20.0 million of
the revolving facility and reduced the maximum amount available under the
revolving facility to $60.0 million. At December 31, 2008, there was $55.0
million outstanding under the revolving facility. 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 the balance of the
Second Amended Credit Facility.
During 2008, we made scheduled principal payments totaling $8.7 million on
our Second Amended Credit Facility. The scheduled repayment of our direct
corporate obligations (including payments required under the Second Amended
Credit Facility, the revolving credit facility, the Senior Note and the
Debentures) is as follows (dollars in millions):
2009.......................................... $ 90.0
2010.......................................... 326.8
2011.......................................... 33.7
2012.......................................... 33.8
2013.......................................... 845.5
--------
$1,329.8
========
Pursuant to our Second Amended Credit Facility, we agreed to a number of
covenants and other provisions that restrict our ability to borrow money and
pursue some operating activities without the prior consent of the lenders. We
also agreed to meet or maintain various financial ratios and balances. Our
ability to meet these financial tests and maintain ratings may be affected by
events beyond our control. 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 Second Amended Credit Facility also requires that the
Company's audited consolidated financial statements be accompanied by an
opinion, from a nationally-recognized independent public accounting firm,
stating that such audited consolidated financial statements present fairly, in
all material respects, the financial position and results of operations of the
Company in conformity with GAAP for the periods indicated. Such opinion shall
not include an explanatory paragraph regarding the Company's ability to continue
as a going concern or similar qualification. Although we were in compliance with
the provisions of the Second Amended Credit Facility as of December 31, 2008,
these provisions represent significant restrictions on the manner in which we
may operate our business. If we default under any of these provisions, the
lenders could declare all outstanding borrowings, accrued interest and fees to
be due and payable. If that were to occur, no assurance can be given that we
would have sufficient liquidity to repay our bank indebtedness in full or any of
our other debts.
Pursuant to the Second Amended Credit Facility, as long as the debt to
total capitalization ratio (as defined in the Second Amended Credit Facility) is
greater than 20 percent or certain insurance subsidiaries (as defined in the
Second Amended Credit Facility) have financial strength ratings of less than A-
from A.M. Best, the Company is required to make mandatory prepayments with all
or a portion of the proceeds from the following transactions or events
including: (i) the issuance of certain indebtedness; (ii) certain 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,
of approximately $1.3 million, is expected to be paid in March 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 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
97
of the lenders. The following describes the financial ratios and amounts
as of December 31, 2008:
Covenant under the Balance or Margin for adverse
Second Amended ratio as of development from
Credit Facility (a) December 31, 2008 December 31, 2008 levels
--------------- ----------------- ------------------------
Aggregate risk-based capital ratio......... greater than or equal 255% Reduction to
to 250% statutory capital and
surplus of
approximately $25
million, or an
increase to the risk-
based capital of
approximately $10
million.
Combined statutory capital and surplus..... greater than $1,270 $1,366 million Reduction to
million combined statutory
capital and surplus
of approximately
$96 million.
Debt to total capitalization ratio......... not more than 30% 28% Reduction to
shareholders' equity
of approximately
$273 million or
additional debt of
$117 million.
Interest coverage ratio.................... greater than or equal 2.35 to 1 Reduction in cash
to 2.00 to 1 for each flows to the holding
rolling four quarters company of
approximately
$20 million.
<FN>
- --------------
(a) Refer to the information provided below for a description of changes
to the covenant requirements as a result of the amendment to the
Second Amended Credit Facility on March 30, 2009.
</FN>
These covenants place 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
covenants, the lenders could declare all outstanding borrowings, accrued
interest and fees to be immediately due and payable. If the lenders under our
Second Amended Credit Facility would elect to accelerate the amounts due, the
holders of our Debentures and Senior Note could elect to take similar action
with respect to those debts. If that were to occur, we would not have sufficient
liquidity to repay our indebtedness.
98
The following summarizes the pro forma financial ratios and amounts as of
December 31, 2008 as if the amendments made to the covenants on March 30, 2009
were effective on December 31, 2008:
Covenant under the
Second Amended Pro Forma margin for
Credit Facility as Balance or adverse development from
amended on ratio as of December 31, 2008
March 30, 2009 December 31, 2008 levels (a)
-------------- ----------------- ----------
Aggregate risk-based
capital ratio........... Greater than or equal to 255% Reduction to statutory capital
200% from March 31, 2009 and surplus of approximately
through June 30, 2010 and $290 million, or an increase
thereafter, greater than 250% to the risk-based capital of
(the same ratio required by approximately $145 million.
the facility prior to the
amendment).
Combined statutory
capital and surplus..... Greater than $1,100 million $1,366 Reduction to combined
from March 31, 2009 through statutory capital and surplus
June 30, 2010 and thereafter, of approximately $265 million.
$1,270 (the same amount
required by the facility prior
to the amendment).
Debt to total capitalization
ratio................... Not more than 32.5% from 28% Reduction to shareholders'
March 31, 2009 through equity of approximately $615
June 30, 2010 and thereafter, million or additional debt of
not more than 30% (the same $295 million.
ratio required by the facility
prior to the amendment).
Interest coverage ratio..... Greater than or equal to 1.50 2.35 to 1 Reduction in cash flows to
to 1 for rolling four quarters the holding company of
from March 31, 2009 through approximately $45 million.
June 30, 2010 and thereafter,
2.00 to 1 (the same ratio required
by the facility prior to the
amendment).
<FN>
- ------------
(a) Calculated as if the amendments made to the financial covenants on
March 30, 2009 (applicable to the period March 31, 2009 through June
30, 2010) were effective on December 31, 2008.
</FN>
Pursuant to its amended terms, the applicable interest rate on the Second
Amended Credit Facility (based on either a Eurodollar or base rate) has
increased. The Eurodollar rate is now equal to LIBOR plus 4 percent with a
minimum LIBOR rate of 2.5 percent (such rate was previously LIBOR plus 2 percent
with no minimum rate). The base rate is now equal to 2.5 percent plus the
greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of
America's prime rate. In addition, the amended agreement requires the Company to
pay a fee equal to 1 percent of the outstanding principal balance under the
Second Amended Credit Facility, which fee will be added to the principal balance
outstanding and will be payable at the maturity of the facility. This 1 percent
fee will be reported as non-cash interest expense.
The modifications to the Second Amended Credit Facility also place new
restrictions on the ability of the Company to incur additional indebtedness. The
amendment: (i) deleted the provision that allowed the Company to borrow up to an
additional $330 million under the Second Amended Credit Facility (the lenders
under the facility having had no obligation to lend any amount under that
provision); (ii) reduced the amount of secured indebtedness that the Company can
incur from $75
99
million to $2.5 million; and (iii) limited the ability of the Company to incur
additional unsecured indebtedness, except as provided below, to $25 million, and
eliminated the provision that would have allowed the Company to incur additional
unsecured indebtedness to the extent that principal payments were made on
existing unsecured indebtedness.
The Company is permitted to issue unsecured indebtedness that is used
solely to pay the holders of the Debentures, provided that such indebtedness
shall: (i) have a maturity date that is no earlier than October 10, 2014; (ii)
contain covenants and events of default that are no more restrictive than those
in the Second Amended Credit Facility; (iii) not amortize; and (iv) not have a
put date or otherwise be callable prior to April 10, 2014, and provided further
that the amount of cash interest payable annually on any new issuance of such
indebtedness, together with the cash interest payable on the outstanding
Debentures, shall not exceed twice the amount of cash interest currently payable
on the outstanding Debentures.
The amendment prohibits the Company from redeeming or purchasing the
Debentures with cash from sources other than those described in the previous
paragraph. The amendment permits the Company to amend, modify or refinance the
Debentures so long as such new indebtedness complies with the restrictions set
forth in the previous paragraph.
In addition, pursuant to the terms of the amended debt agreement, the agent
(acting on behalf of the lenders) has the right to appoint a financial advisor
at the Company's expense to, among other things, review financial projections
and other financial information prepared by or on behalf of the Company, perform
valuations of the assets of the Company and take other actions as are customary
or reasonable for an advisor acting in such capacity.
Pursuant to GAAP, the amendment to the Second Amended Credit Facility is
required to be accounted for in accordance with Statement of Financial
Accounting Standards No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings". Accordingly, the effects of the modifications will be
accounted for prospectively from March 31, 2009, and we will not change the
$911.8 million carrying amount of the Second Amended Credit Facility as a result
of the modifications. However, the estimated $9.0 million of fees incurred in
conjunction with the modifications of the facility will be expensed in the first
quarter of 2009.
Our life insurance subsidiaries are subject to risk-based capital
requirements. As described above, our Second Amended Credit Facility contains
certain financial covenants which are based on our aggregate risk-based capital.
The recent unprecedented economic and market conditions has both reduced the
statutory capital of our insurance subsidiaries and increased the risk-based
capital requirements of our insurance subsidiaries as further discussed below:
o We have incurred realized investment losses that reduced available
capital and surplus. For example, during the fourth quarter of 2008,
we incurred net capital losses pursuant to statutory accounting
practices of approximately $113 million. These losses resulted in a
reduction to our aggregate risk-based capital ratio of 21 percentage
points.
o We have had adverse experience related to certain commercial mortgage
loans which has resulted in an increase to our aggregate risk-based
capital. In the second quarter of 2008, we began foreclosure
proceedings on two delinquent commercial mortgage loans. Pursuant to
statutory rules and regulations which are followed to determine the
amount of required risk-based capital, our insurance subsidiaries are
required to apply a "mortgage experience adjustment factor" to the
entire portfolio of commercial mortgage loans based, in large part, on
a comparison of our default and loss experience to the aggregate
industry default and loss experience. The calculation is extremely
sensitive to slight variations in our experience. For example, during
the fourth quarter of 2008, our minimum aggregate risk-based capital
increased by approximately $42 million due to these requirements and
the foreclosure of these two loans which had a combined book value of
approximately $20 million. The establishment of additional required
risk-based capital related to the mortgage experience adjustment
factor resulted in a reduction to the aggregate risk-based capital
ratio of 23 percentage points in the fourth quarter of 2008.
o Certain of our fixed maturity investments have been subject to
downgrades by nationally recognized statistical rating organizations,
which have resulted in an increase to our aggregate risk-based
capital. Pursuant to statutory rules and regulations which are
followed to determine the amount of required risk-based capital, our
insurance subsidiaries are required to apply factors to the carrying
value of their fixed maturity investments which increase required
risk-based capital based on current ratings of nationally recognized
statistical rating organizations. Significant ratings downgrades
increase these capital requirements. For example, during the fourth
quarter of 2008 our required aggregate risk-based capital increased by
approximately $19.1 million as a result of downgrades of certain of
our fixed maturity investments. These downgrades resulted in a
reduction to
100
the aggregate risk-based capital ratio of 9 percentage points.
Additional downgrades in our portfolio during the first quarter of
2009 are expected to result in additional required risk-based capital.
For example, through February 28, 2009, our required risk-based
capital is estimated to have increased by approximately $20 million as
a result of recent downgrades.
We have recently taken capital management actions to improve our
capitalization and ratios and/or to improve our liquidity. In addition, our
insurance subsidiaries have generated statutory operating income, excluding
capital losses. The actions we have taken and our fourth quarter 2008 statutory
operating income are discussed further below:
o We requested and obtained approval of a statutory permitted accounting
practice as of December 31, 2008 for our insurance subsidiaries
domiciled in Illinois and Indiana. The permitted practice modifies the
accounting for deferred income taxes by increasing the realization
period for deferred tax assets from within one year to within three
years of the balance sheet date and increasing the asset recognition
limit from 10 percent to 15 percent of adjusted capital and surplus as
shown in the most recently filed statutory financial statements. The
impact of the permitted practice was to increase the statutory
consolidated capital and surplus of our insurance subsidiaries by $62
million as of December 31, 2008. In addition, the consolidated
risk-based capital ratio increased by 11 percentage points and, as a
result, the Company did not need to take additional actions in order
to meet the risk-based capital financial covenant requirement at
December 31, 2008. The benefit of this permitted practice may not be
considered by our insurance subsidiaries when determining surplus
available for dividends.
o We have entered into reinsurance agreements which have reduced the
aggregate risk-based capital of our insurance subsidiaries. For
example, during the fourth quarter of 2008 we entered into two
reinsurance transactions which had the effect of increasing our
aggregate risk-based capital ratio by 8 percentage points.
o During the fourth quarter of 2008, we completed a transaction pursuant
to which our ownership of Senior Health was transferred to an
independent trust. The completion of this transaction had the effect
of increasing our aggregate risk-based capital ratio by 18 percentage
points.
o In the first quarter of 2009, Conseco Insurance Company terminated an
existing intercompany commission financing arrangement with a non-life
subsidiary of the Company. In connection with the termination of the
agreement, Conseco Insurance Company paid $17 million to the non-life
subsidiary, representing the present value of the future commissions
Conseco Insurance Company would have otherwise paid to the non-life
subsidiary over the next several years. The termination of the
commission financing agreement had the effect of reducing the
statutory capital and surplus of Conseco Insurance Company. However,
the current cash available to the holding company increased by the $17
million termination payment.
o Excluding capital losses, our insurance subsidiaries have generated
statutory operating income which increases our aggregate risk-based
capital ratio. For example, during the fourth quarter of 2008 our
insurance subsidiaries generated $73.5 million of statutory operating
income (excluding the effects of transactions related to the transfer
of Senior Health to an independent trust). This income had the effect
of increasing our aggregate risk-based capital ratio by 12 percentage
points.
The Company's management believes there are additional actions that may be
taken in 2009 to improve the capitalization and aggregate risked-based capital
ratio including, but not limited to the sale of certain securities in our
portfolio, sale leaseback transactions of one of our office buildings, and entry
into additional reinsurance arrangements. Such additional actions that may be
taken in the future are not reflected in our current 2009 operating plan or the
projected sources and uses of cash summarized above. There can be no assurance
that such actions can be completed or that the completion of any such actions
would not result in other adverse effects such as the reduction of future
profitability of the Company.
Pursuant to our Second Amended Credit Facility, we may repurchase
Debentures subject to certain restrictions. During 2008, we repurchased $37.0
million par value of the Debentures for $15.3 million plus accrued interest. In
2008, we recognized a gain on the extinguishment of debt of $21.2 million
related to such repurchases. Debentures with a par value of $293.0 million
remain outstanding. We may elect to repurchase additional Debentures in the
future. Refer to the information provided above related to changes as a result
of the amendment to the Second Amended Credit Facility on March 30, 2009, for
new restrictions on the Company's ability to redeem, purchase, amend, modify or
refinance the Debentures.
Our financial condition and ratings, the degree of our leverage, the
current credit market conditions and the restrictions
101
in our Second Amended Credit Facility present issues which could have material
adverse consequences to us, including the following: (i) our ability to obtain
additional financing is limited; (ii) all of our projected cash flow from the
operations of our holding companies will be required to be used for the payment
of interest expense and principal repayment obligations; (iii) the ability of
our holding companies to receive cash dividends and surplus debenture interest
payments from our insurance subsidiaries is subject to regulator approval; (iv)
any new financing or any refinancing or modifications of our current
indebtedness will likely be available only at interest rates that are
significantly higher than we are currently paying; and (v) our ability to
compete in certain markets and to sell certain products is severely limited by
our current financial condition and ratings.
The current uncertainty or volatility in the financial markets has reduced
our ability to obtain new financing on favorable terms, and eliminated our
ability to access certain markets at all. As a result, we do not believe we will
be able to replace our current revolving credit facility when it matures on June
22, 2009, or if a replacement is available it would likely have unattractive
terms. In addition, if we would violate any loan covenants or financial ratios
under our Second Amended Credit Facility, the cost of a waiver or modification
would likely be unattractive, or may not be possible at all.
On March 4, 2009, A.M. Best downgraded the financial strength ratings of
our primary insurance subsidiaries to "B" from "B+" and such ratings have been
placed under review with negative implications. On March 3, 2009, Moody's
downgraded the financial strength ratings of our primary insurance subsidiaries
to "Ba2" from "Ba1" and the outlook remained negative for our primary insurance
subsidiaries. On February 26, 2009, S&P downgraded the financial strength
ratings of our primary insurance subsidiaries to "BB-" from "BB+" and the
outlook remained negative for our primary insurance subsidiaries.
On September 18, September 29, October 2 and October 10, 2008, A.M. Best,
Fitch, Moody's, and S&P, respectively, each revised its outlook for the U.S.
life insurance sector to negative from stable, citing, among other things, the
significant deterioration and volatility in the credit and equity markets,
economic and political uncertainty, and the expected impact of realized and
unrealized investment losses on life insurers' capital levels and profitability.
In light of the difficulties experienced recently by many financial
institutions, including insurance companies, rating agencies have increased the
frequency and scope of their credit reviews and requested additional information
from the companies that they rate, including us. They may also adjust upward the
capital and other requirements employed in the rating agency models for
maintenance of certain ratings levels. We cannot predict what actions rating
agencies may take, or what actions we may take in response.
Accordingly, further downgrades and outlook revisions related to us or the
life insurance industry may occur in the future at any time and without notice
by any rating agency. These could increase policy surrenders and withdrawals,
adversely affect relationships with our distribution channels, reduce new sales,
reduce our ability to borrow and increase our future borrowing costs.
We believe that the existing cash available to CNO, the cash flows to be
generated from operations and the other transactions summarized above will be
sufficient to allow us to meet our debt obligations through 2009. Our cash flow
may be affected by a variety of factors, many of which are outside of our
control, including insurance 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 debt service
requirements and other holding company obligations.
Our principal repayments and other debt service requirements in 2010
currently exceed the cash flows expected to be available from our subsidiaries.
We have the following debt repayment obligations in 2010 (dollars in millions):
3.50% convertible debentures.................. $293.0
Secured credit agreement...................... 8.8
6% Senior Note................................ 25.0
------
$326.8
======
We are continuing to explore various alternatives to address our 2010 debt
service requirements, including, without limitation, financing transactions,
reinsurance transactions, asset sales, transactions to improve statutory capital
and debt modification. Failure to generate sufficient cash to meet our debt
obligations in 2010 could have material adverse consequences on the Company.
102
The Second Amended Credit Facility, Debentures and Senior Note are
discussed in further detail in the notes to the consolidated financial
statements entitled "Notes Payable - Direct Corporate Obligations" and
"Subsequent Events". Additional statutory information is included in the note to
the consolidated financial statements entitled "Statutory Information (Based on
Non-GAAP Measures)". For additional discussion regarding the liquidity and other
risks that we face, see "Risk Factors".
MARKET-SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Our spread-based insurance business is subject to several inherent risks
arising from movements in interest rates, especially if we fail to anticipate or
respond to such movements. First, interest rate changes can cause compression of
our net spread between interest earned on investments and interest credited on
customer deposits, thereby adversely affecting our results. Second, if interest
rate changes produce an unanticipated increase in surrenders of our spread-based
products, we may be forced to sell investment assets at a loss in order to fund
such surrenders. Many of our products include surrender charges, market interest
rate adjustments or other features to encourage persistency; however at December
31, 2008, approximately 20 percent of our total insurance liabilities, or
approximately $4.8 billion, could be surrendered by the policyholder without
penalty. Finally, changes in interest rates can have significant effects on the
performance of our structured securities portfolio as a result of changes in the
prepayment rate of the loans underlying such securities. We follow
asset/liability strategies that are designed to mitigate the effect of interest
rate changes on our profitability. However, there can be no assurance that
management will be successful in implementing such strategies and achieving
adequate investment spreads.
We seek to invest our available funds in a manner that will fund future
obligations to policyholders, subject to appropriate risk considerations. We
seek to meet this objective through investments that: (i) have similar cash flow
characteristics with the liabilities they support; (ii) are diversified among
industries, issuers and geographic locations; and (iii) are predominantly
investment-grade fixed maturity securities.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, our entire portfolio of fixed
maturity securities is available to be sold in response to: (i) changes in
market interest rates; (ii) changes in relative values of individual securities
and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit
quality outlook for certain securities; (v) liquidity needs; and (vi) other
factors. From time to time, we invest in securities for trading purposes,
although such investments are a relatively small portion of our total portfolio.
The profitability of many of our products depends on the spread between the
interest earned on investments and the rates credited on our insurance
liabilities. In addition, changes in competition and other factors, including
the level of surrenders and withdrawals, may limit our ability to adjust or to
maintain crediting rates at levels necessary to avoid narrowing of spreads under
certain market conditions. As of December 31, 2008, approximately 41 percent of
our insurance liabilities had interest rates that may be reset annually; 40
percent had a fixed explicit interest rate for the duration of the contract; 14
percent had credited rates which approximate the income earned by the Company;
and the remainder had no explicit interest rates. At December 31, 2008, the
average yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 6.0 percent, and the average interest rate credited or accruing
to our total insurance liabilities (excluding interest rate bonuses for the
first policy year only and excluding the effect of credited rates attributable
to variable or equity-indexed products) was 4.5 percent.
We use computer models to simulate the cash flows expected from our
existing insurance business under various interest rate scenarios. These
simulations help us to measure the potential gain or loss in fair value of our
interest rate-sensitive financial instruments and to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, a change in
the value of assets should be largely offset by a change in the value of
liabilities. At December 31, 2008, the adjusted modified duration of our fixed
maturity investments (as modified to reflect payments and potential calls) was
approximately 7.6 years and the duration of our insurance liabilities was
approximately 7.8 years. We estimate that our fixed maturity securities and
short-term investments (net of corresponding changes in insurance acquisition
costs) would decline in fair value by approximately $185 million if interest
rates were to increase by 10 percent from their levels at December 31, 2008.
This compares to a decline in fair value of $490 million based on amounts and
rates at December 31, 2007. Our computer simulated calculations include numerous
assumptions, require significant estimates and assume an immediate change in
interest rates without any management of the investment portfolio in reaction to
such change. Consequently, potential changes in value of our financial
instruments indicated by the simulations will likely be different from the
actual changes experienced under given interest rate
103
scenarios, and the differences may be material. Because we actively manage our
investments and liabilities, our net exposure to interest rates can vary over
time.
We are subject to the risk that our investments will decline in value. This
has occurred in the past and may occur again. During 2008, we recognized net
realized investment losses of $262.4 million, which were comprised of: (i)
$100.1 million of net losses from the sales of investments (primarily fixed
maturities) and; (ii) $162.3 million of writedowns of investments for other than
temporary declines in fair value. During 2007, we recognized net realized
investment losses of $158.0 million, which were comprised of: (i) $52.5 million
of net losses from the sales of investments (primarily fixed maturities); (ii)
$31.8 million of writedowns of investments for other than temporary declines in
the fair value; and (iii) $73.7 million of writedowns of investments (which were
subsequently transferred pursuant to a coinsurance agreement as further
discussed in the note to the consolidated financial statements entitled "Summary
of Significant Accounting Policies") as a result of our intent not to hold such
investments for a period of time sufficient to allow for any anticipated
recovery in value. During 2006, we recognized net realized investment losses of
$46.6 million, which were comprised of $25.5 million of net losses from the
sales of investments (primarily fixed maturities), and $21.1 million of
writedowns of investments for other than temporary declines in the fair value.
The Company is subject to risk resulting from fluctuations in market prices
of our equity securities. In general, these investments have more year-to-year
price variability than our fixed maturity investments. However, returns over
longer time frames have been consistently higher. We manage this risk by
limiting our equity securities to a relatively small portion of our total
investments.
Our investment in options backing our equity-linked products is closely
matched with our obligation to equity-indexed annuity holders. Market value
changes associated with that investment are substantially offset by an increase
or decrease in the amounts added to policyholder account balances for
equity-indexed products.
Inflation
Inflation rates may impact the financial statements and operating results
in several areas. Inflation influences interest rates, which in turn impact the
market value of the investment portfolio and yields on new investments.
Inflation also impacts a portion of our insurance policy benefits affected by
increased medical coverage costs. Operating expenses, including payrolls, are
impacted to a certain degree by the inflation rate.
104
RESULTS OF DISCONTINUED OPERATIONS.
As further discussed in the note to the consolidated financial statements
entitled "Transfer of Senior Health Insurance Company of Pennsylvania to an
Independent Trust", the long-term care business of Senior Health is reflected as
a discontinued operation in all periods presented. As a result, the comparison
of the 2008 operating results to prior periods is impacted by the Transfer. The
following summarizes the operating results of our discontinued operations
(dollars in millions):
2008 2007 2006
---- ---- ----
Premium collections (all of which are renewal premiums):
Long-term care....................................................... $ 225.9 $ 269.1 $ 283.6
======== ======== ========
Average liabilities for insurance products, net of reinsurance ceded:
Long-term care....................................................... $2,881.2 $2,903.8 $2,787.1
======== ======== ========
Revenues:
Insurance policy income.............................................. $ 227.9 $ 271.6 $ 292.6
Net investment income on general account
invested assets.................................................... 156.9 166.8 155.6
------- -------- --------
Total revenues................................................... 384.8 438.4 448.2
------- -------- --------
Expenses:
Insurance policy benefits............................................ 311.2 517.8 355.4
Amortization related to operations................................... 16.7 22.5 18.3
Gain on reinsurance recapture........................................ (29.7) - -
Loss on Transfer and transaction expenses............................ 363.6 - -
Other operating costs and expenses................................... 54.0 63.7 73.4
------- -------- --------
Total benefits and expenses...................................... 715.8 604.0 447.1
------- -------- --------
Income (loss) before net realized investment
gains (losses) and income taxes...................................... (331.0) (165.6) 1.1
Net realized investment gains (losses)............................... (380.1) 2.6 (.6)
------- -------- --------
Income (loss) before income taxes...................................... $(711.1) $ (163.0) $ .5
======= ======== ========
Health benefit ratios:
Insurance policy benefits.......................................... $311.2 $517.8 $355.4
Benefit ratio (a).................................................. 136.6% 190.6% 121.5%
Interest-adjusted benefit ratio (b)................................ 67.7% 129.2% 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 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-
</FN>
105
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 discontinued operations was $156.9 million, $166.8
million and $155.6 million in 2008, 2007 and 2006, respectively.
Total premium collections were $225.9 million in 2008, down 16 percent from
2007 and $269.1 million in 2007, down 5.1 percent from 2006. We ceased marketing
this long-term care business in 2003. Accordingly, collected premiums have
decreased over time as policies lapsed, partially offset by premium rate
increases.
Average liabilities for insurance products, net of reinsurance ceded were
approximately $2.9 billion, $2.9 billion and $2.8 billion in 2008, 2007 and
2006, respectively.
Insurance policy income is comprised of premiums earned on these long-term
care policies.
Net investment income on general account invested assets decreased 5.9
percent, to $156.9 million, in 2008 and increased 7.2 percent, to $166.8
million, in 2007. The average balance of general account invested assets was
$2.5 billion, $2.9 billion and $2.7 billion in 2008, 2007 and 2006,
respectively. The average yield on these assets was 6.22 percent, 5.73 percent
and 5.78 percent in 2008, 2007 and 2006, respectively. The increase in yield in
2008 reflects the decrease in the cost basis of investments as a result of the
recognition of other-than-temporary impairments as further discussed below under
net realized investment gains (losses).
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below.
Insurance policy benefits were $311.2 million in 2008; $517.8 million in
2007; and $355.4 million in 2006.
The benefit ratio on this block of business was 136.6 percent, 190.6
percent and 121.5 percent in 2008, 2007 and 2006, respectively. Benefit ratios
are calculated by dividing the product's insurance policy benefits by insurance
policy income. Since the insurance product liabilities we establish for
long-term care business are subject to significant estimates, the ultimate claim
liability we incur for a particular period is likely to be different than our
initial estimate. Our insurance policy benefits reflected reserve deficiencies
from prior years of $21.8 million, $123.8 million and $48.9 million in 2008,
2007 and 2006, respectively. Excluding the effects of prior year claim reserve
deficiencies, our benefit ratios would have been 127.0 percent, 145.0 percent
and 104.8 percent in 2008, 2007 and 2006, respectively. These ratios reflect the
significantly higher level of incurred claims experienced in 2007 and 2006
resulting in increases in reserves for future benefits as discussed below,
adverse development on claims incurred in prior periods as discussed below, and
decreases in policy income. The prior period deficiencies have resulted from the
impact of paid claim experience being different than prior estimates, changes in
actuarial assumptions and refinements to claimant data used to determine claim
reserves.
The net cash flows from long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in benefits will be partially offset
by investment income earned on the assets which have accumulated. The
interest-adjusted benefit ratio for long-term care products is calculated by
dividing the insurance product's insurance policy benefits less interest income
on the accumulated assets backing the insurance liabilities by insurance policy
income. The interest-adjusted benefit ratio on this business was 67.7 percent,
129.2 percent and 68.3 percent in 2008, 2007 and 2006, respectively. Excluding
the effects of prior year claim reserve deficiencies, our interest-adjusted
benefit ratios would have been 58.1 percent, 83.6 percent and 51.6 percent in
2008, 2007 and 2006, respectively.
This long-term care business was primarily issued by Senior Health prior to
its acquisition by our Predecessor in 1996. The loss experience on these
products has been worse than we originally expected. Although we anticipated a
higher
106
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
2008, 2007 and 2006.
In each quarterly period, we calculated 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
estimated 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 provided
consulting services which involved a review of the Company's judgments and
estimates for claim reserves on this long-term care block of business on a
periodic 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 this
long-term care insurance block by $108 million as a result of changes in our
estimates of claim reserves incurred in prior periods. Approximately $18 million
of this increase related to claims with incurrence dates in the first quarter of
2007 and $90 million related to claims with incurrence dates prior to 2007.
The $108 million increase in estimates of claims incurred in prior periods
included $100 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 $100
million adjustment:
o We increased our reserves by $32 million for changes to our
assumptions regarding the future duration of existing claims. We
updated these assumptions to reflect our current expectation that
policyholders will receive benefits for a longer period based on
changing trends in the duration of our claims.
o We increased our reserves by $31 million related to a block of
long-term care policies originally sold by Transport Life Insurance
Company ("Transport") and acquired by our Predecessor. We estimate
claim reserves for this block of business using an aggregate paid loss
development method, which uses historical payment patterns to project
ultimate losses for all the claims in a given incurral period. We
refined our loss development assumptions by developing separate
assumption tables for claimants with and without lifetime benefit
periods and for claimants with and without inflationary benefits,
since this block's recent loss experience has been extremely sensitive
to the mix of its business. This adjustment further improved 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 $22 million to better reflect
fluctuations in claim inventories related to certain blocks of
business. This increase relates to our estimate of claim status on the
reporting date.
o We increased our claim reserves by $15 million for our estimate of
incurred but not reported claims, reflecting recent experience and the
impact of the other adjustments on waiver of premium reserves.
During the first quarter of 2007, we recorded a pre-tax adjustment that
increased policy benefits for the Transport block by $22 million. We found that
our previous claim estimates on this block were deficient because claims on
policies with lifetime benefits and inflation benefits had increased
significantly in recent periods. Since the policies with these benefits will
have longer average claim payout periods than similar policies without such
benefits, a shift in the mix of claimants can have a significant impact on
incurred claims that is not immediately reflected using a completion factor
methodology. We improved our methodologies to address this and other
shortcomings of the aggregate loss development methodology, which resulted in
the pre-tax adjustment.
During the fourth quarter of 2006, we increased claim liabilities for this
long-term care insurance block by $49.1 million as a result of changes in our
estimates of claim reserves incurred in prior periods. Approximately $22.2
million of this increase related to claims with incurrence dates in the first
three quarters of 2006 and $26.9 million related to claims with incurrence dates
prior to 2006.
107
The $49.1 million adjustment primarily related to two assumption changes
reflecting recent trends we noted in our claims experience in the fourth quarter
of 2006:
(i) Benefit utilization assumptions: Most of our long-term care policies
provide for the payment of covered benefits up to a maximum daily
benefit specified in the policy. When we estimate claim reserves for
these policies, we make an assumption regarding the percentage of the
maximum daily benefit that will be paid (since not all policyholders
will incur claims at the maximum daily benefit level). We base our
assumptions on studies of actual experience. Such assumptions are
periodically adjusted to reflect current trends. In the fourth quarter
of 2006, we updated our studies of benefit utilization. Recent
experience reflected a trend that we did not observe in previous
studies: policyholders are incurring claims closer to the maximum
benefit level, and the ratio of incurred claims to maximum benefits is
increasing faster as claims age.
Accordingly, we updated our assumptions to reflect these trends, which
had the effect of increasing our claim reserves by approximately $23
million.
(ii) Liabilities for incurred but not reported claims: In determining the
estimate of claims incurred in a particular period, we must make an
assumption regarding the ultimate liability for claims that have been
incurred but not yet reported to us. This assumption is based on
historical studies related to claims that are reported to us after the
date of our financial statements, but were incurred prior to the date
of our financial statements. For the most recent incurral periods, we
apply loss ratio adjustments to our estimates of liabilities for
incurred but not reported claims in an effort to ensure the ratio of
incurred claims to premiums (incurred loss ratio) related to these
estimated unreported claims, reflects recent trends in our experience.
During 2006, we experienced a significant increase in the incurred
loss ratio for 2005 and 2006 incurral periods. We increased the
aforementioned loss ratio adjustments in response to this experience,
which had the effect of increasing our claim reserves by approximately
$24 million.
In 2006, we experienced increases in our reserves for future benefits due
to higher than expected persistency in this block of business. A small variance
in persistency can have a significant impact on our earnings as reserves
accumulated over the life of a policy are released when coverage terminates. The
effect of changes in persistency will vary based on the mix of business that
persists.
We had 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 of Senior Health as we believed the existing rates were
too low to fund expected future benefits. These filings were 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. We
chose 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 were partially realized in our
premium revenue. In the second quarter of 2007, we began filing requests for the
second round of rate increases on many of the same policies. The full effect of
all three rounds of rate increases was not expected to be fully realized until
2011.
On April 20, 2004, the Florida Office of Insurance Regulation issued an
order to Senior Health, that affected approximately 12,600 home health care
policies issued in Florida by Senior Health and its predecessor companies.
Pursuant to the Order, Senior Health offered the following three alternatives to
holders of these policies subject to rate increases as follows:
o retention of their current policy with a rate increase of 50 percent
in the first year and actuarially justified increases in subsequent
years (which is also the default election for policyholders who failed
to make an election by 30 days prior to the anniversary date of their
policies) ("option one");
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15 percent
in subsequent years ("option two"); or
o receipt of a paid-up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy ("option three").
Policyholders selecting option one or option two are entitled to receive a
contingent non-forfeiture benefit if their policy subsequently lapses. In
addition, policyholders could change their initial election any time up to 30
days prior to the anniversary date of their policies. We began to implement
premium adjustments with respect to policyholder elections in the fourth quarter
of 2005 and the implementation of these premium adjustments was completed in
2007. We did not make any
108
adjustments to the insurance liabilities when these elections were made.
Reserves for all three groups of policies under the order were prospectively
adjusted using the prospective revision methodology described in the "Critical
Accounting Policies - Accounting for Long-term Care Premium Rate Increases" in
"Management's Discussion and Analysis of Consolidated Financial Condition and
Results of Operations".
Amortization related to operations includes amortization of insurance
acquisition costs. Fluctuations in amortization of insurance acquisition costs
generally correspond with changes in lapse experience.
Gain on reinsurance recapture resulted from the recapture of a block of
previously reinsured long-term care business in the third quarter of 2008. Such
business was included in the Transfer.
Loss on Transfer and transaction expenses relates to the loss on the
transfer of Senior Health to an independent trust as further discussed in the
note to the consolidated financial statements entitled "Transfer of Senior
Health Insurance Company of Pennsylvania to an Independent Trust".
Other operating costs and expenses were $54.0 million in 2008; $63.7
million in 2007; and $73.4 million in 2006, respectively. Other operating costs
and expenses, excluding commission expenses, for this segment were $29.7 million
in 2008, $34.7 million in 2007 and $40.7 million in 2006.
Net realized investment gains (losses) fluctuated each period. During 2008,
net realized investment losses included $.4 million of net gains from the sales
of investments (primarily fixed maturities), net of $380.5 million of writedowns
of investments (which were transferred to the Independent Trust) 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 2007, net realized investment gains
included $3.8 million from the sales of investments (primarily fixed
maturities), net of $1.2 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. During
2006, net realized investment gains included $.7 million of net gains from the
sales of investments (primarily fixed maturities), net of $1.3 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information included under the caption "Market-Sensitive Instruments
and Risk Management" in Item 7. "Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations" is incorporated
herein by reference.
109
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Index to Consolidated Financial Statements
Page
----
Report of Independent Registered Public Accounting Firm............................................................... 111
Consolidated Balance Sheet at December 31, 2008 and 2007.............................................................. 112
Consolidated Statement of Operations for the years ended December 31, 2008, 2007 and 2006............................. 114
Consolidated Statement of Shareholders' Equity for the years ended December 31, 2008, 2007 and 2006................... 115
Consolidated Statement of Cash Flows for the years ended December 31, 2008, 2007 and 2006............................. 117
Notes to Consolidated Financial Statements............................................................................ 118
110
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors Conseco, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of
Conseco Inc. and its subsidiaries at December 31, 2008 and 2007, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2008 in conformity with accounting principles
generally accepted in the United States of America. Also in our opinion, the
Company did not maintain, in all material respects, effective internal control
over financial reporting as of December 31, 2008, based on criteria established
in Internal Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) because a material weakness in
internal control over financial reporting related to 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
existed as of that date. A material weakness is a deficiency, or a combination
of deficiencies, in internal control over financial reporting, such that there
is a reasonable possibility that a material misstatement of the annual or
interim financial statements will not be prevented or detected on a timely
basis. The material weakness referred to above is described in Management's
Report on Internal Control Over Financial Reporting appearing under Item 9A. We
considered this material weakness in determining the nature, timing, and extent
of audit tests applied in our audit of the 2008 consolidated financial
statements, and our opinion regarding the effectiveness of the Company's
internal control over financial reporting does not affect our opinion on those
consolidated financial statements. The Company's management is responsible for
these financial statements, for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting included in management's report referred to
above. Our responsibility is to express opinions on these financial statements
and on the Company's internal control over financial reporting based on our
integrated audits. We conducted our audits in accordance with the standards of
the Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audits to obtain reasonable assurance about
whether the financial statements are free of material misstatement and whether
effective internal control over financial reporting was maintained in all
material respects. Our audits of the financial statements included examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
Our audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, assessing the risk
that a material weakness exists, and testing and evaluating the design and
operating effectiveness of internal control based on the assessed risk. Our
audits also included performing such other procedures as we considered necessary
in the circumstances. We believe that our audits provide a reasonable basis for
our opinions.
As discussed in Note 18 to the consolidated financial statements, certain events
occurred subsequent to December 31, 2008, which include an amendment to the
Company's Second Amended Credit Facility, certain rating agency downgrades and
the obtainment of certain insurance regulatory agency approvals.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Indianapolis, Indiana
March 31, 2009
111
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
December 31, 2008 and 2007
(Dollars in millions)
ASSETS
2008 2007
---- ----
Investments:
Actively managed fixed maturities at fair value (amortized cost:
2008 - $18,276.3; 2007 - $18,281.5)............................................... $15,277.0 $17,859.5
Equity securities at fair value (cost: 2008 - $31.0; 2007 - $34.0).................. 32.4 34.5
Mortgage loans...................................................................... 2,159.4 1,855.8
Policy loans........................................................................ 363.5 370.4
Trading securities.................................................................. 326.5 665.8
Securities lending collateral....................................................... 393.7 405.8
Other invested assets .............................................................. 95.0 132.7
--------- ---------
Total investments................................................................. 18,647.5 21,324.5
Cash and cash equivalents - unrestricted................................................. 894.5 361.9
Cash and cash equivalents - restricted................................................... 4.8 21.1
Accrued investment income................................................................ 298.7 281.0
Value of policies inforce at the Effective Date.......................................... 1,477.8 1,573.6
Cost of policies produced................................................................ 1,812.6 1,423.0
Reinsurance receivables.................................................................. 3,284.8 3,513.0
Income tax assets, net................................................................... 2,053.7 1,610.2
Assets held in separate accounts......................................................... 18.2 27.4
Other assets............................................................................. 277.1 283.1
Assets of discontinued operations........................................................ - 3,552.4
--------- ---------
Total assets...................................................................... $28,769.7 $33,971.2
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
112
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (Continued)
December 31, 2008 and 2007
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
2008 2007
---- ----
Liabilities:
Liabilities for insurance products:
Interest-sensitive products........................................................ $13,332.8 $13,169.4
Traditional products............................................................... 9,828.7 9,548.4
Claims payable and other policyholder funds........................................ 1,008.4 909.7
Liabilities related to separate accounts........................................... 18.2 27.4
Other liabilities.................................................................... 457.4 492.3
Investment borrowings................................................................ 767.5 913.0
Securities lending payable........................................................... 408.8 409.5
Notes payable - direct corporate obligations......................................... 1,328.7 1,193.7
Liabilities of discontinued operations............................................... - 3,071.9
--------- ---------
Total liabilities................................................................ 27,150.5 29,735.3
--------- ---------
Commitments and Contingencies (Note 9)
Shareholders' equity:
Common stock ($0.01 par value, 8,000,000,000 shares authorized,
shares issued and outstanding: 2008 - 184,753,758; 2007 - 184,652,017)............ 1.9 1.9
Additional paid-in capital........................................................... 4,076.0 4,068.6
Accumulated other comprehensive loss................................................. (1,770.7) (273.3)
Retained earnings (accumulated deficit).............................................. (688.0) 438.7
--------- ---------
Total shareholders' equity....................................................... 1,619.2 4,235.9
--------- ---------
Total liabilities and shareholders' equity....................................... $28,769.7 $33,971.2
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
113
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
for the years ended December 31, 2008, 2007 and 2006
(Dollars in millions, except per share data)
2008 2007 2006
---- ---- ----
Revenues:
Insurance policy income............................................ $ 3,253.6 $ 2,895.7 $ 2,696.4
Net investment income (loss):
General account assets.......................................... 1,254.5 1,350.5 1,279.6
Policyholder and reinsurer accounts and other special-purpose
portfolios.................................................... (75.7) 19.3 71.2
Net realized investment losses..................................... (262.4) (158.0) (46.6)
Fee revenue and other income....................................... 19.7 23.8 19.2
--------- --------- ---------
Total revenues.................................................. 4,189.7 4,131.3 4,019.8
--------- --------- ---------
Benefits and expenses:
Insurance policy benefits.......................................... 3,212.5 2,915.9 2,677.6
Interest expense................................................... 97.8 117.3 73.5
Amortization....................................................... 367.9 426.8 423.3
(Gain) loss on extinguishment of debt.............................. (21.2) - .7
Costs related to a litigation settlement........................... - 64.4 174.7
Loss related to an annuity coinsurance transaction................. - 76.5 -
Other operating costs and expenses................................. 520.3 540.4 503.3
--------- --------- ---------
Total benefits and expenses..................................... 4,177.3 4,141.3 3,853.1
--------- --------- ---------
Income (loss) before income taxes and discontinued operations... 12.4 (10.0) 166.7
Income tax expense (benefit):
Tax expense (benefit) on period income............................. 12.5 (4.0) 61.0
Valuation allowance for deferred tax assets........................ 403.9 68.0 -
--------- --------- ---------
Income (loss) before discontinued operations.................... (404.0) (74.0) 105.7
Discontinued operations, net of income taxes........................... (722.7) (105.9) .3
--------- --------- ---------
Net income (loss).................................................. (1,126.7) (179.9) 106.0
Preferred stock dividends.............................................. - 14.1 38.0
--------- --------- ---------
Net income (loss) applicable to common stock....................... $(1,126.7) $ (194.0) $ 68.0
========= ========= =========
Earnings (loss) per common share:
Basic:
Weighted average shares outstanding............................. 184,704,000 173,374,000 151,690,000
=========== =========== ===========
Income (loss) before discontinued operations.................... $(2.19) $(.51) $.45
Discontinued operations......................................... (3.91) (.61) -
------ ------ ----
Net income (loss)............................................. $(6.10) $(1.12) $.45
====== ====== ====
Diluted:
Weighted average shares outstanding............................. 184,704,000 173,374,000 152,509,000
=========== =========== ===========
Income (loss) before discontinued operations.................... $(2.19) $ (.51) $.45
Discontinued operations......................................... (3.91) (.61) -
------ ------ ---
Net income (loss)............................................. $(6.10) $(1.12) $.45
====== ====== ====
The accompanying notes are an integral part
of the consolidated financial statements.
114
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
Retained
Common stock Accumulated other earnings
Preferred and additional comprehensive (accumulated
Total stock paid-in capital income (loss) deficit)
----- ----- --------------- ------------- --------
Balance, December 31, 2005........................... $4,497.3 $ 667.8 $3,190.4 $ 71.7 $567.4
Comprehensive loss, net of tax:
Net income...................................... 106.0 - - - 106.0
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $77.4)............................. (137.9) - - (137.9) -
--------
Total comprehensive loss.................... (31.9)
Adjustment to initially apply SFAS No. 158
related to the unrecognized net loss related
to deferred compensation plan (net of
applicable income tax benefit of $3.5).......... (6.4) - - (6.4) -
Reduction of deferred income tax valuation
allowance....................................... 260.0 - 260.0 - -
Stock option and restricted stock plans........... 12.4 - 12.4 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date............................................ 6.7 - 6.7 - -
Dividends on preferred stock...................... (38.0) - - - (38.0)
-------- ------- -------- ------- ------
Balance, December 31, 2006........................... 4,700.1 667.8 3,469.5 (72.6) 635.4
Comprehensive loss, net of tax:
Net loss........................................ (179.9) - - - (179.9)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $113.0)............................ (202.4) - - (202.4) -
--------
Total comprehensive loss.................... (382.3)
Cost of shares acquired........................... (87.2) - (87.2) - -
Stock option and restricted stock plans........... 14.4 - 14.4 - -
Change in unrecognized net loss related to
deferred compensation plan (net of applicable
income tax expense of $.9 million).............. 1.7 - - 1.7 -
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 pursuant
to SOP 05-1..................................... (2.7) - - - (2.7)
Conversion of preferred stock into common shares.. - (667.8) 667.8 - -
Dividends on preferred stock...................... (14.1) - - - (14.1)
-------- ------- -------- ------- ------
Balance, December 31, 2007........................... $4,235.9 $ - $4,070.5 $(273.3) $438.7
(continued on following page)
The accompanying notes are an integral part
of the consolidated financial statements.
115
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Continued)
(Dollars in millions)
Retained
Common stock Accumulated other earnings
Preferred and additional comprehensive (accumulated
Total stock paid-in capital income (loss) deficit)
----- ----- --------------- ------------- --------
Balance, December 31, 2007 (carried forward
from prior page).................................. $ 4,235.9 $ - $4,070.5 $ (273.3) $ 438.7
Comprehensive loss, net of tax:
Net loss........................................ (1,126.7) - - - (1,126.7)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $833.9)............................ (1,496.9) - - (1,496.9) -
Change in unrecognized net loss related to deferred
compensation plan (net of applicable income tax
benefit of $.2 million)....................... (.5) - - (.5) -
---------
Total comprehensive loss.................... (2,624.1)
Stock option and restricted stock plans........... 7.4 - 7.4 - -
--------- ------- -------- --------- ---------
Balance, December 31, 2008........................... $ 1,619.2 $ - $4,077.9 $(1,770.7) $ (688.0)
========= ======= ======== ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
116
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
for the years ended December 31, 2008, 2007 and 2006
(Dollars in millions)
2008 2007 2006
---- ---- ----
Cash flows from operating activities:
Insurance policy income............................................... $ 3,140.7 $ 2,818.0 $ 2,633.4
Net investment income................................................. 1,339.6 1,610.0 1,500.5
Fee revenue and other income.......................................... 19.7 23.8 19.3
Net sales (purchases) of trading securities........................... 346.5 (114.3) 36.0
Insurance policy benefits............................................. (2,722.3) (2,339.6) (2,184.2)
Interest expense...................................................... (95.4) (114.7) (66.9)
Policy acquisition costs.............................................. (459.1) (545.9) (484.7)
Other operating costs................................................. (587.0) (631.3) (523.7)
Taxes................................................................. 4.1 (2.7) 1.5
--------- --------- ---------
Net cash provided by operating activities......................... 986.8 703.3 931.2
--------- --------- ---------
Cash flows from investing activities:
Sales of investments.................................................. 6,832.7 7,192.9 6,412.1
Maturities and redemptions of investments............................. 695.1 948.4 2,038.0
Purchases of investments.............................................. (8,193.7) (9,248.7) (9,490.8)
Change in restricted cash............................................. 16.3 2.9 11.2
Change in cash held by discontinued operations........................ 45.6 (30.9) (19.1)
Other................................................................. (25.8) (24.2) (21.7)
--------- --------- ---------
Net cash used by investing activities............................. (629.8) (1,159.6) (1,070.3)
--------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net........................................ 75.0 200.0 196.7
Issuance of common stock.............................................. - 3.4 1.0
Payments to repurchase common stock................................... - (87.2) -
Payments on notes payable............................................. (44.0) (7.8) (48.0)
Amounts received for deposit products................................. 1,863.4 1,852.2 2,067.7
Withdrawals from deposit products..................................... (1,573.3) (1,989.3) (2,014.5)
Investment borrowings................................................. (145.5) 494.7 103.2
Dividends paid on preferred stock..................................... - (19.0) (38.0)
--------- --------- ---------
Net cash provided by financing activities......................... 175.6 447.0 268.1
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents.............. 532.6 (9.3) 129.0
Cash and cash equivalents, beginning of year............................. 361.9 371.2 242.2
--------- --------- ---------
Cash and cash equivalents, end of year................................... $ 894.5 $ 361.9 $ 371.2
========= ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
117
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
1. DESCRIPTION OF BUSINESS
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation (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.
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; and corporate operations, which
consists of holding company activities and certain noninsurance company
businesses that are not part of our other segments. Prior to the fourth quarter
of 2008, we had a fourth segment comprised of other business in run-off. The
other business in run-off segment had included blocks of business that we no
longer market or underwrite and were managed separately from our other
businesses. Such segment had consisted of: (i) long-term care insurance sold in
prior years through independent agents; and (ii) major medical insurance. As a
result of the Transfer, as further discussed in the note to the consolidated
financial statements entitled "Transfer of Senior Health Insurance Company of
Pennsylvania to an Independent Trust", a substantial portion of the long-term
care business in the other business in run-off segment is presented as
discontinued operations in our consolidated financial statements. Accordingly,
we have restated all prior year segment disclosures to conform to management's
current view of the Company's operating segments. Our segments are described
below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company, 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 approximately 5,500
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 Health Care ("Coventry").
o Colonial Penn, which consists of the business of Colonial Penn Life
Insurance Company ("Colonial Penn"), markets primarily graded benefit
and simplified issue life insurance directly to customers through
television advertising, direct mail, the internet and telemarketing.
Colonial Penn markets its products under its own brand name.
o 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
approximately 400 independent marketing organizations that represent
over 2,400 independent producing agents, including approximately 575
from Performance Matters Associates, Inc., a wholly owned marketing
company. This segment markets its products under the "Conseco" and
"Washington National" brand names. Conseco Insurance Group includes
the business of Conseco Health Insurance Company ("Conseco Health"),
Conseco Life Insurance Company ("Conseco Life"), Conseco Insurance
Company and Washington National Insurance Company ("Washington
National"). This segment also includes blocks of long-term care and
other health business of these companies that we no longer market or
underwrite.
2. TRANSFER OF SENIOR HEALTH INSURANCE COMPANY OF PENNSYLVANIA TO AN
INDEPENDENT TRUST
On November 12, 2008, Conseco and CDOC, Inc. ("CDOC"), a wholly owned
subsidiary of Conseco (and together with Conseco, the "Conseco Parties"),
completed the transfer (the "Transfer") of the stock of Senior Health Insurance
Company of Pennsylvania ("Senior Health", formerly known as Conseco Senior
Health Insurance Company prior to its name change in October 2008) to Senior
Health Care Oversight Trust, an independent trust (the "Independent Trust") for
the exclusive benefit of Senior Health's long-term care policyholders.
Consummation of the transaction was subject to the approval of the Pennsylvania
Insurance Department.
In connection with the Transfer, the Company entered into a $125.0 million
Senior Note due November 12, 2013 (the
118
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
"Senior Note"), payable to Senior Health. The note has a five-year maturity
date; a 6 percent interest rate; and requires annual principal payments of $25.0
million. As a condition of the order from the Pennsylvania Insurance Department
approving the Transfer, Conseco agreed that it would not pay cash dividends on
its common stock while any portion of the $125.0 million note remained
outstanding.
Conseco recorded accounting charges totaling $1.0 billion related to the
transaction, comprised of Senior Health's equity (as calculated in accordance
with generally accepted accounting principles), an additional valuation
allowance for deferred tax assets, the capital contribution to Senior Health and
the Independent Trust and transaction expenses. The accounting charges are
summarized as follows (dollars in millions):
Recognition of unrealized losses on investments transferred
to the Independent Trust................................................................... $ 380.5 (a)
Gain on reinsurance recapture, net of tax..................................................... (19.3)
Increase to deferred tax valuation allowance based on recent results which
have had a significant impact on taxable income and the
effects of the transaction................................................................. 298.0
Write-off of remaining shareholder's equity of Senior Health ................................. 159.2 (a)
Additional capital contribution and transaction expenses...................................... 204.4 (a)
--------
Total charges.................................................................................... $1,022.8
========
<FN>
- -----------------
(a) Amount is before the potential tax benefit. A deferred tax valuation
allowance was 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.
</FN>
119
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
As a result of the Transfer, Senior Health's long-term care business is
presented as a discontinued operation for all periods presented. The operating
results from the discontinued operations are as follows (dollars in millions):
2008 2007 2006
---- ---- ----
Revenues:
Insurance policy income....................................... $ 227.9 $ 271.6 $292.6
Net investment income......................................... 156.9 166.8 155.6
Net realized investment gains (losses)........................ (380.1) 2.6 (.6)
------- ------- ------
Total revenues............................................. 4.7 441.0 447.6
------- ------- ------
Benefits and expenses:
Insurance policy benefits..................................... 311.2 517.8 355.4
Amortization.................................................. 16.7 22.5 18.3
Gain on reinsurance recapture (a)............................. (29.7) - -
Loss on Transfer and transaction expenses..................... 363.6 - -
Other operating costs and expenses............................ 54.0 63.7 73.4
------- ------- ------
Total benefits and expenses................................ 715.8 604.0 447.1
------- ------- ------
Income (loss) before income taxes.......................... (711.1) (163.0) .5
Income tax expense (benefit):
Tax expense (benefit) on period income........................ (440.7) (57.1) .2
Valuation allowance for deferred tax assets................... 452.3 - -
------- ------- ------
Net income (loss) from discontinued operations............. $(722.7) $(105.9) $ .3
======= ======= ======
<FN>
- ---------------
(a) In the third quarter of 2008, Senior Health recaptured a block of
previously reinsured long-term care business which was included in the
business transferred to the Independent Trust.
</FN>
The assets and liabilities of the discontinued operations are as follows
(dollars in millions):
December 31, 2007
-----------------
Investments.............................................................. $2,933.8
Cash and cash equivalents - unrestricted................................. 45.6
Accrued investment income................................................ 38.3
Value of policies inforce at the Effective Date.......................... 149.2
Reinsurance receivables.................................................. 79.8
Income tax assets, net................................................... 299.2
Other assets............................................................. 6.5
--------
Assets of discontinued operations........................................ $3,552.4
========
Liabilities for insurance products....................................... $3,007.3
Securities lending payable............................................... 50.9
Other liabilities........................................................ 13.7
--------
Liabilities of discontinued operations................................... $3,071.9
========
120
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
3. BASIS OF PRESENTATION
We prepare our financial statements in accordance with accounting
principles generally accepted in the United States of America ("GAAP"). We
follow the accounting standards established by the Financial Accounting
Standards Board ("FASB"), the American Institute of Certified Public Accountants
and the Securities and Exchange Commission (the "SEC"). We have reclassified
certain amounts from prior periods to conform to the 2008 presentation. These
reclassifications have no effect on net income or shareholders' equity.
The accompanying financial statements include the accounts of the Company
and its subsidiaries. Our consolidated financial statements exclude the results
of material transactions between us and our consolidated affiliates, or among
our consolidated affiliates.
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.
Consistent with our prior financial statements, these financial statements
have been prepared assuming the Company will continue as a going concern.
However, we have significant indebtedness which will require over $165
million in cash to service in 2009 (including the additional interest expense
required after the modification to our $675.0 million secured credit agreement
(the "Second Amended Credit Facility") described in the note to these
consolidated financial statements entitled "Subsequent Events"). Pursuant to our
Second Amended Credit Facility, we must maintain certain financial ratios. The
levels of margin between the financial covenant requirements and our financial
status, both at year-end 2008 and the projected levels during 2009, are
relatively small and a failure to satisfy any of our financial covenants at the
end of a fiscal quarter would trigger a default under our Second Amended Credit
Facility. Achievement of our 2009 operating plan is a critical factor in having
sufficient income and liquidity to meet all of our 2009 debt service
requirements and other holding company obligations and failure to do so would
have material adverse consequences for the Company. These items are discussed
further below.
At December 31, 2008, CNO, CDOC (our wholly owned subsidiary and a
guarantor under the Second Amended Credit Facility) and our other non-insurance
subsidiaries held unrestricted cash of $59.0 million. CNO 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. CNO and CDOC receive cash
from insurance subsidiaries, consisting of dividends and distributions, interest
payments on surplus debentures and tax-sharing payments, as well as cash from
non-insurance subsidiaries consisting of dividends, distributions, loans and
advances. Additional information on the ability of our insurance subsidiaries to
pay dividends is included in the note to these consolidated financial statements
entitled "Statutory Information (Based on Non-GAAP Measures)". The principal
non-insurance subsidiaries that provide cash to CNO and CDOC are 40|86 Advisors
Inc. ("40|86 Advisors"), which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives fees from the
insurance subsidiaries for providing administrative services. The agreements
between our insurance subsidiaries and Conseco Services, LLC and 40|86 Advisors,
respectively, were previously approved by the domestic insurance regulator for
each insurance company, and any payments thereunder do not require further
regulatory approval.
In assessing Conseco's current financial position and operating plans for
the future, management made significant judgments and estimates with respect to
the potential financial and liquidity effects of Conseco's risks and
uncertainties, including but not limited to:
o the approval of dividend payments and surplus debenture interest
payments from our insurance subsidiaries by the director or
commissioner of the applicable state insurance departments;
o the potential adverse effects on Conseco's businesses from recent
downgrades or further downgrades by rating
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agencies;
o our ability to achieve our operating plan;
o the potential for continued declines in the bond and equity markets
and the potential for further significant recognition of
other-than-temporary impairments;
o the potential need to provide additional capital to our insurance
subsidiaries;
o our ability to continue to achieve compliance with our loan covenants
and the financial ratios we are required to maintain;
o the potential loss of key personnel that could impair our ability to
achieve our operating plan;
o the potential impact of an ownership change or a decrease in our
operating earnings on the valuation allowance related to our deferred
tax assets; and
o the potential impact on certain of Conseco's insurance subsidiaries if
regulators do not allow us to continue to recognize certain deferred
tax assets pursuant to permitted statutory accounting practices.
Pursuant to our Second Amended Credit Facility, we agreed to a number of
covenants and other provisions that restrict our ability to borrow money and
pursue some operating activities without the prior consent of the lenders. We
also agreed to meet or maintain various financial ratios and balances. Our
ability to meet these financial tests and maintain ratings may be affected by
events beyond our control. Additional information on the covenant and other
provisions of our Second Amended Credit Facility is included in the note to
these consolidated financial statements entitled "Notes Payable - Direct
Corporate Obligations."
The covenants and provisions of the Second Amended Credit Facility place
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 covenants, the lenders could
declare all outstanding borrowings, accrued interest and fees to be immediately
due and payable. If the lenders under our Second Amended Credit Facility would
elect to accelerate the amounts due, the holders of our 3.50% Convertible
Debentures due September 30, 2035 and Senior Note could elect to take similar
action with respect to those debts. If that were to occur, we would not have
sufficient liquidity to repay our indebtedness.
Our life insurance subsidiaries are subject to risk-based capital
requirements. As described above, our Second Amended Credit Facility contains
certain financial covenants which are based on our aggregate risk-based capital.
The recent unprecedented economic and market conditions has both reduced the
statutory capital of our insurance subsidiaries and increased the risk-based
capital requirements of our insurance subsidiaries as further discussed below:
o We have incurred realized investment losses that reduced available
capital and surplus. For example, during the fourth quarter of 2008,
we incurred net capital losses pursuant to statutory accounting
practices of approximately $113 million. These losses resulted in a
reduction to our aggregate risk-based capital ratio of 21 percentage
points.
o We have had adverse experience related to certain commercial mortgage
loans which has resulted in an increase to our aggregate risk-based
capital. In the second quarter of 2008, we began foreclosure
proceedings on two delinquent commercial mortgage loans. Pursuant to
statutory rules and regulations which are followed to determine the
amount of required risk-based capital, our insurance subsidiaries are
required to apply a "mortgage experience adjustment factor" to the
entire portfolio of commercial mortgage loans based, in large part, on
a comparison of our default and loss experience to the aggregate
industry default and loss experience. The calculation is extremely
sensitive to slight variations in our experience. For example, during
the fourth quarter of 2008, our minimum aggregate risk-based capital
increased by approximately $42 million due to these requirements and
the foreclosure of these two loans which had a combined book value of
approximately $20 million. The establishment of additional required
risk-based capital related to the mortgage experience adjustment
factor resulted in a reduction to the aggregate risk-based capital
ratio of 23 percentage points in the
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fourth quarter of 2008.
o Certain of our fixed maturity investments have been subject to
downgrades by nationally recognized statistical rating organizations,
which have resulted in an increase to our aggregate risk-based
capital. Pursuant to statutory rules and regulations which are
followed to determine the amount of required risk-based capital, our
insurance subsidiaries are required to apply factors to the carrying
value of their fixed maturity investments which increase required
risk-based capital based on current ratings of nationally recognized
statistical rating organizations. Significant ratings downgrades
increase these capital requirements. For example, during the fourth
quarter of 2008 our required aggregate risk-based capital increased by
approximately $19.1 million as a result of downgrades of certain of
our fixed maturity investments. These downgrades resulted in a
reduction to the aggregate risk-based capital ratio of 9 percentage
points. Additional downgrades in our portfolio during the first
quarter of 2009 are expected to result in additional required
risk-based capital. For example, through February 28, 2009, our
required risk-based capital is estimated to have increased by
approximately $20 million as a result of recent downgrades.
The Company's management believes there are additional actions that may be
taken in 2009 to improve the capitalization and aggregate risked-based capital
ratio including, but not limited to the sale of certain securities in our
portfolio, sale leaseback transactions of one of our office buildings, and entry
into additional reinsurance arrangements. Such additional actions that may be
taken in the future are not reflected in our current 2009 operating plan. There
can be no assurance that such actions can be completed or that the completion of
any such actions would not result in other adverse effects such as the reduction
of future profitability of the Company.
The current uncertainty or volatility in the financial markets has reduced
our ability to obtain new financing on favorable terms, and eliminated our
ability to access certain markets at all. As a result, we do not believe we will
be able to replace our current revolving credit facility when it matures on June
22, 2009, or if a replacement is available it would likely have unattractive
terms. In addition, if we would violate any loan covenants or financial ratios
under our Second Amended Credit Facility, the cost of a waiver or modification
would likely be unattractive, or may not be possible at all.
We believe that the existing cash available to CNO, the cash flows to be
generated from operations and the other potential transactions we could take
will be sufficient to allow us to meet our debt obligations through 2009. Our
cash flow may be affected by a variety of factors, many of which are outside of
our control, including insurance 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 debt service
requirements and other holding company obligations.
We are continuing to explore various alternatives to address our 2010 debt
service requirements, including, without limitation, financing transactions,
reinsurance transactions, asset sales, transactions to improve statutory capital
and debt modification. Failure to generate sufficient cash to meet our debt
obligations in 2010 would have material adverse consequences on the Company.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following summary explains the significant accounting policies we use
to prepare our financial statements.
Investments
We classify our fixed maturity securities into one of three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); or (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
Equity securities include investments in common stock and non-redeemable
preferred stock. We carry these investments at estimated fair value. We record
any unrealized gain or loss, net of tax and related adjustments, as a component
of shareholders' equity. When declines in value considered to be other than
temporary occur, we reduce the amortized cost to estimated fair value and
recognize a loss in the statement of operations.
Mortgage loans held in our investment portfolio are carried at amortized
unpaid balances, net of provisions for estimated
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losses. Interest income is accrued on the principal amount of the loan based on
the loan's contractual interest rate. Payment terms specified for mortgage loans
may include a prepayment penalty for unscheduled payoff of the investment.
Prepayment penalties are recognized as investment income when received.
Policy loans are stated at current unpaid principal balances.
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 sections of this note 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
$326.5 million and $665.8 million at December 31, 2008 and 2007, respectively.
Securities lending collateral primarily consists of fixed maturities,
equity securities and cash and cash equivalents. We carry these investments at
estimated fair value. We record any unrealized gains or loss, net of tax, as a
component of shareholders' equity.
Other invested assets include: (i) certain call options purchased in an
effort to hedge the effects of certain policyholder benefits related to our
equity-indexed annuity and life insurance products; and (ii) certain
non-traditional investments. We carry the call options at estimated fair value
as further described in the section of this note entitled "Accounting for
Derivatives". Non-traditional investments include investments in certain limited
partnerships, which are accounted for using the equity method, and promissory
notes, which are accounted for using the cost method.
We defer any fees received or costs incurred when we originate investments.
We amortize fees, costs, discounts and premiums as yield adjustments over the
contractual lives of the investments without anticipation of prepayments. We
consider anticipated prepayments on mortgage-backed securities in determining
estimated future yields on such securities.
When we sell a security (other than trading securities), we report the
difference between the sale proceeds and amortized cost (determined based on
specific identification) as a realized investment gain or loss.
We regularly evaluate our investments for possible impairment. When we
conclude that a decline in a security's net realizable value is other than
temporary, the decline is recognized as a realized loss and the cost basis of
the security is reduced to its estimated fair value.
Cash and Cash Equivalents
Cash and cash equivalents include commercial paper, invested cash and other
investments purchased with original maturities of less than three months. We
carry them at amortized cost, which approximates estimated fair value.
Cost of Policies Produced
The costs that vary with, and are primarily related to, producing new
insurance business subsequent to September 10, 2003 are referred to as cost of
policies produced. For universal life or investment products, we amortize these
costs in relation to the estimated gross profits using the interest rate
credited to the underlying policies. For other products, we amortize these costs
in relation to future anticipated premium revenue using the projected investment
earnings rate.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect on future investment yields. We also adjust the cost of policies
produced for the change in amortization that would have been recorded if
actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We limit the
total adjustment related to the impact of unrealized losses to the total of
costs capitalized plus interest related to insurance policies issued in a
particular year. We include the impact of this adjustment in accumulated other
comprehensive income within shareholders' equity.
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The investment environment during the fourth quarter of 2008 resulted in
significant net unrealized losses in our actively managed fixed maturity
investment portfolio. The total adjustment to accumulated other comprehensive
income related to the change in the cost of policies produced for the negative
amortization that would have been recorded if actively managed fixed maturity
securities had been sold at their stated aggregate fair value would have
resulted in the balance of the cost of policies produced exceeding the total of
costs capitalized plus interest for annuity blocks of business issued in certain
years. Accordingly, the adjustment made to the cost of policies produced and
accumulated other comprehensive income was reduced by $206 million.
As of January 1, 2007, we adopted Statement of Position 05-1, "Accounting
by Insurance Enterprises for Deferred Acquisition Costs in Connection with
Modifications or Exchanges of Insurance Contracts" ("SOP 05-1"). SOP 05-1
provides guidance on accounting by insurance enterprises for the cost of
policies produced on internal replacements of insurance and investment contracts
other than those specifically described in Statement of Financial Accounting
Standards No. 97, "Accounting and Reporting by Insurance Enterprises for Certain
Long-Duration Contracts and for Realized Gains and Losses from the Sale of
Investments". As a result of the adoption of SOP 05-1 and related guidance, if
an internal replacement modification substantially changes a contract, then the
cost of policies produced is written off immediately through the consolidated
statement of operations and any new definable cost associated with the new
replacement are deferred as the cost of policies produced. If a contract
modification does not substantially change the contract, the amortization of the
cost of policies produced on the original contract will continue and any
acquisition costs associated with the related modification are immediately
expensed.
We regularly evaluate the recoverability of the unamortized balance of the
cost of policies produced. We consider estimated future gross profits or future
premiums, expected mortality or morbidity, interest earned and credited rates,
persistency and expenses in determining whether the balance is recoverable. If
we determine a portion of the unamortized balance is not recoverable, it is
charged to amortization expense. In certain cases, the unamortized balance of
the cost of policies produced may not be deficient in the aggregate, but our
estimates of future earnings indicate that profits would be recognized in early
periods and losses in later periods. In this case, we increase the amortization
of the cost of policies produced over the period of profits, by an amount
necessary to offset losses that are expected to be recognized in the later
years.
Value of Policies Inforce at the Effective Date
The value assigned to the right to receive future cash flows from contracts
existing at September 10, 2003 is referred to as the value of policies inforce
at the Effective Date. We also defer renewal commissions paid in excess of
ultimate commission levels related to the existing policies in this account. The
balance of this account is amortized and evaluated for recovery in the same
manner as described above for the cost of policies produced. We also adjust the
value of policies inforce at the Effective Date for the change in amortization
that would have been recorded if actively managed fixed maturity securities had
been sold at their stated aggregate fair value and the proceeds reinvested at
current yields, similar to the manner described above for the cost of policies
produced. We limit the total adjustment related to the impact of unrealized
losses to the total value of policies inforce recognized at the Effective Date
plus interest.
The discount rate we used to determine the value of the value of policies
inforce at the Effective Date was 12 percent.
The Company expects to amortize the balance of the value of policies
inforce at the Effective Date as of December 31, 2008 as follows: 14 percent in
2009, 12 percent in 2010, 11 percent in 2011, 9 percent in 2012 and 7 percent in
2013.
Assets Held in Separate Accounts
Separate accounts are funds on which investment income and gains or losses
accrue directly to certain policyholders. The assets of these accounts are
legally segregated. They are not subject to the claims that may arise out of any
other business of Conseco. We report separate account assets at fair value; the
underlying investment risks are assumed by the contractholders. We record the
related liabilities at amounts equal to the separate account assets. We record
the fees earned for administrative and contractholder services performed for the
separate accounts in insurance policy income.
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Recognition of Insurance Policy Income and Related Benefits and Expenses on
Insurance Contracts
For universal life and investment contracts that do not involve significant
mortality or morbidity risk, the amounts collected from policyholders are
considered deposits and are not included in revenue. Revenues for these
contracts consist of charges for policy administration, cost of insurance
charges and surrender charges assessed against policyholders' account balances.
Such revenues are recognized when the service or coverage is provided, or when
the policy is surrendered.
We establish liabilities for investment and universal life products equal
to the accumulated policy account values, which include an accumulation of
deposit payments plus credited interest, less withdrawals and the amounts
assessed against the policyholder through the end of the period. Sales
inducements provided to the policyholders of these products are recognized as
liabilities over the period that the contract must remain in force to qualify
for the inducement. The options attributed to the policyholder related to our
equity-indexed annuity products are accounted for as embedded derivatives as
described in the section of this note entitled "Accounting for Derivatives".
Traditional life and the majority of our accident and health products
(including long-term care, Medicare supplement and specified disease products)
are long duration insurance contracts. Premiums on these products are recognized
as revenues when due from the policyholders.
We also have a small block of short duration accident and health products.
Premiums on these products are recognized as revenue over the premium coverage
period.
We establish liabilities for traditional life, accident and health
insurance, and life contingent payment annuity products using mortality tables
in general use in the United States, which are modified to reflect the Company's
actual experience when appropriate. We establish liabilities for accident and
health insurance products using morbidity tables based on the Company's actual
or expected experience. These reserves are computed at amounts that, with
additions from estimated future premiums received and with interest on such
reserves at estimated future rates, are expected to be sufficient to meet our
obligations under the terms of the policy. Liabilities for future policy
benefits are computed on a net-level premium method based upon assumptions as to
future claim costs, investment yields, mortality, morbidity, withdrawals, policy
dividends and maintenance expenses determined when the policies were issued (or
with respect to policies inforce at August 31, 2003, the Company's best estimate
of such assumptions on the Effective Date). We make an additional provision to
allow for potential adverse deviation for some of our assumptions. Once
established, assumptions on these products are generally not changed unless a
premium deficiency exists. In that case, a premium deficiency reserve is
recognized and the future pattern of reserve changes are modified to reflect the
relationship of premiums to benefits based on the current best estimate of
future claim costs, investment yields, mortality, morbidity, withdrawals, policy
dividends and maintenance expenses, determined without an additional provision
for potential adverse deviation.
We establish claim reserves based on our estimate of the loss to be
incurred on reported claims plus estimates of incurred but unreported claims
based on our past experience.
Accounting for Long-term Care Premium Rate Increases
Many of our long-term care policies were subject to premium rate increases
in the three years ending December 31, 2008. In some cases, these premium rate
increases were materially consistent with the assumptions we used to value the
particular block of business at the fresh-start date. With respect to the 2006
premium rate increases, some of our policyholders were provided an option to
cease paying their premiums and receive a non-forfeiture option in the form of a
paid-up policy with limited benefits. In addition, our policyholders could
choose to reduce their coverage amounts and premiums in the same proportion,
when permitted by our contracts or as required by regulators. The following
describes how we account for these policyholder options:
o Premium rate increases - If premium rate increases reflect a change in
our previous rate increase assumptions, the new assumptions are 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.
o Benefit reductions - A policyholder may choose reduced coverage with a
proportionate reduction in premium, when permitted by our contracts.
This option does not require additional underwriting. Benefit
reductions are treated as a
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partial lapse of coverage, and the balance of our reserves and
deferred insurance acquisition costs is reduced in proportion to the
reduced coverage.
o Non-forfeiture benefits offered in conjunction with a rate increase -
In some cases, non-forfeiture benefits are offered to policyholders
who wish to lapse their policies at the time of a significant rate
increase. In these cases, exercise of this option is treated as an
extinguishment of the original contract and issuance of a new
contract. The balance of our reserves and deferred insurance
acquisition costs are released, and a reserve for the new contract is
established.
o Florida Order - In 2004, the Florida Office of Insurance Regulation
issued orders to Washington National and Senior Health, regarding
their home health care business in Florida. The orders required them
to offer a choice of three alternatives to holders of home health care
policies in Florida subject to premium rate increases as follows:
o retention of their current policy with a rate increase of 50
percent in the first year and actuarially justified increases in
subsequent years;
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15
percent in subsequent years; or
o receipt of a paid-up policy, allowing the holder to file future
claims up to 100 percent of the amount of premiums paid since the
inception of the policy.
Reserves for all three groups of policies under the order were
prospectively adjusted using a prospective revision methodology, as
these alternatives were required by the Florida Office of Insurance
Regulation. These policies had no insurance acquisition costs
established at the Effective Date.
Some of our policyholders may receive a non-forfeiture benefit if they cease
paying their premiums pursuant to their original contract (or pursuant to
changes made to their original contract as a result of a litigation settlement
made prior to the Effective Date or an order issued by the Florida Office of
Insurance Regulation). In these cases, exercise of this option is treated as the
exercise of a policy benefit, and the reserve for premium paying benefits is
reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect
the election of this benefit.
Accounting for marketing and reinsurance agreements with Coventry
Prescription Drug Benefit
The Medicare Prescription Drug, Improvement and Modernization Act of 2003
provided for the introduction of a prescription drug benefit ("PDP"). In order
to offer this product to our current and potential future policyholders without
investing in management and infrastructure, we entered into a national
distribution agreement with Coventry to use our career and independent agents to
distribute Coventry's prescription drug plan, Advantra Rx. We receive a fee
based on the premiums collected on plans sold through our distribution channels.
In addition, Conseco has a quota-share reinsurance agreement with Coventry for
Conseco enrollees that provides Conseco with 50 percent of net premiums and
related policy benefits subject to a risk corridor. The Part D program was
effective January 1, 2006.
The following describes how we account for and report our PDP business:
Our accounting for the national distribution agreement
o We recognize distribution and licensing fee income from Coventry based
upon negotiated percentages of collected premiums on the underlying
Medicare Part D contracts. This fee income is recognized over the
calendar year term as premiums are collected.
o We also pay commissions to our agents who sell the plans on behalf of
Coventry. These payments are deferred and amortized over the remaining
term of the initial enrollment period (the one-year life of the
initial policy).
Our accounting for the quota-share agreement
o We recognize premium revenue evenly over the period of the underlying
Medicare Part D contracts.
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o We recognize policyholder benefits and ceding commission expense as
incurred.
o We recognize risk-share premium adjustments consistent with Coventry's
risk-share agreement with the Centers for Medicare and Medicaid
Services.
Private-Fee-For-Service
Conseco expanded its strategic alliance with Coventry by entering into a
national distribution agreement under which our career agents began distributing
Coventry's Private-Fee-For-Service ("PFFS") plan, beginning January 1, 2007. The
Advantra Freedom product is a Medicare Advantage plan designed to provide
seniors with more choices and better coverage at lower cost than original
Medicare and Medicare Advantage plans offered through HMOs. Under the agreement,
we receive a fee based on the number of PFFS plans sold through our distribution
channels. In addition, Conseco has a quota-share reinsurance agreement with
Coventry for Conseco enrollees that provides Conseco with a specified percentage
of the net premiums and related profits.
We receive distribution fees from Coventry and we pay sales commissions to
our agents for these enrollments. In addition, we receive a specified percentage
of the income (loss) related to this business pursuant to a quota-share
agreement with Coventry.
The following summarizes our accounting and reporting practices for the
PFFS business.
Our accounting for the distribution agreement
o We receive distribution income from Coventry and other parties based
on a fixed fee per PFFS contract. This income is deferred and
recognized over the remaining calendar year term of the initial
enrollment period.
o We also pay commissions to our agents who sell the plans on behalf of
Coventry and other parties. These payments are deferred and amortized
over the remaining term of the initial enrollment period (the one-year
life of the initial policy).
Our accounting for the quota-share agreement
o We recognize revenue evenly over the period of the underlying PFFS
contracts.
o We recognize policyholder benefits and ceding commission expense as
incurred.
Large Group Private-Fee-For-Service Blocks
During 2007 and 2008, Conseco entered into three quota-share reinsurance
agreements with Coventry related to the PFFS business written by Coventry under
two large group policies. Conseco receives a specified percentage of the net
premiums and related profits associated with this business as long as the ceded
revenue margin (as defined in the quota-share reinsurance agreements) is less
than or equal to five percent. Conseco also receives a specified percentage of
the net premiums and related profits on the ceded margin in excess of five
percent. In order to reduce the required statutory capital associated with the
assumption of this business, Conseco terminated two group policy quota-share
agreements as of December 31, 2008 and will terminate the last agreement on June
30, 2009. Premiums assumed through these reinsurance agreements totaled $313.5
million in 2008 (including $185.3 million assumed through the agreement to be
terminated on June 30, 2009). The income before income taxes related to the
assumed business was $.4 million during the year ended December 31, 2008.
Reinsurance
In the normal course of business, we seek to limit our loss exposure on any
single insured or to certain groups of policies by ceding reinsurance to other
insurance enterprises. We currently retain no more than $.8 million of mortality
risk on any one policy. We diversify the risk of reinsurance loss by using a
number of reinsurers that have strong claims-paying ratings. In each case, the
ceding Conseco subsidiary is directly liable for claims reinsured even if the
assuming company is unable to pay.
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The cost of reinsurance on life and health coverages is recognized over the
life of the reinsured policies using assumptions consistent with those used to
account for the underlying policy. The cost of reinsurance ceded totaled $164.0
million, $202.4 million and $212.4 million in 2008, 2007 and 2006, respectively.
We deduct this cost from insurance policy income. Reinsurance recoveries netted
against insurance policy benefits totaled $536.3 million, $354.0 million and
$231.5 million in 2008, 2007 and 2006, respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced described above.
Reinsurance premiums assumed totaled $641.0 million, $307.8 million and $115.1
million in 2008, 2007 and 2006, respectively. Reinsurance premiums included
amounts assumed pursuant to marketing and quota-share agreements with Coventry
of $609.6 million, $271.4 million and $74.4 million in 2008, 2007 and 2006,
respectively. The increase in premiums assumed under these agreements in 2008
resulted from agreements whereby we are assuming: (i) a specified percentage of
the PFFS business written by Coventry under a large group policy effective July
1, 2007 (which will be terminated on June 30, 2009); and (ii) a specified
percentage of the PFFS business written by Coventry under another large group
policy effective May 1, 2008 (which was terminated on December 31, 2008).
See the section of this note entitled "Accounting for Derivatives" for a
discussion of the derivative embedded in the payable related to certain modified
coinsurance agreements.
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.
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, resulted in increases
(decreases) to the loss calculated as of January 1, 2007. Such after-tax
earnings (loss) include the market value declines on invested assets transferred
to the reinsurer occurring during the first three quarters of 2007.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The following summarizes the profits and losses recognized on this business
in 2007 (dollars in millions):
2007
Net earnings on the block before tax.................................................... $ 17.0
Realized investment losses, net of amortization of insurance intangibles................ (40.6)
Loss related to the annuity coinsurance transaction..................................... (76.5) (a)
-------
Net loss before income taxes............................................................ $(100.1)
=======
<FN>
- ------------
(a) Amount represents the net loss before income taxes recognized on the
annuity coinsurance transaction during 2007, including the earnings
and losses on the block during that period and the loss recognized
upon completion of the transaction. The following summarizes the
components of the loss before income taxes (dollars in millions):
Assets received (transferred)
Investments.................................... $(2,560.8)
Accrued investment income...................... (28.7)
Value of policies inforce at the Effective Date (198.9)
Cost of policies produced...................... (20.5)
Reinsurance receivables........................ 2,764.3
Other.......................................... (31.9)
---------
Net loss before income taxes................ $ (76.5)
=========
</FN>
In 2007, we completed the recapture of a block of traditional life
insurance in force that had been ceded in 2002 to REALIC. In the transaction,
which had an effective date of October 1, 2007, Colonial Penn paid REALIC a
recapture fee of $63 million. The recapture of this block resulted in a $2.8
million gain accounted for as a reduction to insurance policy benefits. Colonial
Penn recaptured 100 percent of the liability for the future benefits previously
ceded, and will recognize profits from the block as they emerge over time.
Colonial Penn already administers the policies that were recaptured.
In 2008, Bankers Life entered into a reinsurance agreement pursuant to
which it ceded 70 percent of its new 2008 long-term care business, excluding
certain business sold in the state of Florida and 50 percent of such new
long-term care business, excluding certain business sold in Florida commencing
on January 1, 2009. The pre-tax impact of this reinsurance agreement was not
significant in 2008.
Income Taxes
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 net operating loss carryforwards
("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
130
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
carryforward periods, our experience with operating loss and tax credit
carryforwards expiring unused, and tax planning alternatives.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets as we believed that the realization of such net
deferred income tax assets in future periods was uncertain. During 2006, we
concluded that it was no longer necessary to hold certain portions of the
previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $260.0 million in 2006. However, we are required to
continue to hold a valuation allowance of $1.2 billion at December 31, 2008
because we have determined that it is more likely than not that a portion of our
deferred tax assets will not be realized. This determination was made by
evaluating each component of the deferred tax asset and assessing the effects of
limitations or interpretations on the value of such component to be fully
recognized in the future.
Investment Borrowings
In the first quarter of 2007, one of the Company's insurance subsidiaries
(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 December
31, 2008, the carrying value of the FHLBI common stock was $22.5 million.
Collateralized borrowings from the FHLBI totaled $450.0 million as of December
31, 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 $504.6 million at December 31, 2008, which are
maintained in a custodial account for the benefit of the FHLBI. Conseco Life
recognized interest expense of $21.9 million and $16.7 million in 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 December 31, 2008
-------- ---- --------------------
$ 54.0 May 2012 Variable rate - 2.153%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 4.810%
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 December 31, 2008, investment borrowings consisted of: (i)
collateralized borrowings of $450.0 million; (ii) $311.7 million of securities
issued to other entities by a variable interest entity ("VIE") which is
consolidated in our financial statements as further discussed in the note to the
consolidated financial statements entitled "Investment in a Variable Interest
Entity"; and (iii) other borrowings of $5.8 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.
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 or call spreads 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.
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 $(104.3) million, $(8.5) million
and $40.4 million during
131
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
2008, 2007 and 2006, respectively. These amounts were substantially offset by a
corresponding charge to insurance policy benefits. The estimated fair value of
these options was $17.6 million and $51.2 million at December 31, 2008 and 2007,
respectively. We classify these instruments as other invested assets. Pursuant
to the annuity coinsurance agreement described above, 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 options to
hedge liabilities which may arise after the next policy anniversary date. The
Company must value both the 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 $430.6 million and $353.2 million at December 31, 2008 and 2007,
respectively. 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 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 December 31, 2008, substantially 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 $6.6 million and $1.4 million at December 31, 2008 and
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.
Multibucket Annuity Product
The Company's multibucket annuity is a fixed annuity product that credits
interest based on the experience of a particular market strategy. Policyholders
allocate their annuity premium payments to several different market strategies
based on different asset classes within the Company's investment portfolio.
Interest is credited to this product based on the market return of the given
strategy, less management fees, and funds may be moved between different
strategies. The Company guarantees a minimum return of premium plus
approximately 3 percent per annum over the life of the contract. The investments
backing the market strategies of these products are designated by the Company as
trading securities. The change in the fair value of these securities is
recognized currently in investment income (classified as income from
policyholder and reinsurer accounts), which is substantially offset by the
change in insurance policy benefits for these products. As of December 31, 2008,
we hold insurance liabilities of $73.6 million related to multibucket annuity
products.
132
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Stock Based Compensation
Prior to January 1, 2006, we measured compensation cost for our stock
option plans using the intrinsic value method pursuant to Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related
interpretations ("APB 25"). Under this method, compensation cost was recorded
when the quoted market price at the grant date exceeded the amount an employee
had to pay to acquire the stock. When the Company issued employee stock options
with an exercise price equal to or greater than the market price of our stock on
the grant date, no compensation cost was recorded. Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123") and Statement of Financial Accounting Standards No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" required disclosures of
the pro forma effects of using the fair value method of accounting for stock
options.
In December 2004, the FASB issued Statement of Financial Accounting
Standards No. 123 (revised 2004) "Share-Based Payment" ("SFAS 123R"), which
revised SFAS 123 and superseded APB 25. SFAS 123R provided additional guidance
on accounting for share-based payments and required all such awards to be
measured at fair value with the related compensation cost recognized in the
statement of operations over the related service period. Conseco implemented
SFAS 123R using the modified prospective method on January 1, 2006. Under this
method, the Company began recognizing compensation cost for all awards granted
on or after January 1, 2006. In addition, we are required to recognize
compensation cost over the remaining requisite service period for the portion of
outstanding awards that were not vested as of January 1, 2006 and were not
previously expensed on a pro forma basis pursuant to SFAS 123. In accordance
with the modified prospective transition method, our consolidated financial
statements for prior periods have not been restated to reflect compensation cost
determined under the fair value method. SFAS 123R also requires the benefits of
tax deductions in excess of recognized compensation cost to be reported as a
financing cash flow rather than as an operating cash flow, as previously
required. During 2008 and 2007, we did not capitalize any stock-based
compensation expense as cost of policies produced or any other asset category.
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.
133
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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) 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. Substantially all of our Level 2
fixed maturity securities and separate account assets were valued from
independent pricing services. 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. The number of prices obtained is
dependent on the Company's analysis of such prices as further described below.
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 are non-binding and represent an exit price, but assumptions used to
establish the fair value may not be observable and therefore represent Level 3
inputs. Approximately 5 percent and 1 percent of our Level 3 fixed maturity
securities were valued using broker quotes or independent pricing services,
respectively. The remaining Level 3 fixed maturity 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.
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
134
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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. As a result of such procedures, the Company may conclude the prices
received from third parties are not reflective of current market conditions. In
those instances, we may request additional pricing quotes or apply internally
developed valuations. However, the number of instances is insignificant and the
aggregate change in value of such investments is not materially different from
the original prices received.
The categorization of the fair value measurements of our investments priced
by independent pricing services was based upon the Company's judgment of the
inputs or methodologies used by the independent pricing services to value
different asset classes. Such inputs include: benchmark yields, reported trades,
broker dealer quotes, issuer spreads, benchmark securities, bids, offers and
reference data. The Company categorizes such fair value measurements based upon
asset classes and the underlying observable or unobservable inputs used to value
such investments.
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.
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 December 31, 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........ $74.9 $13,326.0 $1,876.1 $15,277.0
Equity securities........................ - - 32.4 32.4
Trading securities....................... 8.8 315.0 2.7 326.5
Securities lending collateral............ - 170.3 48.1 218.4
Other invested assets.................... - 55.9 (a) 2.3 (b) 58.2
Assets held in separate accounts......... - 18.2 - 18.2
Liabilities:
Liabilities for insurance products:
Embedded derivative instruments........ - - 437.2 (c) 437.2
<FN>
- -------------
(a) Includes corporate-owned life insurance and derivatives.
(b) Includes equity-like holdings in special-purpose entities.
(c) Includes $430.6 million of embedded derivatives associated with our
equity-indexed annuity products and $6.6 million of embedded
derivatives associated with a modified coinsurance agreement.
</FN>
135
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The following table presents 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 year ended December 31, 2008 (dollars in millions):
Embedded derivative
Actively Securities Other instruments included
managed fixed Equity Trading lending invested in liabilities for
maturities securities securities collateral assets insurance products
---------- ---------- ---------- ---------- ------ ------------------
Assets:
Beginning balance as of
December 31, 2007..................... $1,753.3 $34.5 $11.8 $105.7 $ 4.3 $(354.6)
Purchases, sales, issuances and
settlements, net...................... 465.4 (3.0) (6.3) (18.7) (1.4) (10.6)
Total realized and unrealized gains (losses):
Included in net loss.................. (18.9) - (2.3) - .9 (72.0)
Included in other comprehensive
income (loss)....................... (247.9) .9 - (2.6) (1.5) -
Transfers in and/or (out) of Level 3 (a) (75.8) - (.5) (36.3) - -
-------- ----- ----- ------ ----- -------
Ending balance as of December 31, 2008.... $1,876.1 $32.4 $ 2.7 $ 48.1 $ 2.3 $(437.2)
======== ===== ===== ====== ===== =======
Amount of total gains (losses) for the
year ended December 31, 2008 included
in our net loss relating to assets and
liabilities still held as of the
reporting date.......................... $(5.6) $ - $ - $ - $ .9 $(72.0)
===== ===== ===== ====== ===== ======
<FN>
- -----------
(a) Net transfers out of Level 3 are reported as having occurred at the
beginning of the period.
</FN>
At December 31, 2008, 80 percent of our Level 3 actively managed fixed
maturities were investment grade and 91 percent of our Level 3 actively managed
fixed maturities consisted of corporate securities.
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.
Transfers in and/or (out) of Level 3 in 2008 were primarily due to changes in
the observability of the valuation attributes resulting 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.
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.
136
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
We use the following methods and assumptions to determine the estimated
fair values of other financial instruments:
Cash and cash equivalents. The carrying amount for these instruments
approximates their estimated fair value.
Mortgage loans and policy loans. We discount future expected cash flows for
loans included in our investment portfolio based on interest rates
currently being offered for similar loans to borrowers with similar credit
ratings. We aggregate loans with similar characteristics in our
calculations. The market value of policy loans approximates their carrying
value.
Other invested assets. We use quoted market prices, where available. When
quotes are not available, we estimate the fair value based on discounted
future expected cash flows or independent transactions which establish a
value for our investment.
Insurance liabilities for interest-sensitive products. We discount future
expected cash flows based on interest rates currently being offered for
similar contracts with similar maturities.
Investment borrowings and notes payable. For publicly traded debt, we use
current market values. For other notes, we use discounted cash flow
analyses based on our current incremental borrowing rates for similar types
of borrowing arrangements.
The estimated fair values of our financial instruments at December 31, 2008
and 2007, were as follows (dollars in millions):
2008 2007
--------------------- ---------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
Financial assets:
Actively managed fixed maturities............................... $15,277.0 $15,277.0 $17,859.5 $17,859.5
Equity securities............................................... 32.4 32.4 34.5 34.5
Mortgage loans.................................................. 2,159.4 2,122.1 1,855.8 1,901.9
Policy loans.................................................... 363.5 363.5 370.4 370.4
Trading securities.............................................. 326.5 326.5 665.8 665.8
Securities lending collateral................................... 393.7 393.7 405.8 405.8
Other invested assets........................................... 95.0 95.0 132.7 132.7
Cash and cash equivalents....................................... 899.3 899.3 383.0 383.0
Financial liabilities:
Insurance liabilities for interest-sensitive
products (a).................................................. $13,332.8 $13,332.8 $13,169.4 $13,169.4
Investment borrowings........................................... 767.5 767.5 913.0 913.0
Notes payable - direct corporate obligations.................... 1,328.7 1,162.5 1,193.7 1,156.8
<FN>
- --------------------
(a) The estimated fair value of insurance liabilities for
interest-sensitive products was approximately equal to its carrying
value at December 31, 2008 and 2007. This was because interest rates
credited on the vast majority of account balances approximate current
rates paid on similar products and because these rates are not
generally guaranteed beyond one year.
</FN>
Sales Inducements
Certain of our annuity products offer sales inducements to contract holders
in the form of enhanced crediting rates or bonus payments in the initial period
of the contract. Certain of our life insurance products offer persistency
bonuses credited to the contract holders balance after the policy has been
outstanding for a specified period of time. These enhanced rates and persistency
bonuses are considered sales inducements under Statement of Position 03-01
"Accounting and Reporting by Insurance Enterprises for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts". Such amounts are deferred
and amortized in the same manner as the cost of policies produced. Sales
inducements deferred totaled $47.1 million, $52.4 million and $64.0 million in
2008, 2007 and 2006, respectively. Amounts amortized totaled $16.7 million,
$18.4 million and $19.1 million in 2008, 2007 and 2006, respectively. The
unamortized balance of deferred sales inducements was $179.4 million and $149.0
million at December 31, 2008 and 2007, respectively. The balance of insurance
137
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
liabilities for persistency bonus benefits was $195.9 million and $252.8 million
at December 31, 2008 and 2007, respectively.
Out-of-Period Adjustments
In 2008, we recorded the net effects of certain out-of-period adjustments
which increased our net loss by $6.9 million (or 4 cents per diluted share). Of
this amount, $6.1 million (or 3 cents per diluted share) related to our
discontinued operations.
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 adoption of FSP APB 14-1 will affect the accounting for our 3.5%
convertible debentures due in 2035. Upon adoption of FSP APB 14-1, we expect the
effective interest rate on our convertible debentures will range from 7 percent
to 7.5 percent, which would result in the recognition of an approximate $40
million to $50 million discount to these notes with the offsetting after tax
amount recorded to paid-in capital. Interest expense is expected to increase as
summarized below (dollars in millions):
Range of increase
-----------------
2006.................................. $7 - $8 million
2007.................................. 7 - 8 million
2008.................................. 8 - 9 million
2009.................................. 9 - 10 million
2010.................................. 7 - 8 million
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
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
138
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 entity's derivative and hedging activities. SFAS 161 is
effective for financial statements issued for fiscal years and interim periods
beginning after November 15, 2008. SFAS 161 is not expected to have a material
impact on our consolidated financial statements.
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 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, any 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 January 2009, the FASB issued FASB Staff Position No. EITF 99-20-1,
"Amendments to the Impairment Guidance of EITF Issue No. 99-20," ("FSP EITF
99-20-1"). FSP EITF 99-20-1 amends the impairment guidance of Emerging Issues
Task Force Issue No. 99-20, "Recognition of Interest Income and Impairment of
Purchased Beneficial Interest and Beneficial Interest that Continue to Be Held
by a Transferor in Securitized Financial Assets," by removing the exclusive
reliance upon market participant assumptions about future cash flows when
evaluating impairment of securities within its scope. FSP EITF 99-20-1 requires
companies to follow the impairment guidance in Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115"), which permits the use of reasonable management
judgment of the probability that the holder will be unable to collect all
amounts due. FSP EITF 99-20-1 is effective prospectively for interim and annual
reporting periods ending after December 15, 2008. The Company adopted FSP EITF
99-20-1 on December 31, 2008 and the adoption did not have a material effect on
the Company's consolidated financial statements.
139
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
In December 2008, the FASB issued FSP FAS 140-4 and FIN 46 (R) - 8,
"Disclosures by Public Entities (Enterprises) about Transfers of Financial
Assets and Interests in Variable Interest Entities" ("FSP FAS 140-4 and FIN 46
(R)-8"). The purpose of FSP FAS 140-4 and FIN 46 (R)-8 is to promptly improve
disclosures by public entities and enterprises until pending amendments to SFAS
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 140") and FASB Interpretation No. 46 (R).
"Consolidation of Variable Interest Entities" ("FIN 46 (R)") are finalized and
approved by the FASB. The FSP amends SFAS 140 to require public entities to
provide additional disclosures about transferors' continuing involvements with
transferred financial assets. It also amends FIN 46 (R) to require public
enterprises to provide additional disclosures about their involvement with
variable interest entities. FSP 140-4 and FIN 46 (R)-8 are effective for
financial statements issued for fiscal years and interim periods ending after
December 15, 2008. We adopted FSP FAS 140-4 and FIN 46 (R)-8 on December 31,
2008.
In October 2008, the FASB issued FASB Staff Position FAS 157-3,
"Determining the Fair Value of a Financial Asset When the Market for That Asset
is Not Active" ("FSP 157-3"). FSP 157-3 clarifies the application of SFAS 157 in
a market that is not active and applies to financial assets within the scope of
accounting pronouncements that require or permit fair value measurements in
accordance with SFAS 157. FSP 157-3 is effective upon issuance, including prior
periods for which financial statements have not been issued. Accordingly, the
Company adopted this guidance effective September 30, 2008. The Company's
adoption of this guidance did not have a material effect on the Company's
consolidated financial statements.
In February 2007, the FASB issued Statement of Financial Accounting
Standards No. 159, "The Fair Value Option for Financial Assets and Financial
Liabilities - Including an Amendment of FASB Statement No. 115" ("SFAS 159").
SFAS 159 allows entities to choose to measure many financial instruments and
certain other items, including insurance contracts, at fair value (on an
instrument-by-instrument basis) that are not currently required to be measured
at fair value. The objective is to improve financial reporting by providing
entities with the opportunity to mitigate volatility in reported earnings caused
by measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. 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 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
December 31, 2008, $11.4 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.
140
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
5. INVESTMENTS
At December 31, 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 (a):
Corporate securities................................................ $11,874.8 $ 76.5 $(1,797.4) $10,153.9
United States Treasury securities and obligations of
United States government corporations and agencies................ 122.3 8.7 (.4) 130.6
States and political subdivisions................................... 427.4 .4 (52.2) 375.6
Debt securities issued by foreign governments....................... 4.8 .1 (.8) 4.1
Asset-backed securities............................................. 290.5 - (87.4) 203.1
Collateralized debt obligations..................................... 122.5 .3 (31.1) 91.7
Commercial mortgage-backed securities............................... 808.9 .7 (263.1) 546.5
Mortgage pass-through securities.................................... 75.0 1.4 (.1) 76.3
Collateralized mortgage obligations................................. 2,566.5 59.0 (322.2) 2,303.3
--------- ------ --------- ---------
Total investment grade actively managed fixed maturities........ 16,292.7 147.1 (2,554.7) 13,885.1
--------- ------ --------- ---------
Below-investment grade (a):
Corporate securities................................................ 1,587.2 21.4 (389.2) 1,219.4
States and political subdivisions................................... 8.6 - (1.6) 7.0
Debt securities issued by foreign governments....................... 5.6 - (1.1) 4.5
Asset-backed securities............................................. .8 - (.2) .6
Collateralized debt obligations..................................... 11.8 - (6.9) 4.9
Commercial mortgage-backed securities............................... 23.3 - (2.6) 20.7
Collateralized mortgage obligations................................. 346.3 - (211.5) 134.8
--------- ------ --------- ---------
Total below-investment grade actively
managed fixed maturities...................................... 1,983.6 21.4 (613.1) 1,391.9
--------- ------ --------- ---------
Total actively managed fixed maturities............................. $18,276.3 $168.5 $(3,167.8) $15,277.0
========= ====== ========= =========
Equity securities...................................................... $31.0 $1.5 $(.1) $32.4
===== ==== ==== =====
<FN>
- ---------------
(a) Investment ratings - The Securities Valuation Office ("SVO") of the
National Association of Insurance Commissioners (the "NAIC") evaluates
fixed maturity investments for regulatory reporting purposes and
assigns securities to one of six investment categories called "NAIC
Designations". The NAIC ratings are similar to the rating agency
descriptions of the Nationally Recognized Statistical Rating
Organization ("NRSROs"). NAIC designations of "1" or "2" include fixed
maturities generally rated investment grade (rated "Baaa3" or higher
by Moody's Investor Service, Inc. ("Moody's") or rated "BBB-" or
higher by S&P and Fitch Ratings ("Fitch")). NAIC Designations of "3"
through "6" are referred to as below investment grade (which generally
are rated "Ba1" or lower by Moody's or rated "BB+" or lower by S&P and
Fitch). As a result of time lags between the funding of investments,
the finalization of legal documents and the completion of the SVO
filing process, our fixed maturities generally include securities that
have not yet been rated by the SVO as of each balance sheet date.
Pending receipt of the SVO ratings, the classification of these
securities by NAIC Designation is based on the expected ratings as
determined by the Company. References to investment grade or below
investment grade throughout our consolidated financial statements are
based on NAIC Designations.
</FN>
141
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
At December 31, 2007, the amortized cost and estimated fair value of
actively managed fixed maturities and equity securities were as follows (dollars
in millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade:
Corporate securities................................................ $11,036.6 $ 92.9 $(306.9) $10,822.6
United States Treasury securities and obligations of
United States government corporations and agencies................ 523.2 14.2 (1.5) 535.9
States and political subdivisions................................... 449.2 4.2 (8.2) 445.2
Debt securities issued by foreign governments....................... 6.7 .2 - 6.9
Asset-backed securities............................................. 399.6 .3 (39.6) 360.3
Collateralized debt obligations..................................... 44.6 - (4.2) 40.4
Commercial mortgage-backed securities............................... 840.5 4.9 (26.6) 818.8
Mortgage pass-through securities.................................... 89.6 .1 (.4) 89.3
Collateralized mortgage obligations................................. 3,152.3 7.2 (63.6) 3,095.9
--------- ------ ------- ---------
Total investment grade actively managed fixed maturities........ 16,542.3 124.0 (451.0) 16,215.3
--------- ------ ------- ---------
Below-investment grade:
Corporate securities................................................ 1,653.6 3.0 (88.8) 1,567.8
States and political subdivisions................................... 18.3 - (2.3) 16.0
Debt securities issued by foreign governments....................... 6.1 - (.1) 6.0
Collateralized debt obligations..................................... 10.4 - (2.4) 8.0
Commercial mortgage-backed securities............................... 23.2 - (1.0) 22.2
Collateralized mortgage obligations................................. 27.6 .1 (3.5) 24.2
--------- ------ ------- ---------
Total below-investment grade actively
managed fixed maturities...................................... 1,739.2 3.1 (98.1) 1,644.2
--------- ------ ------- ---------
Total actively managed fixed maturities............................. $18,281.5 $127.1 $(549.1) $17,859.5
========= ====== ======= =========
Equity securities...................................................... $34.0 $.5 $ - $34.5
===== === ===== =====
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 December 31, 2008 and 2007 were
as follows (dollars in millions):
2008 2007
---- ----
Net unrealized depreciation on investments................................................ $(3,015.9) $(481.3)
Adjustment to value of policies inforce at the Effective Date............................. 111.0 18.3
Adjustment to cost of policies produced................................................... 154.8 43.7
Unrecognized net loss related to deferred compensation plan............................... (8.0) (7.3)
Deferred income tax asset................................................................. 987.4 153.3
--------- -------
Accumulated other comprehensive loss............................................... $(1,770.7) $(273.3)
========= =======
142
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our actively managed
fixed maturity securities by category as of December 31, 2008 (dollars in
millions):
Percent of
Gross gross
Percent of unrealized unrealized
Carrying value fixed maturities losses losses
-------------- ---------------- ------ ------
Collateralized mortgage obligations........... $ 2,438.1 16.0% $ (533.7) 16.8%
Utilities..................................... 1,428.0 9.3 (194.2) 6.1
Energy/pipelines.............................. 1,323.0 8.7 (258.4) 8.2
Food/beverage................................. 1,069.2 7.0 (118.5) 3.7
Banks......................................... 820.3 5.4 (219.0) 6.9
Healthcare/pharmaceuticals.................... 808.5 5.3 (84.0) 2.7
Insurance..................................... 716.1 4.7 (228.7) 7.2
Cable/media................................... 589.4 3.9 (123.0) 3.9
Commercial mortgage-backed securities......... 567.2 3.7 (265.7) 8.4
Real estate/REITs............................. 462.6 3.0 (211.5) 6.7
Telecom....................................... 460.6 3.0 (63.0) 2.0
Brokerage..................................... 432.6 2.8 (78.0) 2.5
Capital goods................................. 403.0 2.6 (44.4) 1.4
States and political subdivisions............. 382.6 2.5 (53.8) 1.7
Aerospace/defense............................. 365.0 2.4 (11.7) .4
Transportation................................ 357.5 2.3 (41.3) 1.3
Building materials............................ 278.5 1.8 (103.0) 3.2
Technology.................................... 242.2 1.6 (41.4) 1.3
Asset-backed securities....................... 203.7 1.3 (87.6) 2.8
Consumer products............................. 179.1 1.2 (26.6) .8
Other......................................... 1,749.8 11.5 (380.3) 12.0
--------- ----- --------- -----
Total actively managed fixed maturities.... $15,277.0 100.0% $(3,167.8) 100.0%
========= ===== ========= =====
Below-Investment Grade Securities
At December 31, 2008, the amortized cost of the Company's below-investment
grade fixed maturity securities was $1,983.6 million, or 11 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,391.9 million, or 70 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$379.2 million and an estimated fair value of $261.7 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. Refer to the note to the consolidated financial
statements entitled "Investment in a Variable Interest Entity" concerning the
Company's investment in the VIE. At December 31, 2008, our total investment in
the VIE was $83.8 million. Our investments in the VIE were rated as follows:
$25.2 million was rated NAIC 4, $56.7 million was rated NAIC 6 and $1.9 million
was not rated as it was an equity-type security.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Based on historical performance,
risk of default by the borrower is significantly greater for below-investment
grade securities and in many cases, severity of loss is relatively greater as
such securities are generally unsecured and often subordinated to other
indebtedness of the issuer. Also, issuers of below-investment grade securities
usually have higher levels of debt and may be more financially leveraged, hence,
all other things being equal, more sensitive to adverse economic conditions,
such as recession or increasing interest rates. The Company attempts to reduce
the overall risk related to its investment in below-investment grade securities,
as in all investments, through careful credit analysis, strict investment policy
guidelines, and diversification by issuer and/or guarantor and by industry.
143
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Contractual Maturity
The following table sets forth the amortized cost and estimated fair value
of actively managed fixed maturities at December 31, 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 referred 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...................................................................... $ 90.6 $ 88.9
Due after one year through five years........................................................ 1,553.5 1,324.5
Due after five years through ten years....................................................... 4,727.5 3,876.0
Due after ten years.......................................................................... 7,659.1 6,605.7
--------- ---------
Subtotal................................................................................. 14,030.7 11,895.1
Structured securities........................................................................ 4,245.6 3,381.9
--------- ---------
Total actively managed fixed maturities.............................................. $18,276.3 $15,277.0
========= =========
Net Investment Income
Net investment income consisted of the following (dollars in millions):
2008 2007 2006
---- ---- ----
Fixed maturities..................................................... $1,094.4 $1,194.9 $1,143.7
Trading income related to policyholder and
reinsurer accounts and other special-purpose portfolios........... 2.1 31.2 32.9
Equity securities.................................................... 1.4 1.6 1.8
Mortgage loans....................................................... 126.1 109.3 96.0
Policy loans......................................................... 23.6 26.5 25.0
Change in value of options
related to equity-indexed products................................ (77.8) (11.9) 38.3
Other invested assets................................................ 13.8 10.8 13.1
Cash and cash equivalents............................................ 11.9 24.0 17.8
-------- -------- --------
Gross investment income........................................... 1,195.5 1,386.4 1,368.6
Less investment expenses............................................. 16.7 16.6 17.8
-------- -------- --------
Net investment income............................................. $1,178.8 $1,369.8 $1,350.8
======== ======== ========
The estimated fair value of fixed maturity investments and mortgage loans
not accruing investment income totaled $15.5 million at December 31, 2008. We
had no fixed maturity investments or mortgage loans that were not accruing
investment income at December 31, 2007.
144
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Net Realized Investment Gains (Losses)
Net realized investment gains (losses) were included in revenue as follows
(dollars in millions):
2008 2007 2006
---- ---- ----
Fixed maturities:
Gross gains.......................................................... $ 110.3 $ 81.9 $ 58.1
Gross losses......................................................... (177.3) (124.7) (86.3)
Other-than-temporary declines in fair value.......................... (152.7) (98.3) (10.7)
------- ------- ------
Net realized investment gains (losses) from
fixed maturities.............................................. (219.7) (141.1) (38.9)
Equity securities........................................................ - (5.0) .2
Mortgages................................................................ (19.7) (.2) .1
Other-than-temporary declines in fair value of mortgage loans,
equity securities and other invested assets.......................... (9.6) (7.2) (10.4)
Other.................................................................... (13.4) (4.5) 2.4
------- ------- ------
Net realized investment losses.................................. $(262.4) $(158.0) $(46.6)
======= ======= ======
During 2008, we recognized net realized investment losses of $262.4
million, which were comprised of: (i) $100.1 million of net losses from the
sales of investments (primarily fixed maturities); and (ii) $162.3 million of
writedowns of investments for other than temporary declines in fair value (no
single investment accounted for more than $10 million of such writedowns).
During 2007, net realized investment losses included: (i) $52.5 million of net
losses from the sales of investments (primarily fixed maturities); (ii) $31.8
million of writedowns of investments for other than temporary declines in fair
value (no single investment accounted for more than $5.0 million of such
writedowns); and (iii) $73.7 million of writedowns of investments (which were
subsequently transferred pursuant to a coinsurance agreement as further
discussed in the note to the consolidated financial statements entitled "Summary
of Significant Accounting Policies - Reinsurance") as a result of our intent not
to hold such investments for a period of time sufficient to allow for any
anticipated recovery in value. During 2006, we recognized net realized
investment losses of $46.6 million, which were comprised of $25.5 million of net
losses from the sales of investments (primarily fixed maturities), and $21.1
million of writedowns of investments for other than temporary declines in fair
value. At December 31, 2008, fixed maturity securities in default as to the
payment of principal or interest had both an aggregate amortized cost and
carrying value of $7.2 million. At December 31, 2008, we had mortgage loans with
an aggregate carrying value of $8.3 million that were 90 days or more past due
as to the payment of principal or interest.
During 2008, we sold $.8 billion of fixed maturity investments which
resulted in gross investment losses (before income taxes) of $177.3 million. We
sell securities at a loss for a number of reasons including, but not limited to:
(i) changes in the investment environment; (ii) expectation that the market
value could deteriorate further; (iii) desire to reduce our exposure to an
issuer or an industry; (iv) changes in credit quality; or (v) changes in
expected liability cash flows.
The following summarizes the investments sold at a loss during 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........................ 37 $151.7 $55.2
Greater than or equal to 6 and less than 12 months
prior to sale ........................................ 6 37.4 18.0
Greater than 12 months.................................. 2 7.5 1.5
-- ------ -----
45 $196.6 $74.7
== ====== =====
145
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 estimated fair values of our investments could have a
material adverse effect on our earnings in future periods and on our financial
condition and may require us to make additional capital contributions to our
insurance subsidiaries.
Investments with Unrealized Losses
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at December
31, 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. 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................................................................... $ 77.7 $ 75.9
Due after one year through five years..................................................... 1,448.6 1,214.9
Due after five years through ten years.................................................... 4,392.0 3,521.4
Due after ten years....................................................................... 6,145.7 5,009.1
--------- ---------
Subtotal............................................................................... 12,064.0 9,821.3
Structured securities..................................................................... 2,850.2 1,925.1
--------- ---------
Total.................................................................................. $14,914.2 $11,746.4
========= =========
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
December 31, 2008 (dollars in millions):
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------ ---------- ----- ---- ----------
Less than 6 months............................. 240 $1,171.3 $(511.4) $659.9
Greater than or equal to
6 months and less
than 12 months............................... 57 104.9 (53.2) 51.7
Greater than 12 months......................... 4 3.2 (1.1) 2.1
--- -------- ------- ------
301 $1,279.4 $(565.7) $713.7
=== ======== ======= ======
146
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The following table summarizes the gross unrealized losses of our actively
managed fixed maturity securities by category and ratings category as of
December 31, 2008 (dollars in millions):
Below investment grade
Investment grade ------------------------ Total gross
---------------------- NAIC 4 unrealized
NAIC 1 NAIC 2 NAIC 3 and below losses
------ ------ ------ --------- ------
Collateralized mortgage obligations.. $ 315.7 $ 6.5 $209.3 $ 2.2 $ 533.7
Commercial mortgage-backed
securities......................... 158.1 105.0 2.6 - 265.7
Energy/pipelines..................... 40.9 197.6 14.1 5.8 258.4
Insurance............................ 167.5 60.4 - .8 228.7
Banks................................ 178.2 32.7 4.3 3.8 219.0
Real estate/REITs.................... 31.4 169.7 7.1 3.3 211.5
Utilities............................ 51.4 131.5 4.0 7.3 194.2
Cable/media.......................... 17.7 60.4 18.2 26.7 123.0
Food/beverage........................ 35.9 65.8 5.6 11.2 118.5
Building materials................... .3 56.4 42.5 3.8 103.0
Asset-backed securities.............. 46.1 41.3 .2 - 87.6
Healthcare/pharmaceuticals........... 25.8 33.6 8.6 16.0 84.0
Brokerage............................ 47.4 30.6 - - 78.0
Telecom.............................. 15.8 19.2 23.5 4.5 63.0
States and political subdivisions.... 20.1 32.1 1.4 .2 53.8
Retail............................... 5.2 21.9 8.2 10.7 46.0
Capital goods........................ 9.8 31.3 1.7 1.6 44.4
Entertainment/hotels................. 2.7 28.3 9.5 3.1 43.6
Technology........................... 11.1 15.1 6.3 8.8 41.3
Transportation....................... 3.5 35.7 .6 1.5 41.3
Collateralized debt obligations...... 10.4 20.7 6.9 - 38.0
Chemicals............................ 2.2 11.3 7.7 11.0 32.2
Metals and mining.................... 4.8 17.3 7.4 .2 29.7
Paper................................ - 21.0 1.8 5.2 28.0
Consumer products.................... 5.3 14.9 - 6.4 26.6
Gaming............................... - - 5.0 18.1 23.1
Autos................................ 3.1 - .6 14.2 17.9
Aerospace/defense.................... .7 5.4 4.8 .8 11.7
Textiles............................. 7.9 .4 .7 2.5 11.5
Foreign governments.................. .8 - 1.1 - 1.9
U.S. Treasury and Obligations........ .4 - - - .4
Mortgage pass-through securities..... .1 - - - .1
Other................................ 8.2 60.1 20.3 19.4 108.0
-------- -------- ------ ------ --------
Total actively managed fixed
maturities....................... $1,228.5 $1,326.2 $424.0 $189.1 $3,167.8
======== ======== ====== ====== ========
147
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
At December 31, 2008, we held five individual non-investment grade
collateralized mortgage-backed securities that had a cost basis of $319.6
million, an estimated fair value of $110.3 million and unrealized losses of
$209.3 million. As of December 31, 2008, these securities had been in an
unrealized loss position exceeding 30 percent of cost for one to five months.
These securities are senior tranches in their respective securitization
structures which hold standard and Alt-A residential mortgages originating in
2006 and 2007. These securities were rated NAIC 3 at December 31, 2008,
following ratings downgrades by one nationally recognized rating agency. Given
current market conditions, limited trading of these securities and the recent
rating actions, the estimated fair value of these securities has declined. We
believe the decline is largely due to widening credit spreads and high premium
for liquidity that existed at December 31, 2008. The estimated fair value of
these securities has increased by $38 million since December 31, 2008 based on
February 27, 2009 estimates. We have examined the performance of the underlying
collateral and expect that our investments will continue to perform in
accordance with the contractual terms.
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.
148
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position, at
December 31, 2008 (dollars in millions):
Less than 12 months 12 months or greater Total
---------------------- ----------------------- -------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 25.5 $ (.3) $ 1.9 $ (.1) $ 27.4 $ (.4)
States and political subdivisions. 200.7 (27.4) 148.8 (26.4) 349.5 (53.8)
Debt securities issued by
foreign governments............ 1.4 - 6.2 (1.9) 7.6 (1.9)
Corporate securities.............. 5,125.7 (787.9) 4,311.1 (1,398.7) 9,436.8 (2,186.6)
Asset-backed securities........... 61.8 (12.5) 141.9 (75.1) 203.7 (87.6)
Collateralized debt obligations... 54.9 (11.4) 28.8 (26.6) 83.7 (38.0)
Commercial mortgage-backed
securities..................... 137.1 (27.3) 416.6 (238.4) 553.7 (265.7)
Mortgage pass-through securities.. 13.7 (.1) .3 - 14.0 (.1)
Collateralized mortgage
obligations.................... 522.2 (117.6) 547.8 (416.1) 1,070.0 (533.7)
-------- ------- -------- --------- --------- ---------
Total actively managed
fixed maturities............... $6,143.0 $(984.5) $5,603.4 $(2,183.3) $11,746.4 $(3,167.8)
======== ======= ======== ========= ========= =========
The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that were not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities had been in a continuous unrealized loss position, at
December 31, 2007 (dollars in millions):
Less than 12 months 12 months or greater Total
---------------------- ----------------------- -------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 18.7 $ (.1) $ 38.5 $ (1.4) $ 57.2 $ (1.5)
States and political subdivisions. 129.3 (5.4) 120.5 (5.1) 249.8 (10.5)
Debt securities issued by
foreign governments............ 4.0 (.1) - - 4.0 (.1)
Corporate securities.............. 5,666.5 (237.4) 2,214.3 (158.3) 7,880.8 (395.7)
Asset-backed securities........... 184.9 (13.2) 150.5 (26.4) 335.4 (39.6)
Collateralized debt obligations... 12.4 (3.0) 36.0 (3.6) 48.4 (6.6)
Commercial mortgage-backed
securities..................... 234.6 (22.5) 95.2 (5.1) 329.8 (27.6)
Mortgage pass-through securities.. 42.4 (.2) 26.8 (.2) 69.2 (.4)
Collateralized mortgage
obligations.................... 1,272.1 (40.0) 985.1 (27.1) 2,257.2 (67.1)
-------- ------- -------- ------- --------- -------
Total actively managed
fixed maturities............... $7,564.9 $(321.9) $3,666.9 $(227.2) $11,231.8 $(549.1)
======== ======= ======== ======= ========= =======
149
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Based on management's current assessment of investments with unrealized
losses at December 31, 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). While we have
both the ability and intent to hold securities in unrealized loss positions
until they recover, 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 December 31, 2008, fixed maturity investments included $3.4 billion of
structured securities (or 22 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. 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
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 December 31, 2008 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 61.9 $ 49.8 $ 45.0
4 percent - 5 percent............................................................... 85.4 81.7 79.7
5 percent - 6 percent............................................................... 3,097.6 3,021.6 2,544.9
6 percent - 7 percent............................................................... 870.6 842.7 544.4
7 percent - 8 percent............................................................... 190.5 186.9 121.2
8 percent and above................................................................. 66.6 62.9 46.7
-------- -------- --------
Total structured securities.................................................. $4,372.6 $4,245.6 $3,381.9
======== ======== ========
150
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The amortized cost and estimated fair value of structured securities at
December 31, 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..................... $1,525.9 $1,406.8 9.2%
Planned amortization classes, target amortization classes and
accretion-directed bonds............................................. 1,388.2 1,059.3 7.0
Commercial mortgage-backed securities................................... 832.2 567.2 3.7
Asset-backed securities................................................. 291.3 203.7 1.3
Collateralized debt obligations......................................... 134.3 96.6 .6
Other................................................................... 73.7 48.3 .3
-------- -------- ----
Total structured securities...................................... $4,245.6 $3,381.9 22.1%
======== ======== ====
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 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 $58.2 million and a book
value of $81.4 million at December 31, 2008. These securities represent .3
percent of our consolidated investment portfolio. Of these securities, $49.5
million (85 percent) were rated NAIC 1, $8.2 million (14 percent) were rated
NAIC 2 and $.5 million (1 percent) were rated NAIC 3. 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 December 31, 2008,
we held no sub prime securities collateralized by residential loans extended in
2006 and we held $5.8 million extended in 2007.
Commercial Mortgage Loans
At December 31, 2008, the mortgage loan balance was primarily comprised of
commercial loans. Approximately 7 percent, 7 percent, 7 percent, 6 percent, 6
percent and 6 percent of the mortgage loan balance were on properties located in
Indiana, California, Florida, Ohio, Minnesota and Arizona, respectively. No
other state comprised greater than 5 percent of the mortgage loan balance. Less
than one percent of the commercial mortgage loan balance was noncurrent at
December 31, 2008. Our allowance for losses on mortgage loans was nil and $2.4
million at December 31, 2008 and 2007, respectively.
Other Investment Disclosures
The Company participates in a securities lending program whereby certain
fixed maturity securities from our investment portfolio are loaned to third
parties via a lending agent for a short period of time. We maintain ownership of
the loaned securities. We require collateral equal to 102 percent of the market
value of the loaned securities. The collateral is invested by
151
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
the lending agent in accordance with our guidelines. The fair value of the
loaned securities is monitored on a daily basis with additional collateral
obtained as necessary. Under the terms of the securities lending program, the
lending agent indemnifies the Company against borrower defaults. As of December
31, 2008 and 2007, the fair value of the loaned securities was $389.3 million
and $450.3 million, respectively. As of December 31, 2008 and 2007, the Company
had received collateral of $408.8 million and $460.4 million, respectively.
Income generated from the program, net of expenses is recorded as net investment
income and totaled $2.4 million, $1.3 million and $1.4 million in 2008, 2007 and
2006, respectively. In 2008, we changed our presentation of collateral held in
conjunction with the securities lending program to present such collateral as a
separate asset, rather than as a reduction to investment borrowings. We
reclassified amounts from prior periods to conform to the 2008 presentation.
These reclassifications have no effect on net income or shareholders' equity.
Life insurance companies are required to maintain certain investments on
deposit with state regulatory authorities. Such assets had aggregate carrying
values of $76.2 million and $104.8 million at December 31, 2008 and 2007,
respectively.
Conseco had one fixed maturity investment, with an amortized cost of $283.7
million and an estimated fair value of $305.0 million, that was in excess of 10
percent of shareholders' equity at December 31, 2008 (other than investments
issued or guaranteed by the United States government or a United States
government agency). There were no fixed maturity investments in excess of 10
percent of shareholders' equity at December 31, 2007.
6. LIABILITIES FOR INSURANCE PRODUCTS
These liabilities consisted of the following (dollars in millions):
Interest
Withdrawal Mortality rate
assumption assumption assumption 2008 2007
---------- ---------- ---------- ---- ----
Future policy benefits:
Interest-sensitive products:
Investment contracts.................... N/A N/A (c) $ 9,612.9 $ 9,389.7
Universal life contracts................ N/A N/A N/A 3,719.9 3,779.7
--------- ---------
Total interest-sensitive products..... 13,332.8 13,169.4
--------- ---------
Traditional products:
Traditional life insurance contracts.... Company (a) 5% 2,300.2 2,289.0
experience
Limited-payment annuities............... Company (b) 5% 917.2 944.3
experience,
if applicable
Individual and group accident and
health................................ Company Company 6% 6,611.3 6,315.1
experience experience --------- ---------
Total traditional products............ 9,828.7 9,548.4
--------- ---------
Claims payable and other
policyholder funds........................ N/A N/A N/A 1,008.4 909.7
Liabilities related to separate accounts.... N/A N/A N/A 18.2 27.4
--------- ---------
Total................................. $24,188.1 $23,654.9
========= =========
<FN>
- --------------------
(a) Principally, modifications of the 1965 - 70 and 1975 - 80 Basic,
Select and Ultimate Tables.
(b) Principally, the 1984 United States Population Table and the NAIC 1983
Individual Annuitant Mortality Table.
(c) In 2008 and 2007, all of this liability represented account balances
where future benefits are not guaranteed.
</FN>
152
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The Company establishes reserves for insurance policy benefits based on
assumptions as to investment yields, mortality, morbidity, withdrawals, lapses
and maintenance expenses. These reserves include amounts for estimated future
payment of claims based on actuarial assumptions. The balance is based on the
Company's best estimate of the future policyholder benefits to be incurred on
this business, given recent and expected future changes in experience.
Changes in the unpaid claims reserve (included in claims payable) and
disabled life reserves related to accident and health insurance (included in
individual and group accident and health liabilities) were as follows (dollars
in millions):
2008 2007 2006
---- ---- -----
Balance, beginning of the year....................................... $1,247.7 $1,129.0 $1,044.3
Incurred claims (net of reinsurance) related to:
Current year...................................................... 1,729.3 1,559.0 1,359.1
Prior years (a)................................................... (25.9) (18.8) (30.7)
-------- -------- --------
Total incurred................................................. 1,703.4 1,540.2 1,328.4
-------- -------- --------
Interest on claim reserves........................................... 61.4 56.7 52.6
-------- -------- --------
Paid claims (net of reinsurance) related to:
Current year...................................................... 1,001.1 900.9 778.6
Prior years....................................................... 609.5 541.9 512.4
-------- -------- --------
Total paid..................................................... 1,610.6 1,442.8 1,291.0
-------- -------- --------
Net change in balance for reinsurance assumed and ceded.............. (60.6) (35.4) (5.3)
-------- -------- --------
Balance, end of the year............................................. $1,341.3 $1,247.7 $1,129.0
======== ======== ========
<FN>
- -----------
(a) The reserves and liabilities we establish are necessarily based on
estimates, assumptions and prior years' statistics. Such amounts will
fluctuate based upon the estimation procedures used to determine the
amount of unpaid losses. It is possible that actual claims will exceed
our reserves and have a material adverse effect on our results of
operations and financial condition.
</FN>
7. INCOME TAXES
The components of income tax expense (benefit) were as follows (dollars in
millions):
2008 2007 2006
---- ---- ----
Current tax expense...................................................... $ 3.8 $ 2.7 $ 1.4
Deferred tax provision (benefit)......................................... 8.7 (6.7) 59.6
------ ----- -----
Income tax expense (benefit) on period income................... 12.5 (4.0) 61.0
Valuation allowance...................................................... 403.9 68.0 -
------ ----- -----
Total income tax expense........................................ $416.4 $64.0 $61.0
====== ===== =====
153
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
2008 2007 2006
---- ---- ----
U.S. statutory corporate rate............................................ 35.0% (35.0)% 35.0%
Valuation allowance...................................................... 3,257.3 680.0 -
Other nondeductible expenses............................................. 37.7 (5.9) 1.4
State taxes.............................................................. 23.8 (9.8) .3
Provision for tax issues, tax credits and other.......................... 4.3 10.7 (.1)
------- ----- ----
Effective tax rate.............................................. 3,358.1% 640.0% 36.6%
======= ===== ====
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
2008 2007
---- ----
Deferred tax assets:
Net federal operating loss carryforwards attributable to:
Life insurance subsidiaries...................................................... $ 840.7 $ 855.9
Non-life companies............................................................... 835.4 843.8
Net state operating loss carryforwards.............................................. 20.3 30.2
Tax credits......................................................................... 13.7 13.7
Capital loss carryforwards.......................................................... 406.0 255.6
Deductible temporary differences:
Insurance liabilities............................................................ 789.9 909.2
Unrealized depreciation of investments........................................... 987.4 129.7
Reserve for loss on loan guarantees.............................................. 68.2 71.9
Other............................................................................ 31.1 39.4
-------- --------
Gross deferred tax assets...................................................... 3,992.7 3,149.4
-------- --------
Deferred tax liabilities:
Actively managed fixed maturities................................................... (17.7) (143.1)
Value of policies inforce at the Effective Date and cost of policies produced....... (739.1) (725.6)
-------- --------
Gross deferred tax liabilities................................................. (756.8) (868.7)
-------- --------
Net deferred tax assets before valuation allowance............................. 3,235.9 2,280.7
Valuation allowance..................................................................... (1,180.7) (672.9)
-------- --------
Net deferred tax assets........................................................ 2,055.2 1,607.8
Current income taxes prepaid (accrued).................................................. (1.5) 2.4
-------- --------
Income tax assets, net......................................................... $2,053.7 $1,610.2
======== ========
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
154
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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.
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 December 31, 2008, we
have incurred a cumulative loss over the evaluation period, resulting from the
substantial loss during 2008 primarily related to the transfer of Senior Health
to an independent trust as described in the note to these consolidated financial
statements entitled "Transfer of Senior Health Insurance Company of Pennsylvania
to an Independent Trust". 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 December 31, 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
transferred as further described in the note to these financial statements
entitled "Transfer of Senior Health Insurance Company of Pennsylvania to an
Independent Trust". 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.
At December 31, 2008, our valuation allowance for our net deferred tax
assets was $1.2 billion, 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 December 31, 2008, we believe
that we will, more likely than not, recover $2.1 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 similar
limitation on the extent to which losses realized by a life insurance entity (or
entities) may offset income from a non-life entity (or entities).
In addition, the timing and manner in which the Company will be able to
utilize some of its NOLs is limited by Section 382 of the Code. Section 382
imposes limitations on a corporation's ability to use its NOLs when the company
undergoes an ownership change. Because the Company underwent an ownership change
pursuant to its reorganization, this limitation applies to the Company. Any
losses that are subject to the Section 382 limitation will only be utilized by
the Company up to approximately $142 million per year with any unused amounts
carried forward to the following year. Absent an additional ownership change,
our Section 382 limitation for 2009 will be approximately $662 million
(including $520 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
155
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 NOLs 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 5.4 percent),
and the new annual restriction could effectively eliminate our ability to use a
substantial portion of our NOLs to offset future taxable income. We regularly
monitor ownership change (as calculated for purposes of Section 382) and, as of
December 31, 2008, we were below the 50 percent ownership change level that
would trigger further impairment of our ability to utilize our NOLs.
On January 20, 2009, the Company's Board of Directors adopted a Section 382
Rights Plan (the "Rights Plan") which is designed to protect shareholder value
by preserving the value of our tax assets primarily associated with tax NOLs
under Section 382. The Rights Plan was adopted to reduce the likelihood of this
occurring by deterring the acquisition of stock that would create "5 percent
shareholders" as defined in Section 382.
Under the Rights Plan, one right was distributed for each share of our
common stock outstanding as of the close of business on January 30, 2009.
Effective January 20, 2009, if any person or group (subject to certain
exemptions) becomes a "5 percent shareholder" of Conseco without the approval of
the Board of Directors, there would be a triggering event causing significant
dilution in the voting power and economic ownership of that person or group.
Existing shareholders who currently are "5 percent shareholders" will trigger a
dilutive event only if they acquire additional shares exceeding one percent of
our outstanding shares without prior approval from the Board of Directors.
The Rights Plan will continue in effect until January 20, 2012, unless
earlier terminated or redeemed by the Board of Directors. The Company's Audit
Committee will review our NOLs on an annual basis and will recommend amending or
terminating the Rights Plan based on its review. Additionally, the Board of
Directors has resolved to submit the continuation of the Rights Plan to a vote
at the next annual meeting of the shareholders in May 2009. If the shareholders
do not approve the Rights Plan, it will be terminated.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets as we believed that the realization of such net
deferred income tax assets in future periods was uncertain. During 2006, we
concluded that it was no longer necessary to hold certain portions of the
previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $260.0 million in 2006. However, we were required to
continue to record a valuation allowance of $1.2 billion at December 31, 2008
because we have determined that it is more likely than not that a portion of our
deferred tax assets will not be realized. This determination was made by
evaluating each component of the deferred tax asset and assessing the effects of
limitations or interpretations on the value of such component to be fully
recognized in the future.
156
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Changes in our valuation allowance are summarized as follows (dollars in
millions):
Balance at December 31, 2005............................................. $1,043.8
Expiration of NOL and capital loss carryforwards....................... (6.0)
Release of valuation allowance (a)..................................... (260.0)
--------
Balance at December 31, 2006............................................. 777.8
Increase in 2007....................................................... 68.0
Expiration of capital loss carryforwards............................... (157.6)
Write-off of certain state NOLs (recovery is remote)................... (15.3)
--------
Balance at December 31, 2007............................................. 672.9
Increase in 2008....................................................... 856.2 (b)
Expiration of capital loss carryforwards............................... (209.7)
Write-off of capital loss carryforwards related to Senior Health....... (133.2)
Write-off of certain NOLs related to Senior Health..................... (5.5)
--------
Balance at December 31, 2008............................................. $1,180.7
========
<FN>
- --------------------
(a) There is a corresponding increase to additional paid-in capital.
(b) The $856.2 million increase to our valuation allowance during 2008
included increases of: (i) $452 million of deferred tax assets related
to Senior Health, which was transferred to an independent trust during
2008; (ii) $298 million related to our reassessment of the recovery of
our deferred tax assets in accordance with GAAP, following the
additional losses incurred as a result of the transaction to transfer
Senior Health to an independent trust; (iii) $60 million related to
the recognition of additional realized investment losses for which we
are unlikely to receive any tax benefit; and (iv) $45 million related
to the projected additional future expense following the modifications
to our Second Amended Credit Facility as described in the note to
these consolidated financial statements entitled "Subsequent Events."
</FN>
We have also evaluated the likelihood that we will have sufficient taxable
income to offset the available deferred tax assets. This assessment required
significant judgment. Based upon our current projections of future income that
we completed at December 31, 2008, we believe that we will, more likely than
not, recover $2.1 billion of our deferred tax assets through reductions of our
tax liabilities in future periods. However, recovery is dependent on achieving
such projections and failure to do so would result in an increase in the
valuation allowance in a future period. Any future increase in the valuation
allowance would result in additional income tax expense and reduce shareholders'
equity, and such an increase could have a significant impact upon our earnings
in the future.
157
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
As of December 31, 2008, we had $4.8 billion of federal NOLs and $1.2
billion of capital loss carryforwards, which expire as follows (dollars in
millions):
Net operating
loss carryforwards(a) Total loss carryforwards
--------------------- Capital loss Total loss ---------------------------------------
Year of expiration Life Non-life carryforwards carryforwards Subject to ss.382 Not subject to ss.382
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
2009....... $ - $ - $ 86.2 $ 86.2 $ - $ 86.2
2010....... - .1 - .1 .1 -
2011....... - .1 - .1 .1 -
2012....... - - 63.6 63.6 - 63.6
2013....... - - 1,010.1 1,010.1 - 1,010.1
2017....... 12.2 - - 12.2 12.2 -
2018....... 2,152.4 (a) - - 2,152.4 38.1 2,114.3
2021....... 29.6 - - 29.6 - 29.6
2022....... 207.9 - - 207.9 - 207.9
2023....... - 2,073.7 (a) - 2,073.7 71.1 2,002.6
2024....... - 3.2 - 3.2 - 3.2
2025....... - 118.8 - 118.8 - 118.8
2026....... - 1.6 - 1.6 - 1.6
2027....... - 188.4 - 188.4 - 188.4
2028....... - .9 - .9 - .9
-------- -------- -------- -------- ------- --------
Total...... $2,402.1 $2,386.8 $1,159.9 $5,948.8 $121.6 $5,827.2
======== ======== ======== ======== ====== ========
<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 $20.3
million and $30.2 million at December 31, 2008 and 2007, respectively. The
related state NOLs are available to offset future state taxable income in
certain states through 2015.
The Company adopted FIN 48 on January 1, 2007, which resulted in a $6
million increase to additional paid-in capital. As of January 1, 2007 and
December 31, 2007, the amount of unrecognized tax benefits was not significant.
While it is expected that the amount of unrecognized tax benefits will change in
the next twelve months, the Company does not expect the change to have a
significant impact on its results of operations.
As more fully discussed below, the Company's interpretation of the tax law,
as it relates to the application of the cancellation of indebtedness income to
its NOLs, is an uncertain tax position. Since all other life NOLs must be
utilized prior to this portion of the NOL, it has not yet been utilized nor is
it expected to be utilized within the next twelve months. As a result, an
uncertain tax position has not yet been taken on the Company's tax return.
Although FIN 48 allowed a change in accounting, the Company has chosen to
continue its past accounting policy of classifying interest and penalties as
income tax expense in the consolidated statement of operations. No such amounts
were recognized in 2008 or 2007. The liability for accrued interest and
penalties was not significant at December 31, 2008 or December 31, 2007.
Tax years 2005 through 2007 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 2005 through 2007
based on the individual state statutes of limitation.
The following paragraphs describe an open matter related to the
classification of our NOLs.
158
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
In July 2006, the Joint Committee of Taxation accepted the audit and the
settlement which characterized $2.1 billion of the tax losses on our
Predecessor's investment in Conseco Finance Corp. as life company losses and the
remaining amount as non-life losses prior to the application of the cancellation
of indebtedness attribute reductions described below. As a result of the
approval of the settlement, we concluded it was appropriate to reduce our
valuation allowance by $260 million in the second quarter of 2006, which was
accounted for as an addition to paid-in capital.
The Code provides that any income realized as a result of the cancellation
of indebtedness in bankruptcy (cancellation of debt income or "CODI") must
reduce NOLs. We realized an estimated $2.5 billion of CODI when we emerged from
bankruptcy. Pursuant to the Company's interpretation of the tax law, the CODI
reductions were all used to reduce non-life NOLs. However, if the IRS were to
disagree with our interpretation and ultimately prevail, we believe $631 million
of NOLs classified as life company NOLs would be re-characterized as non-life
NOLs and subject to the 35% limitation discussed above. Such a
re-characterization would also extend the year of expiration as life company
NOLs expire after 15 years whereas non-life NOLs expire after 20 years. The
Company does not expect the IRS to consider this issue for a number of years.
The Company adopted SFAS 123R in calendar year 2006. Pursuant to this
accounting rule, the Company is precluded from recognizing the tax benefits of
any tax windfall upon the exercise of a stock option or the vesting of
restricted stock unless such deduction resulted in actual cash savings to the
Company. Because of the Company's NOLs, no cash savings have occurred. NOL
carryforwards of $1.9 million related to deductions for stock options and
restricted stock will be reflected in additional paid-in capital if realized.
Prior to January 1, 1984, life insurance subsidiaries of the Company were
entitled to exclude certain amounts from taxable income and accumulate such
amounts in a "Policyholders Surplus Account". The aggregate balance in this
account at December 31, 2005 was $150.7 million, which could have resulted in
federal income taxes payable of $52.7 million if such amounts had been
distributed or deemed distributed from the Policyholders Surplus Account. No
provision for taxes had ever been made for this item since the affected
subsidiaries had no intention of distributing such amounts. Pursuant to
provisions of the American Jobs Creation Act of 2004, our subsidiaries
distributed amounts from the Policyholders Surplus Account in 2006 without
incurring any tax liability, thereby permanently eliminating this potential tax
liability.
8. NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of December 31, 2008 and 2007 (dollars in millions):
2008 2007
---- ----
3.50% convertible debentures............................................................ $ 293.0 $ 330.0
Secured credit agreement................................................................ 911.8 865.5
6% Senior Note.......................................................................... 125.0 -
Unamortized discount on convertible debentures.......................................... (1.1) (1.8)
-------- --------
Direct corporate obligations....................................................... $1,328.7 $1,193.7
======== ========
In August 2005, we completed the private offering of $330 million of 3.50%
Convertible Debentures due September 30, 2035 (the "Debentures"). The net
proceeds from the offering of approximately $320 million were used to repay term
loans outstanding under the Company's $800.0 million secured credit facility
(the "Credit Facility"). The terms of the Debentures are governed by an
indenture dated as of August 15, 2005 between the Company and The Bank of New
York Trust Company, N.A., as trustee (the "Indenture"). At December 31, 2008 and
2007, unamortized issuance costs (classified as other assets) related to the
Debentures were $2.5 million and $4.4 million, respectively, and are amortized
as an increase to interest expense through September 30, 2010, which is the
earliest date the Debenture holders may require the Company to repurchase them.
The Debentures are senior, unsecured obligations and bear interest at a
rate of 3.50 percent per year, payable semi-annually, beginning on March 31,
2006 and ending on September 30, 2010. Thereafter, the principal balance of the
Debentures will accrete at a rate that provides holders with an aggregate yield
to maturity of 3.50 percent, computed on a semi-annual, bond-equivalent basis.
Beginning with the six-month interest period commencing September 30, 2010, the
159
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Company will pay contingent interest on the Debentures if the average trading
price per Debenture for the five trading day period immediately preceding the
six-month interest period equals or exceeds a certain level, as described in the
Indenture.
Upon the occurrence of certain specified events, the Debentures will be
convertible, at the option of the holders, into cash or, under certain
circumstances, cash and shares of the Company's common stock at an initial
conversion price of approximately $26.66 per share. The number of shares to be
received by a converting holder is subject to adjustment for certain dilutive
events. The amount of cash to be received upon conversion is equal to the lesser
of: (i) the accreted principal amount of the converting Debenture; or (ii) the
conversion value of such Debentures (as calculated in accordance with the
Indenture).
On or after October 5, 2010, the Company may redeem for cash all or a
portion of the Debentures at any time at a redemption price equal to 100 percent
of the accreted principal amount of the Debentures plus accrued and unpaid
interest, including additional interest and contingent interest, if any, to the
redemption date. Holders may require the Company to repurchase in cash all or
any portion of the Debentures on September 30, 2010, 2015, 2020, 2025 and 2030
at a repurchase price equal to 100 percent of the accreted principal amount of
the Debentures to be repurchased, plus accrued and unpaid interest, including
additional interest and contingent interest, if any, to the applicable
repurchase date.
If an event of default occurs and is continuing with respect to the
Debentures, either the trustee or the holders of at least 25 percent of the
aggregate accreted principal amount of the Debentures then outstanding may
declare the accreted principal amount, plus accrued and unpaid interest,
including additional interest and contingent interest, if any, on the Debentures
to be due and payable immediately. If an event of default relating to certain
events of bankruptcy, insolvency or reorganization occurs, the accreted
principal amount plus accrued and unpaid interest, including additional interest
and contingent interest, if any, on the Debentures will become immediately due
and payable. The following are events of default with respect to the Debentures:
o default for 30 days in payment of any interest, contingent interest or
additional interest due and payable on the Debentures;
o default in payment of accreted principal of the Debentures at
maturity, upon redemption, upon repurchase or following a fundamental
change, when the same becomes due and payable;
o default by the Company or any of its subsidiaries in the payment of
principal, interest or premium when due under any other instruments of
indebtedness having an aggregate outstanding principal amount of $50.0
million (or its equivalent in any other currency or currencies) or
more following a specified period for cure;
o default in the Company's conversion obligations upon exercise of a
holder's conversion right, following a specified period for cure;
o default in the Company's obligations to give notice of the occurrence
of a fundamental change within the time required to give such notice;
o acceleration of any of the Company's indebtedness or the indebtedness
of any of its subsidiaries under any instrument or instruments
evidencing indebtedness (other than the Debentures) having an
aggregate outstanding principal amount of $50.0 million (or its
equivalent in any other currency or currencies) or more, subject to
certain exceptions; and
o certain events of bankruptcy, insolvency and reorganization of the
Company or any of its subsidiaries.
During 2008, we repurchased $37.0 million par value of such Debentures for
$15.3 million plus accrued interest. In 2008, we recognized a gain on the
extinguishment of debt of $21.2 million related to such repurchases. Debentures
with a par value of $293.0 million remain outstanding. Refer to the note to
these consolidated financial statements entitled "Subsequent Events" for a
description of new restrictions on the Company's ability to redeem, purchase,
amend, modify or refinance the Debentures as a result of the amendment to the
Second Amended Credit Facility on March 30, 2009.
The Company's credit facility was amended during 2006 and 2007 as further
described below and on March 30, 2009, as described in the note to these
consolidated financial statements entitled "Subsequent Events".
160
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
On October 10, 2006, we entered into the Second Amended Credit Facility. As
a result of the refinancing, the principal amount outstanding under the previous
credit facility was increased from $478.3 million to $675.0 million.
Approximately $195 million of the proceeds were used to strengthen the capital
of our insurance subsidiaries. The Company recognized a $.7 million loss on the
extinguishment of debt during the fourth quarter of 2006 for the write off of
certain debt issuance costs and other costs incurred related to the transaction.
The Second Amended Credit Facility extended the maturity date from June 22, 2010
to October 10, 2013. On June 12, 2007, Conseco amended its current credit
facility. The amendment of the credit facility provided for, among other things:
o an increase of $200.0 million in the principal amount of the facility;
o an increase in the general basket for restricted payments in an
aggregate amount of up to $300 million over the term of the facility;
and
o the Company to be able to request the addition of up to two new
facilities or up to two increases in the credit facility of up to $330
million, subject to compliance with certain financial covenants and
other conditions. Such increases would be effective as of a date that
is at least 90 days prior to the scheduled maturity date.
No changes were made to the interest rate or the maturity schedule of the
amounts borrowed under the credit facility. We are required to make minimum
quarterly principal payments of $2.2 million through September 30, 2013. The
remaining unpaid principal balance is due on October 10, 2013. There were no
changes to the various financial ratios and balances that are required to be
maintained by the Company. The additional borrowings were used for general
corporate purposes, including the repurchase of Conseco common stock and the
strengthening of the Company's insurance subsidiaries.
During 2008, 2007 and 2006, we made scheduled principal payments totaling
$8.7 million, $7.8 million and $1.7 million, respectively, on our Second Amended
Credit Facility. Also, during 2006, we made scheduled principal payments
totaling $1.3 million on our previous credit facility as well as a mandatory
prepayment of $45.0 million based on the Company's excess cash flows at December
31, 2005, as defined in the previous credit facility. There were $5.8 million
and $6.8 million of unamortized issuance costs (classified as other assets)
related to our Second Amended Credit Facility at December 31, 2008 and 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 and "BB" by S&P, in each case with a stable outlook,
the margins on the Eurodollar rate or the base rate would each be reduced by .25
percent. At December 31, 2008, the interest rate on our Second Amended Credit
Facility was 3.8 percent. Refer to the note to these consolidated financial
statements entitled "Subsequent Events" for a description of changes to the
interest rate as a result of the amendment to the Second Amended Credit Facility
on March 30, 2009.
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) certain 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,
of approximately $1.3 million, is expected to be paid in March 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.
161
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The following chart summarizes: (i) the most significant financial ratios
and balances we must maintain pursuant to our Second Amended Credit Facility;
(ii) the current ratios and balances as of December 31, 2008; and (iii) the
margins for adverse developments before such ratio or balance requirement is not
met (dollars in millions):
Covenant under the Balance or Margin for adverse
Second Amended ratio as of development from
Credit Facility December 31, 2008 December 31, 2008 levels
--------------- ----------------- ------------------------
Aggregate risk-based capital ratio......... greater than or equal Reduction to
to 250% 255% statutory capital and
surplus of
approximately $25
million, or an
increase to the risk-
based capital of
approximately $10
million.
Combined statutory capital and surplus..... greater than $1,270 Reduction to
million $1,366 million combined statutory
capital and surplus
of approximately
$96 million.
Debt to total capitalization ratio......... not more than 30% 28% Reduction to
shareholders' equity
of approximately
$273 million or
additional debt of
$117 million.
Interest coverage ratio.................... greater than or equal Reduction in cash
to 2.00 to 1 for each flows to the holding
rolling four quarters 2.35 to 1 company of
approximately
$20 million.
As described in the note to the consolidated financial statements entitled
"Subsequent Events", on March 30, 2009, we completed an amendment to our Second
Amended Credit Facility, which provides for, among other things: (i) additional
margins between our current financial status and certain financial covenant
requirements through June 30, 2010; (ii) higher interest rates and the payment
of a fee; (iii) new restrictions on the ability of the Company to incur
additional indebtedness; and (iv) the ability of the lender to appoint a
financial advisor at the Company's expense.
The Second Amended Credit Facility also requires that the Company's audited
consolidated financial statements be accompanied by an opinion, from a
nationally-recognized independent public accounting firm, stating that such
audited consolidated financial statements present fairly, in all material
respects, the financial position and results of operations of the Company in
conformity with GAAP for the periods indicated. Such opinion shall not include
an explanatory paragraph regarding the Company's ability to continue as a going
concern or similar qualification. The Company was in compliance with all
covenants as defined in the Second Amended Credit Facility as of December 31,
2008.
The Second Amended Credit Facility included an $80.0 million revolving
credit facility that could be used for general corporate purposes and that would
mature on June 22, 2009. In October 2008, the Company borrowed $75.0 million
under the revolving credit facility to assure the future availability of this
additional liquidity given our concerns with the ability of certain financial
institutions to be able to provide funding in the future. The Company also
requested borrowings of $5.0 million which were not funded. In December 2008, we
repaid $20.0 million of the revolving facility and reduced the maximum amount
available under the revolving facility to $60.0 million. At December 31, 2008,
there was $55.0 million outstanding under the revolving facility. There were no
amounts outstanding under the revolving credit facility at December
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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 Conseco Life Insurance Company of
Texas, Washington National Insurance Company and Conseco Health Insurance
Company. Under the Second Amended Credit Facility, we were permitted to 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. However, as a
condition of the order from the Pennsylvania Insurance Department approving the
Transfer, we agreed that we would not pay cash dividends on our common stock
while any portion of the $125.0 million Senior Note (as described in the
following paragraph) remained outstanding. As further discussed in the note to
the consolidated financial statements entitled "Shareholders' Equity", we
repurchased $87.2 million of our common stock in 2007. No repurchases were made
in 2008.
In connection with the Transfer, the Company issued the Senior Note payable
to Senior Health. The Senior Note is unsecured and bears interest at a rate of
6.00 percent per year payable quarterly, beginning on March 15, 2009. We are
required to make annual principal payments of $25.0 million beginning on
November 12, 2009. The Company may redeem the Senior Note, in whole or in part,
at any time by giving the holder 30 days notice (unless a shorter notice is
satisfactory to the holder). The redemption amount is equal to the principal
amount redeemed plus any accrued and unpaid interest thereon. Any outstanding
amount under the Senior Note will be due and payable immediately if an event of
default (as defined in the Senior Note) occurs and continues without remedy.
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
2009.......................................... $ 90.0
2010.......................................... 326.8
2011.......................................... 33.7
2012.......................................... 33.8
2013.......................................... 845.5
--------
$1,329.8
========
9. COMMITMENTS AND CONTINGENCIES
Litigation
Legal Proceedings
The Company and its subsidiaries are involved in various legal actions in
the normal course of business, in which claims for compensatory and punitive
damages are asserted, some for substantial amounts. Some of the pending matters
have 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
163
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
experience, monetary demands in complaints bear little relation to the ultimate
loss, if any, to the Company. However, for the reasons stated above, it is not
possible to make meaningful estimates of the amount or range of loss that could
result from some of these matters at this time. The Company reviews these
matters on an ongoing basis and follows the provisions of Statement of Financial
Accounting Standards No. 5, "Accounting for Contingencies", when making accrual
and disclosure decisions. When assessing reasonably possible and probable
outcomes, the Company bases its decisions on its assessment of the ultimate
outcome following all appeals.
Securities Litigation
After our Predecessor announced its intention to restructure on August 9,
2002, eight purported securities fraud class action lawsuits were filed in the
United States District Court for the Southern District of Indiana. The
complaints named us as a defendant, along with certain of our former officers.
These lawsuits were filed on behalf of persons or entities who purchased our
Predecessor's common stock on various dates between October 24, 2001 and August
9, 2002. The plaintiffs allege claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and allege material omissions and
dissemination of materially misleading statements regarding, among other things,
the liquidity of 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, and on March 20, 2009 the court granted that
motion. 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 our
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 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. 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
164
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
of which was recognized in 2008).
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. The ultimate outcome
of this lawsuit 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 December 17, 2003, a complaint was filed in the 19th Judicial District
Court, Parish of East Baton Rouge, Louisiana, Southern Capitol Enterprises, Inc.
and F. David Tutt v. Conseco Services, LLC and Conseco Health Insurance Company,
Case No. 515105. Plaintiffs are a former Conseco Health Insurance Company agency
and its principal that allege in the complaint that they were damaged by Conseco
Health Insurance Company's termination of their Executive Marketing Agreement
("EMA") and Business Continuation Plan ("BCP"). Plaintiffs sought a declaratory
judgment declaring the parties' rights and obligations under plaintiffs' EMA and
BCP including definitions of terms within those contracts. Plaintiffs also
demanded a full accounting of all commissions allegedly due and a preliminary
injunction stopping Conseco from reducing or stopping commission payments during
the pendency of this action. At Conseco Health Insurance Company's request, the
case was removed to the United States District Court for the Middle District of
Louisiana, Case No. 04CV40-D-M1. On September 30, 2004, Mr. Tutt filed a
separate complaint for breach of contract and damages against defendants in
federal court which includes claims for: (1) breach of the EMA and BCP; (2)
tortuous interference with the EMA and BCP; (3) unjust enrichment related to the
EMA and BCP; and (4) requests an accounting of back commissions under the EMA
and BCP. The court consolidated the two cases on October 20, 2004. Plaintiff
later filed an amended and restated complaint for damages on March 15, 2006,
which added our subsidiary, Performance Matters Associates, as a defendant. Mr.
Tutt moved for partial summary judgment in July 2004, asking the court to
invalidate the non-competition and non-solicitation provisions in the EMA and
the non-competition provision of the BCP. Defendants opposed this motion, but
plaintiffs' motion was granted by the court on December 15, 2004. The court did
not decide the issue of the BCP's continued validity. After discovery,
defendants filed a partial motion for summary judgment on January 1, 2006,
reasserting that the entire BCP was invalidated because the non-competition
provision had been stricken from the agreement. Plaintiff filed a cross-motion
for partial summary judgment regarding the validity of the BCP on May 31, 2006.
Both motions were denied by the court, and the court set that issue for a bench
trial. After that issue was tried in April 2007, the court ruled that the BCP
was valid and enforceable. The court further ruled that the issues of breach of
contract relating to plaintiffs' exclusive rights and due to improper commission
payments, breach of the duty of good faith and fair dealing as to the EMA and
plaintiffs' Single Business Enterprise theory remain to be tried to a jury. 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 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
original 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. On October 7, 2008, the plaintiff
filed a first amended complaint which changes the proposed scope of the putative
class from all agents in California for the subject time period to all agents at
a single branch office in Alameda, California. This would reduce the putative
class from hundreds of members to approximately 100 members. We believe the
action is without merit and we intend to defend the case vigorously. The
ultimate outcome of the action cannot be predicted with certainty.
Other Litigation
On November 17, 2005, a complaint was filed in the United States District
Court for the Northern District of California, Robert H. Hansen, an individual,
and on behalf of all others similarly situated v. Conseco Insurance Company, an
Illinois corporation f/k/a Conseco Annuity Assurance Company, Cause No.
C0504726. Plaintiff in this putative class action purchased an annuity in 2000
and is claiming relief on behalf of the proposed national class for alleged
violations of
165
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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, which has added
as defendants Conseco Services, LLC and Conseco Marketing, LLC. 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 Health
Insurance Company 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. Briefing in the district court on remand, to determine the
appropriate revised class definition, is scheduled to be concluded in March
2009. 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 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. The plaintiff filed a motion for summary
judgment on July 16, 2008, to which the Company responded with a cross-motion
for summary judgment on August 29, 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 4, 2008, a Complaint was filed in the United States 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. 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 was denied by the court. 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.
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CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
On June 4, 2008, a purported class action complaint was filed in the United
States District Court for the Northern District of Illinois, Ruby Sandock,
individually and on behalf of herself and all others similarly situated v.
Bankers Life and 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 and 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 and 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. On September 26,
2008, the district court entered an order dismissing two out of the three claims
asserted by the plaintiff. After the court's ruling dismissing portions of the
complaint, plaintiff elected to dismiss the entire action without prejudice to
its refiling and the court therefore entered an order of dismissal without
prejudice on November 12, 2008. The settlement of this case was not significant
to our business, financial condition, results of operations or cash flows.
On June 4, 2008, a purported class action complaint was filed in the Cook
County Illinois Circuit Court Chancery Division, Sheldon Langendorf, et. al.
individually and on behalf of themselves and all others similarly situated v.
Conseco Senior Health Insurance Company, and Conseco, Inc., et. al. Case No.
08CH20571. Plaintiff is claiming breach of contract and consumer fraud and seeks
a declaratory judgment, claiming that Senior Health (formerly Conseco Senior
Health Insurance Company prior to its name change in October 2008) and other
affiliated companies routinely and improperly refuse to accept Medicare
explanations of benefits as documentation in support of proofs of claim on
individual hospital indemnity and other policies of health insurance. Senior
Health subsequently removed the action to the U.S. District Court for the
Northern District of Illinois, where it is now pending as Case No. 08-CV-3914.
By stipulation of the parties, Conseco, Inc. was dismissed as a party on
September 29, 2008. Senior Health filed a motion to dismiss and/or for summary
judgment on August 22, 2008, which the court granted in part and denied in part
by entry dated December 18, 2008, dismissing the claim for Illinois statutory
consumer fraud. The court has also established a schedule for briefing on class
certification, which will be concluded by July 20, 2009. We agreed to assume
liability for this litigation in connection with the separation of Senior
Health. 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 July 22, 2008, a purported class action was filed in the U.S. District
Court for the Southern District of Florida, Anna M. Cohen individually and on
behalf of herself and all others similarly situated v. Washington National
Insurance Corporation Case No. 08-CV-61153-JIC. Plaintiff is claiming breach of
contract alleging that the 8% annual inflation adjustment rider, which is part
of her Washington National policy of long-term care insurance, acts to increase
the lifetime maximum benefit above the stated $150,000 benefit and not just the
stated per day benefit, such that Washington National prematurely stops paying
benefits before the correct lifetime maximum benefit amount is paid. On
September 26, 2008, Washington National filed a motion to dismiss the complaint.
While the motion to dismiss was pending, a settlement was reached with the
individual plaintiff, without certification of a class. The court entered an
order of dismissal with prejudice based on the settlement on January 12, 2009.
The settlement of this case was not significant to our business, financial
condition, results of operations or cash flows.
On December 8, 2008, a purported class action was filed in the U.S.
District Court for the Southern District of Florida, Sydelle Ruderman
individually and on behalf of all other similarly situated v. Washington
National Insurance Company, Case No. 08-23401-CIV-Cohn/Selzer. In the complaint,
plaintiff alleges that the inflation escalation rider on her policy of long-term
care insurance operates to increase the policy's lifetime maximum benefit, and
breached the contract by stopping her benefits when they reached the lifetime
maximum. The Company takes the position that the inflation escalator only
affects the per day maximum benefit. The court has scheduled a jury trial on
November 2, 2009. We believe the action is without merit, and intend to defend
it vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On December 24, 2008, a purported class action was filed in the U.S.
District Court for the Northern District of California, Cedric Brady, et. al.
individually and on behalf of all other similarly situated v. Conseco, Inc. and
Conseco Life Insurance Company Case No. 3:08-cv-05746. In their complaint,
plaintiffs allege that the Company committed breach of contract and insurance
bad faith and violated various consumer protection statutes in the
administration of various interest sensitive whole life products sold primarily
under the name "Lifetrends" by requiring the payment of additional cash amounts
to maintain the policies in force. 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.
167
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
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, 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. Mr. Massey filed for bankruptcy on October 10, 2008. A bench trial on
the Company's motion to set aside certain transfers to Mr. Massey's family
members was held in the Hamilton County, Indiana, Superior Court in January 2009
but no decision has been made by the court. The Murray U.S. District Court case
is currently set for trial on May 18, 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 December 31, 2008, we have paid $19.3 million to the
former holders of trust preferred securities under this arrangement. We intend
to prosecute these claims to obtain the maximum recovery possible. Further, with
regard to the various claims brought against the Company and Conseco Services by
certain former directors and officers, we believe that these claims are without
merit and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty. At December 31, 2008, we estimated that
approximately $10.0 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 $4.3 million
will be paid to the former holders of our Predecessor's trust preferred
securities.
Regulatory Examinations and Fines
Insurance companies face significant risks related to regulatory
investigations and actions. Regulatory investigations generally result from
matters related to sales or underwriting practices, payment of contingent or
other sales commissions, claim payments and procedures, product design, product
disclosure, additional premium charges for premiums paid on a periodic basis,
denial or delay of benefits, charging excessive or impermissible fees on
products, changing the way cost of insurance charges are calculated for certain
life insurance products or recommending unsuitable products to customers. We
are, in the ordinary course of our business, subject to various examinations,
inquiries and information requests from state, 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 Senior Health 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 Senior Health and Bankers
Life and Casualty Company. This examination covered the years 2005, 2006 and
2007. More than 40 states are parties to the
168
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
settlement, which included a Senior Health fine of up to $2.3 million, with up
to an additional $10 million payable in the event the process improvements and
benchmarks, on the part of either Senior Health and/or Bankers Life and
Casualty, are not met over an 18 month period for Bankers Life and Casualty or a
two-and-a-half year period for Senior Health, which time starts with the
settlement. The process improvement plan will be monitored by the lead states.
In late October 2008, Conseco Life mailed notice to approximately 12,000
holders of its "Lifetrend" life insurance products to inform them of: (i)
changes to certain "non-guaranteed elements" ("NGEs") of their policies; and
(ii) the fact that certain policyholders who were not paying premiums may have
failed to receive a notice that their policy was underfunded and that additional
premiums were required in order for the policyholders to maintain their
guaranteed cash values. In December 2008, Conseco Life mailed notice to
approximately 16,000 holders of its CIUL3+ universal life policies to inform
them of an increase in certain NGEs with respect to their policies. Prior to or
around the time that the notices were sent, Conseco Life had informed the
insurance regulators in a number of states, including among others Indiana, Iowa
and Florida, of these matters and the planned communication with the impacted
policyholders. Conseco Life received a cease and desist order from the Iowa
Department of Insurance dated December 9, 2008, directing that it cease any
further activity with respect to the matters that had been communicated in the
notice to the Lifetrend policyholders. In December 2008, in response to
communications received from certain regulators and policyholders, Conseco Life
unilaterally agreed to enter into a nationwide temporary moratorium through
March 31, 2009 with regard to the proposed Lifetrend changes. Conseco has agreed
to extend that moratorium to June 30, 2009. In addition, Conseco Life entered
into a stipulation and standstill with the Iowa Department of Insurance pursuant
to which Conseco Life also agreed to take no further action with respect to the
Lifetrend and CIUL3+ policyholders in Iowa.
On December 22, 2008, Conseco Life also received an order to show cause
relating to the Lifetrend changes from the Florida Office of Insurance
Regulation ("OIR"), and Conseco Life entered into an agreement in January 2009
with the Florida OIR preserving Conseco Life's right to a hearing while Conseco
Life and the Florida OIR engaged in settlement discussions regarding the
Lifetrend and CIUL3+ policies. Conseco continues to work with various state
insurance regulators to review the terms of the Lifetrend policies, the
administrative changes and the adjustment of certain NGEs. The ultimate outcome
of these regulatory proceedings involving the Lifetrend policies cannot be
predicted with certainty.
Guaranty Fund Assessments
The balance sheet at December 31, 2008, included: (i) accruals of $9.5
million, representing our estimate of all known assessments that will be levied
against the Company's insurance subsidiaries by various state guaranty
associations based on premiums written through December 31, 2008; and (ii)
receivables of $5.9 million that we estimate will be recovered through a
reduction in future premium taxes as a result of such assessments. At December
31, 2007, such guaranty fund assessment accruals were $7.0 million and such
receivables were $3.4 million. These estimates are subject to change when the
associations determine more precisely the losses that have occurred and how such
losses will be allocated among the insurance companies. We recognized expense
for such assessments of $3.1 million, $1.1 million and $2.4 million in 2008,
2007 and 2006, respectively.
Guarantees
We hold bank loans made to certain former directors and employees to enable
them to purchase common stock of our Predecessor. These loans, with a principal
amount of $481.3 million, had been guaranteed by our Predecessor. We received
all rights to collect the balances due pursuant to the original terms of these
loans. In addition, we hold loans to participants for interest on the loans. The
loans and the interest loans are collectively referred to as the "D&O loans." We
regularly evaluate the collectibility of these loans in light of the credit
worthiness of the participants and the current status of various legal actions
we have taken to collect the D&O loans. At December 31, 2008, we have estimated
that approximately $10.0 million of the D&O loan balance (which is included in
other assets) is collectible (net of the costs of collection). An allowance has
been established to reduce the total D&O loan balance to the amount we estimated
was recoverable. In 2006, other operating costs and expenses are net of
recoveries of $3.0 million related to our evaluation of the collectibility of
the D&O loans.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by our Predecessor's subsidiary trusts and eliminated in our
reorganization) who did not opt out of the bankruptcy settlement, will be
entitled to receive 45 percent of any net proceeds from the collection of
certain D&O loans in an aggregate amount not to exceed $30 million. As of
December 31, 2008, we had paid $19.3 million to the former holders of TOPrS and
we have
169
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
established a liability of $4.3 million (which is included in other
liabilities), representing our estimate of the amount which will be paid to the
former holders of TOPrS pursuant to the settlement.
In accordance with the terms of the employment agreements of two of the
Company's former chief executive officers, certain wholly-owned subsidiaries of
the Company are the guarantors of the former executives' nonqualified
supplemental retirement benefits. The liability for such benefits was $22.0
million and $22.5 million at December 31, 2008 and 2007, respectively, and is
included in the caption "Other liabilities" in the consolidated balance sheet.
Leases and Certain Other Long-Term Commitments
The Company rents office space, equipment and computer software under
noncancellable operating lease agreements. In addition, the Company has entered
into certain sponsorship agreements which require future payments. Total expense
pursuant to these lease and sponsorship agreements was $44.1 million, $44.8
million and $43.3 million in 2008, 2007 and 2006, respectively. Future required
minimum payments as of December 31, 2008, were as follows (dollars in millions):
2009.............................................................................. $ 46.2
2010.............................................................................. 34.2
2011.............................................................................. 27.1
2012.............................................................................. 22.7
2013.............................................................................. 18.3
Thereafter........................................................................ 74.3
------
Total..................................................................... $222.8
======
10. OTHER DISCLOSURES
Agent Deferred Compensation Plan and Postretirement Plans
For our agent deferred compensation plan and postretirement plans, it is
our policy to immediately recognize changes in the actuarial benefit obligation
resulting from either actual experience being different than expected or from
changes in actuarial assumptions.
One of our insurance subsidiaries has a noncontributory, unfunded deferred
compensation plan for qualifying members of its career agency force. Benefits
are based on years of service and career earnings. The actuarial measurement
date of this deferred compensation plan is December 31. The liability recognized
in the consolidated balance sheet for the agents' deferred compensation plan was
$99.3 million and $94.5 million at December 31, 2008 and 2007, respectively.
Costs incurred on this plan were $7.7 million, $5.8 million and $8.9 million
during 2008, 2007 and 2006, respectively (including the recognition of gains
(losses) of $.6 million, $3.3 million and $(.1) million in 2008, 2007 and 2006,
respectively, resulting from actual experience being different than expected or
from changes in actuarial assumptions). The estimated net loss for the agent
deferred compensation plan that will be amortized from accumulated other
comprehensive income into the net periodic benefit cost during 2009 is $.1
million. In 2006, we purchased Company-owned life insurance ("COLI") as an
investment vehicle to fund the agent deferred compensation plan. The COLI assets
are not assets of the agent deferred compensation plan, and as a result, are
accounted for outside the plan and are recorded in the consolidated balance
sheet as other invested assets. The carrying value of the COLI assets was $51.2
million and $40.9 million at December 31, 2008 and 2007, respectively. Changes
in the cash surrender value (which approximates net realizable value) of the
COLI assets are recorded as net investment income.
170
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Effective December 31, 2005, the Company terminated certain postretirement
benefit plans. Prior to the termination of such plans, we provided certain
health care and life insurance benefits for certain eligible retired employees
under partially funded and unfunded plans in existence at the date on which
certain subsidiaries were acquired. Certain postretirement benefit plans were
contributory, with participants' contributions adjusted annually. Actuarial
measurement dates of September 30 and December 31 were used for those
postretirement benefit plans. The remaining liability at December 31, 2006,
related to benefits paid in 2007. Amounts related to the postretirement benefit
plans were as follows (dollars in millions):
2007
----
Benefit obligation, beginning of year.............................................. $ .3
Benefits paid.................................................................. (.3)
----
Benefit obligation, end of year.................................................... $ -
====
Funded status - accrued benefit cost............................................... $ -
====
We used the following assumptions for the deferred compensation plan to
calculate:
2008 2007
---- ----
Benefit obligations:
Discount rate................................................ 6.03% 6.02%
Net periodic cost:
Discount rate................................................ 6.02% 5.75%
The discount rate is based on the yield of a hypothetical portfolio of high
quality debt instruments which could effectively settle plan benefits on a
present value basis as of the measurement date. At December 31, 2008, for our
deferred compensation plan for qualifying members of our career agency force, we
assumed a 5 percent annual increase in compensation until the participant's
normal retirement date (age 65 and completion of five years of service).
There was no expense recognized in 2006 or 2007 related to the
postretirement benefit plans which were terminated in 2005.
The benefits expected to be paid pursuant to our agent deferred
compensation plan and postretirement benefit plans as of December 31, 2008 were
as follows (dollars in millions):
2009.................................................... $ 3.9
2010.................................................... 3.9
2011.................................................... 4.2
2012.................................................... 4.4
2013.................................................... 4.9
2014 - 2017............................................. 31.9
The Company has qualified defined contribution plans for which
substantially all employees are eligible. Company contributions, which match
certain voluntary employee contributions to the plan, totaled $4.4 million, $4.2
million and $4.1 million in 2008, 2007 and 2006, respectively. Employer matching
contributions are discretionary.
Reclassification Adjustments Included in Comprehensive Income (Loss)
The changes in unrealized appreciation (depreciation) included in
comprehensive income (loss) are net of reclassification adjustments for
after-tax net gains (losses) from the sale of investments included in net income
(loss) of approximately $(19) million, $(4) million and $70 million for the
years ended December 31, 2008, 2007 and 2006, respectively.
171
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
11. SHAREHOLDERS' EQUITY
In the second quarter of 2004, we completed the public offerings, including
underwriter over-allotments, of 50.6 million shares of our common stock at an
offering price of $18.25 per share and 27.6 million shares of our 5.5 percent
Class B mandatorily convertible preferred stock (the "Preferred Stock") at an
offering price of $25 per share. In May 2007, all of our Preferred Stock was
converted into shares of Conseco common stock in accordance with the terms of
issuance. Under those terms, each of the 27.6 million shares of Preferred Stock
outstanding was converted into 1.3699 shares of common stock. As a result of the
conversion, our common shares outstanding increased by 37.8 million.
Pursuant to the Plan, we issued warrants to purchase 6.0 million shares of
our common stock (the "Series A Warrants") entitling the holders to purchase
shares of CNO common stock at a price of $27.60 per share. The Series A Warrants
expired on September 10, 2008.
In December 2006, the Company's board of directors authorized a common
share repurchase program of up to $150 million. In May 2007, the Company's board
of directors increased the authorized common share repurchase program to a
maximum of $350 million. As further discussed in the note to the consolidated
financial statements entitled "Notes Payable - Direct Corporate Obligations," we
currently may pay cash dividends on our common stock or repurchase our common
stock in an aggregate amount of up to $300 million over the term of our credit
facility. However, as a condition of the order from the Pennsylvania Insurance
Department approving the Transfer, we agreed that we would not pay cash
dividends on our common stock while any portion of the Senior Note remained
outstanding. Our share repurchase program may be implemented through purchases
made from time to time in either the open market or through private
transactions. With respect to $25 million of the program, the Company entered
into an accelerated share buy back agreement ("ASB") to repurchase 1.2 million
shares. The initial price paid per share as part of the ASB transaction was
$20.12. The repurchased shares were subject to a settlement price adjustment
based upon the difference between: (i) the volume weighted average price of
Conseco common stock (as defined in the ASB); and (ii) $20.12. The settlement
price adjustment was calculated to be $.3 million and was paid to the Company.
The Company recognized a reduction in common stock and additional paid-in
capital of $24.7 million in the first quarter of 2007 related to the ASB
transaction.
During 2007, the Company repurchased an additional 4.5 million shares of
its common stock for $62.5 million. No repurchases were made in 2008.
Changes in the number of shares of common stock outstanding were as follows
(shares in thousands):
2008 2007 2006
---- ---- ----
Balance, beginning of year.............................................. 184,652 152,165 151,513
Treasury stock purchased and retired................................ - (5,699) -
Conversion of preferred stock into common shares.................... - 37,809 -
Stock options exercised............................................. - 207 48
Shares issued under employee benefit
compensation plans............................................... 102(a) 177 (a) 645 (a)
Other............................................................... - (7) (41)
------- ------- -------
Balance, end of year.................................................... 184,754 184,652 152,165
======= ======= =======
<FN>
- --------------------
(a) In 2008, 2007 and 2006, such amounts were reduced by 16 thousand
shares, 24 thousand shares and 220 thousand shares, respectively,
which were tendered for the payment of federal and state taxes owned
on the issuance of restricted stock.
</FN>
The Company has a long-term incentive plan which permits the grant of CNO
incentive or non-qualified stock options, restricted stock awards, stock
appreciation rights, performance shares or units and certain other equity-based
awards to certain directors, officers and employees of the Company and certain
other individuals who perform services for the Company. A maximum of 10 million
shares may be issued under the plan. Our stock option awards are generally
granted with an exercise price equal to the market price of the Company's stock
on the date of grant. For options granted in 2006 and prior years, our stock
option awards generally vest on a graded basis over a four year service term and
expire ten years from the date of grant. Our stock option awards granted in 2007
and 2008 generally vest on a graded basis over a three year service term and
expire five years from the date of grant. The vesting periods for our restricted
stock awards range from immediate vesting to a period of four years.
172
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
A summary of the Company's stock option activity and related information
for 2008 is presented below (shares in thousands):
Weighted Weighted
average average Aggregate
exercise remaining intrinsic
Shares price life value
------ ----- ---- -----
Outstanding at the beginning of
the year....................................................... 4,828 $19.82
Options granted................................................... 1,863 10.27
Exercised......................................................... - - $ -
Forfeited or terminated........................................... (827) 18.69
----
Outstanding at the end of the year................................ 5,864 16.94 4.8 years $27.9
===== ===
Options exercisable at the end of the year........................ 2,412 5.5 years $16.6
===== ===
Available for future grant........................................ 1,154
=====
A summary of the Company's stock option activity and related information
for 2007 is presented below (shares in thousands):
Weighted Weighted
average average Aggregate
exercise remaining intrinsic
Shares price life value
------ ----- ---- -----
Outstanding at the beginning of
the year....................................................... 4,217 $20.76
Options granted................................................... 1,671 17.37
Exercised......................................................... (207) 16.31 $1.3
Forfeited or terminated........................................... (853) 20.54
----
Outstanding at the end of the year................................ 4,828 19.82 5.9 years $28.1
===== ===
Options exercisable at the end of the year........................ 2,462 6.0 years $16.6
===== ===
Available for future grant........................................ 2,794
=====
173
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
A summary of the Company's stock option activity and related information
for 2006 is presented below (shares in thousands):
Weighted Weighted
average average Aggregate
exercise remaining intrinsic
Shares price life value
------ ----- ---- -----
Outstanding at the beginning of
the year....................................................... 3,536 $19.89
Options granted................................................... 1,295 22.57
Exercised......................................................... (48) 20.80 $.3
Forfeited or terminated........................................... (566) 19.47
----
Outstanding at the end of the year................................ 4,217 20.76 7.6 years $27.4
===== ===
Options exercisable at the end of the year........................ 2,257 6.4 years $14.9
===== ===
Available for future grant........................................ 4,020
=====
We recognized compensation expense related to stock options totaling $6.0
million ($3.9 million after income taxes) in 2008, $7.4 million ($4.8 million
after income taxes) in 2007 and $6.5 million ($4.2 million after income taxes)
in 2006. Compensation expense related to stock options reduced both basic and
diluted earnings (loss) per share by 2 cents, 3 cents and 3 cents in 2008, 2007
and 2006. At December 31, 2008, the unrecognized compensation expense for
non-vested stock options totaled $10.2 million which is expected to be
recognized over a weighted average period of 1.6 years. Cash received from the
exercise of stock options was nil, $3.4 million and $1.0 million during 2008,
2007 and 2006, respectively.
The fair value of each stock option grant is estimated on the date of grant
using the Black-Scholes option valuation model with the following weighted
average assumptions:
2008 Grants 2007 Grants 2006 Grants
----------- ----------- -----------
Weighted average risk-free interest rates.............................. 2.5% 4.4% 5.0%
Weighted average dividend yields....................................... 0.0% 0.0% 0.0%
Volatility factors..................................................... 24% 22% 22%
Weighted average expected life......................................... 3.7 years 3.7 years 6.2 years
Weighted average fair value per share.................................. $2.25 $4.22 $7.90
The risk-free interest rate is based on the U.S. Treasury yield curve in
effect at the time of grant. The dividend yield is based on the Company's
history and expectation of dividend payouts. Volatility factors are based on the
weekly historical volatility of the Company's common stock equal to the expected
life of the option or since our emergence from bankruptcy in September 2003. The
expected life is based on the average of the graded vesting period and the
contractual terms of the option.
The exercise price was equal to the market price of our stock for all
options granted in 2008, 2007 and 2006.
174
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
The following table summarizes information about stock options outstanding
at December 31, 2008 (shares in thousands):
Options outstanding Options exercisable
-------------------------------------------- ----------------------------
Number Remaining Average exercise Number Average exercise
Range of exercise prices outstanding life (in years) price exercisable price
- ------------------------ ----------- --------------- ----- ----------- -----
$2.83............................... 65 4.9 $ 2.83 - $ -
$8.91 - $12.96...................... 1,751 4.3 10.60 2 12.96
$14.78 - $21.67..................... 3,514 4.7 19.42 2,138 20.19
$22.42 - $25.45..................... 534 7.4 23.17 272 23.17
----- -----
5,864 2,412
===== =====
During 2008, 2007 and 2006, the Company granted .1 million, .1 million and
..1 million restricted shares, respectively, of CNO common stock to certain
directors, officers and employees of the Company at a weighted average fair
value of $9.75 per share, $18.39 per share and $22.68 per share, respectively.
The fair value of such grants totaled $.8 million, $1.7 million and $1.3 million
in 2008, 2007 and 2006, respectively. Such amounts are recognized as
compensation expense over the vesting period of the restricted stock. A summary
of the Company's non-vested restricted stock activity for 2008 is presented
below (shares in thousands):
Weighted
average
grant date
Shares fair value
------ ----------
Non-vested shares, beginning of year................................ 112 $19.38
Granted.......................................................... 78 9.75
Vested........................................................... (118) 21.67
Forfeited........................................................ (2) 15.89
----
Non-vested shares, end of year...................................... 70 14.41
====
At December 31, 2008, the unrecognized compensation expense for non-vested
restricted stock totaled $.6 million which is expected to be recognized over a
weighted average period of 1.6 years. At December 31, 2007, the unrecognized
compensation expense for non-vested restricted stock totaled $1.3 million. We
recognized compensation expense related to restricted stock awards totaling $1.4
million, $3.2 million and $10.2 million in 2008, 2007 and 2006, respectively.
The fair value of restricted stock that vested during 2008, 2007 and 2006 was
$1.9 million, $3.9 million and $16.1 million, respectively.
SFAS 123R also requires us to estimate the amount of unvested stock-based
awards that will be forfeited in future periods and reduce the amount of
compensation expense recognized over the applicable service period to reflect
this estimate. In accordance with SFAS 123R, we periodically evaluate our
forfeiture assumptions to more accurately reflect our actual forfeiture
experience.
The Company does not currently recognize tax benefits resulting from tax
deductions in excess of the compensation expense recognized because of NOLs
which are available to offset future taxable income.
As further discussed in the footnote to the consolidated financial
statements entitled "Income Taxes", the Company's Board of Directors adopted the
Rights Plan on January 20, 2009, which is designed to protect shareholder value
by preserving the value of our tax assets primarily associated with NOLs. As a
result, the Company declared a dividend of one preferred share purchase right (a
"Right") for each outstanding share of common stock. The dividend was payable on
January 30, 2009, to the shareholders of record as of the close of business on
that date. Each Right entitles the shareholder to purchase from the Company one
one-thousandth of a share of Series A Junior Participating Preferred Stock, par
value $.01 per share (the "Junior Preferred Stock") of the Company at a price of
$20.00 per one one-thousandth of a share of Junior Preferred Stock. The
description and terms of the Rights are set forth in the Rights Plan. The Rights
would become exercisable in the event any person or group (subject to certain
exemptions) becomes a "5 percent shareholder" of Conseco
175
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
without the approval of the Board of Directors or an existing shareholder who is
currently a "5 percent shareholder" acquires additional shares exceeding one
percent of our outstanding shares without prior approval from the Board of
Directors.
A reconciliation of net income (loss) and shares used to calculate basic
and diluted earnings (loss) per share is as follows (dollars in millions and
shares in thousands):
2008 2007 2006
---- ---- ----
Income (loss) before discontinued operations............................ $ (404.0) $ (74.0) $ 105.7
Discontinued operations................................................. (722.7) (105.9) .3
--------- ------- -------
Net income (loss)....................................................... (1,126.7) (179.9) 106.0
Preferred stock dividends............................................... - (14.1) (38.0)
--------- ------- -------
Net income (loss) applicable to common
stock for basic earnings per share............................... $(1,126.7) $(194.0) $ 68.0
========= ======= =======
Shares:
Weighted average shares outstanding for basic
earnings per share................................................. 184,704 173,374 151,690
------- ------- -------
Effect of dilutive securities on weighted average shares:
Stock option and restricted stock plans............................ - - 819
------- ------- -------
Dilutive potential common shares................................... - - 819
------- ------- -------
Weighted average shares outstanding for diluted
earnings per share............................................... 184,704 173,374 152,509
======= ======= =======
There were no dilutive common stock equivalents during 2008 or 2007 because
of the net loss recognized by the Company during such period. 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 potentially dilutive shares related to the Class B mandatorily
convertible preferred stock were not dilutive during 2006, but the common stock
equivalents related to stock option and restricted stock plans were dilutive.
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share, because
doing so would have been antidilutive in such periods (shares in thousands).
2008 2007 2006
---- ---- ----
Equivalent common shares that were antidilutive during the year:
Class B mandatorily convertible preferred stock.................... - 14,334 32,178
Stock option and restricted stock plans............................ 32 144 -
-- ------ ------
Antidilutive equivalent common shares............................ 32 14,478 32,178
== ====== ======
In 2008 and 2007, the Company granted performance shares totaling 645,100
and 420,900, respectively, pursuant to its long-term incentive plan to certain
officers of the Company. The criteria for payment related to a portion of such
awards is based upon the cumulative return on the Company's stock with dividends
reinvested ("total shareholder return") compared to the total shareholder return
of a group of Conseco's peers (represented by the companies comprising the
Standard & Poor's Life and Health Index and the Russell 3000 Health and Life
Index) over a three year performance measurement period. If the Company's
results are below the 50th percentile of the comparison group, no portion of the
award is earned. If the Company's results are equal to or greater than the 75th
percentile, then the maximum award is earned. The criteria for payment of the
remaining performance shares is based upon the Company's operating return on
equity, as defined in the award agreement. If the Company's operating return on
equity is less than 10.0 percent, no portion of the award is earned. If
176
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
the Company's operating return on equity is equal to or greater than 12.0
percent, then the maximum award is earned. Unless antidilutive, the diluted
weighted average shares outstanding would reflect the number of performance
shares expected to be issued, using the treasury stock method.
A summary of the Company's performance shares is presented below (shares in
thousands):
Total shareholder Operating return
return award on equity award
------------ ---------------
Granted in 2007................................... 253 168
Forfeited......................................... (35) (22)
--- ---
Awards outstanding at December 31, 2007........... 218 146
Granted in 2008................................... 387 258
Forfeited......................................... (54) (37)
--- ---
Awards outstanding at December 31, 2008........... 551 367
=== ===
The grant date fair value of the total shareholder return awards was $1.6
million and $1.7 million in 2008 and 2007, respectively. The grant date fair
value of the operating return on equity awards was $2.7 million and $3.0 million
in 2008 and 2007, respectively. We recognized compensation expense of $.1
million and $1.1 million in 2008 and 2007, respectively, related to the
performance shares.
In August 2005, we completed the private offering of 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
2008, 2007 and 2006, the conversion feature of these Debentures did not have a
dilutive effect because the weighted average market price of our common stock
did not exceed the initial conversion price of $26.66. Therefore, the Debentures
had no effect on our diluted shares outstanding or our diluted earnings per
share in 2008, 2007 or 2006.
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 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).
177
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
12. OTHER OPERATING STATEMENT DATA
Insurance policy income consisted of the following (dollars in millions):
2008 2007 2006
---- ---- ----
Traditional products:
Direct premiums collected............................................ $ 4,313.5 $ 4,291.4 $ 4,476.7
Reinsurance assumed.................................................. 642.8 314.0 108.9
Reinsurance ceded.................................................... (164.3) (199.8) (210.6)
--------- --------- ---------
Premiums collected, net of reinsurance......................... 4,792.0 4,405.6 4,375.0
Change in unearned premiums.......................................... (13.5) (2.1) 39.5
Less premiums on universal life and products
without mortality and morbidity risk which
are recorded as additions to insurance
liabilities ...................................................... (1,863.5) (1,852.2) (2,067.7)
--------- --------- ---------
Premiums on traditional products with
mortality or morbidity risk................................. 2,915.0 2,551.3 2,346.8
Fees and surrender charges on interest-sensitive
products............................................................. 338.6 344.4 349.6
--------- --------- ---------
Insurance policy income........................................ $ 3,253.6 $ 2,895.7 $ 2,696.4
========= ========= =========
The four states with the largest shares of 2008 collected premiums were
Florida (7.4 percent), California (7.1 percent), Pennsylvania (6.3 percent) and
Texas (5.9 percent). No other state accounted for more than five percent of
total collected premiums.
Other operating costs and expenses were as follows (dollars in millions):
2008 2007 2006
---- ---- ----
Commission expense....................................................... $128.2 $118.3 $118.7
Salaries and wages....................................................... 160.5 169.3 168.3
Other.................................................................... 231.6 252.8 216.3
------ ------ ------
Total other operating costs and expenses.......................... $520.3 $540.4 $503.3
====== ====== ======
Changes in the value of policies inforce at the Effective Date were as
follows (dollars in millions):
2008 2007 2006
---- ---- ----
Balance, beginning of year............................................... $1,573.6 $1,964.8 $2,209.5
Additional acquisition expense....................................... - 1.9 2.1
Amortization......................................................... (187.3) (246.2) (276.1)
Cumulative effect of accounting change related to the adoption
of SOP 05-1....................................................... - (2.6) -
Effect of annuity coinsurance transaction............................ - (191.2) -
Effect of reinsurance recapture...................................... - 56.3 -
Amounts related to fair value adjustment of actively managed
fixed maturities.................................................. 92.7 (9.4) 29.3
Other................................................................ (1.2) - -
-------- -------- --------
Balance, end of year..................................................... $1,477.8 $1,573.6 $1,964.8
======== ======== ========
178
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Based on current conditions and assumptions as to future events on all
policies inforce, the Company expects to amortize approximately 14 percent of
the December 31, 2008 balance of the value of policies inforce at the Effective
Date in 2009, 12 percent in 2010, 11 percent in 2011, 9 percent in 2012 and 7
percent in 2013. The discount rate used to determine the amortization of the
value of policies inforce at the Effective Date averaged approximately 5 percent
in the years ended December 31, 2008, 2007 and 2006.
In accordance with SFAS 97, we are required to amortize the value of
policies inforce in relation to estimated gross profits for universal life
products and investment-type products. SFAS 97 also requires that estimates of
expected gross profits used as a basis for amortization be evaluated regularly,
and that the total amortization recorded to date be adjusted by a charge or
credit to the statement of operations, if actual experience or other evidence
suggests that earlier estimates should be revised.
Changes in the cost of policies produced were as follows (dollars in
millions):
2008 2007 2006
---- ---- ----
Balance, beginning of year............................................... $1,423.0 $1,106.7 $ 758.8
Additions............................................................. 459.1 487.6 482.5
Amortization.......................................................... (180.6) (180.6) (147.2)
Cumulative effect of accounting change related to the adoption of
SOP 05-1............................................................ - (1.6) -
Effect of annuity coinsurance transaction............................. - (19.3) -
Amounts related to fair value adjustment of actively
managed fixed maturities............................................ 111.1 30.2 12.6
-------- -------- --------
Balance, end of year..................................................... $1,812.6 $1,423.0 $1,106.7
======== ======== ========
179
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
13. CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
2008 2007 2006
---- ---- ----
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............................. $ 7.4 $ 11.0 $ 11.4
Conversion of preferred stock into common shares.................... - 667.8 -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start date.................. - 6.0 6.7
Change in securities lending collateral............................. 51.6 408.3 460.2
Change in securities lending payable................................ (51.6) (408.3) (460.2)
The following reconciles net income to net cash provided by operating
activities (dollars in millions):
2008 2007 2006
---- ---- ----
Cash flows from operating activities:
Net income (loss)..................................................... $(1,126.7) $(179.9) $ 106.0
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Amortization and depreciation..................................... 412.0 483.2 501.2
Income taxes...................................................... 432.1 4.2 62.6
Insurance liabilities............................................. 460.6 744.8 493.2
Accrual and amortization of investment income..................... 3.9 73.4 (5.8)
Deferral of policy acquisition costs.............................. (459.1) (545.9) (484.6)
Net realized investment losses.................................... 642.5 155.4 47.2
(Gain) loss on extinguishment of debt............................. (21.2) - .3
Net sales (purchases) of trading securities....................... 346.5 (114.3) 36.0
Loss related to an annuity coinsurance transaction................ - 76.5 -
Loss on Transfer.................................................. 319.9 - -
Gain on reinsurance recapture..................................... (29.7) - -
Other............................................................. 6.0 5.9 175.1
--------- ------- -------
Net cash provided by operating activities....................... $ 986.8 $ 703.3 $ 931.2
========= ======= =======
Our consolidated statement of cash flows combines the cash flows from
discontinued operations with the cash flows from continuing operations within
each major category (operating, investing and financing) of the cash flow
statement.
At December 31, 2008, restricted cash and cash equivalents consisted of
$4.8 million held by a VIE.
At December 31, 2007, restricted cash and cash equivalents consisted of:
(i) $16.1 million held by a VIE; (ii) $1.9 million of segregated cash held for
the benefit of the former holders of TOPrS; and (iii) $3.1 million held in an
escrow account pursuant to a litigation settlement.
180
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
14. STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES)
Statutory accounting practices prescribed or permitted by regulatory
authorities for the Company's insurance subsidiaries differ from GAAP. The
Company's insurance subsidiaries reported the following amounts to regulatory
agencies, after appropriate elimination of intercompany accounts among such
subsidiaries (dollars in millions):
2008 2007
---- ----
Statutory capital and surplus.................................................................... $1,311.5 $1,336.2
Asset valuation reserve.......................................................................... 55.0 161.3
Interest maintenance reserve..................................................................... 147.7 196.7
-------- --------
Total......................................................................................... $1,514.2 $1,694.2
======== ========
Statutory capital and surplus included investments in upstream affiliates
of $52.2 million and $52.4 million at December 31, 2008 and 2007, respectively,
which were eliminated in the consolidated financial statements prepared in
accordance with GAAP.
Statutory earnings build the capital required by ratings agencies and
regulators. Statutory earnings, fees and interest paid by the insurance
companies to the parent company create the "cash flow capacity" the parent
company needs to meet its obligations, including debt service. The consolidated
statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries
was $(96.9) million, $(321.3) million and $(232.4) million in 2008, 2007 and
2006, respectively. Included in such net income (loss) were net realized capital
gains (losses), net of income taxes, of $(217.1) million, $(38.5) million and
$(1.8) million in 2008, 2007 and 2006, respectively. In addition, such net
income (loss) included pre-tax amounts for fees and interest to Conseco or its
non-life subsidiaries totaling $139.6 million, $162.8 million and $157.6 million
in 2008, 2007 and 2006, respectively.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the ability of our insurance subsidiaries to pay dividends is subject
to state insurance department regulations. Insurance regulations generally
permit dividends to be paid from statutory earned surplus of the insurance
company without regulatory approval for any 12-month period in amounts equal to
the greater of (or in a few states, the lesser of): (i) statutory net gain from
operations or statutory net income for the prior year (excluded from this
calculation would be the $61.9 million of additional surplus recognized due to
the approval of a permitted practice by insurance regulators related to certain
deferred tax assets as further described below); or (ii) 10 percent of statutory
capital and surplus as of the end of the preceding year, excluding $61.9 million
of additional surplus recognized due to the approval of a permitted practice by
insurance regulators related to certain deferred tax assets. This type of
dividend is referred to as "ordinary dividends". Any dividends in excess of
these levels require the approval of the director or commissioner of the
applicable state insurance department. This type of dividend is referred to as
"extraordinary dividends". During 2008, our insurance subsidiaries paid cash
dividends of $20.0 million to CDOC (which is the immediate parent of Washington
National, Conseco Health and Conseco Life Insurance Company of Texas).
Each of the immediate subsidiaries of CDOC have negative earned surplus at
December 31, 2008. Accordingly, any dividend payments from these subsidiaries
require the approval of the director or commissioner of the applicable state
insurance department. During 2009, we are expecting our insurance subsidiaries
to pay approximately $60.0 million of extraordinary dividends to CDOC ($25.0
million of which has been approved by the Texas Department of Insurance for
payment to CDOC and $35.0 million of which is expected to be approved by the
Texas Department of Insurance and paid later in 2009). In addition, we are
expecting our insurance subsidiaries to pay interest on surplus debentures of
$44.5 million ($21.2 million of which has been approved by the Texas Department
of Insurance and $23.3 million of which is expected to be approved by the Texas
Department of Insurance and paid later in 2009). Although we believe the
dividends and surplus debenture interest payments we are expecting to pay during
2009 are consistent with payments that have been approved by insurance
regulators in prior years, there can be no assurance that such payments will be
approved or that the financial condition of our insurance subsidiaries will not
change, making future approvals unlikely. Dividends and other payments from our
non-insurance subsidiaries to CNO or CDOC do not require approval by any
regulatory authority or other third party. Also, during 2008, CDOC made capital
contributions totaling $79.4 million to Conseco Life Insurance Company of Texas
and Washington National Insurance Company.
181
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
In accordance with an order from the Florida Office of Insurance
Regulation, Washington National may not distribute funds to any affiliate or
shareholder without prior notice to the Florida Office of Insurance Regulation.
In addition, the risk-based capital and other capital requirements described
below can also limit, in certain circumstances, the ability of our insurance
subsidiaries to pay dividends.
Risk-Based Capital ("RBC") requirements provide a tool for insurance
regulators to determine the levels of statutory capital and surplus an insurer
must maintain in relation to its insurance and investment risks and the need for
possible regulatory attention. The RBC requirements provide four levels of
regulatory attention, varying with the ratio of the insurance company's total
adjusted capital (defined as the total of its statutory capital and surplus, AVR
and certain other adjustments) to its RBC (as measured on December 31 of each
year) as follows: (i) if a company's total adjusted capital is less than 100
percent but greater than or equal to 75 percent of its RBC, the company must
submit a comprehensive plan to the regulatory authority proposing corrective
actions aimed at improving its capital position (the "Company Action Level");
(ii) if a company's total adjusted capital is less than 75 percent but greater
than or equal to 50 percent of its RBC, the regulatory authority will perform a
special examination of the company and issue an order specifying the corrective
actions that must be taken; (iii) if a company's total adjusted capital is less
than 50 percent but greater than or equal to 35 percent of its RBC, the
regulatory authority may take any action it deems necessary, including placing
the company under regulatory control; and (iv) if a company's total adjusted
capital is less than 35 percent of its RBC, the regulatory authority must place
the company under its control. In addition, the RBC requirements provide for a
trend test if a company's total adjusted capital is between 100 percent and 125
percent of its RBC at the end of the year. The trend test calculates the greater
of the decrease in the margin of total adjusted capital over RBC: (i) between
the current year and the prior year; and (ii) for the average of the last 3
years. It assumes that such decrease could occur again in the coming year. Any
company whose trended total adjusted capital is less than 95 percent of its RBC
would trigger a requirement to submit a comprehensive plan as described above
for the Company Action Level.
During 2007 and 2006, we made capital contributions to Senior Health to
maintain total adjusted capital in excess of the levels subjecting it to any
regulatory action. As a result of losses on the long-term care business, we made
capital contributions to Senior Health of $202.0 million (including $56.0
million which was accrued at December 31, 2007, and paid in February 2008) in
2007 and $110.0 million (including $80 million which was accrued at December 31,
2006 and paid in February 2007) in 2006.
In addition to the RBC requirements, certain states have established
minimum capital requirements for insurance companies licensed to do business in
their state. These additional requirements generally have not had a significant
impact on the Company's insurance subsidiaries, but the capital requirements in
Florida have caused Conseco Health to maintain a higher level of capital and
surplus than it would otherwise maintain and have thus limited its ability to
pay dividends.
In addition, although we are under no obligation to do so, we may elect to
contribute additional capital to strengthen the surplus of certain insurance
subsidiaries. Any election regarding the contribution of additional capital to
our insurance subsidiaries could affect the ability of our insurance
subsidiaries to pay dividends to the holding company. The ability of our
insurance subsidiaries to pay dividends is also impacted by various criteria
established by rating agencies to maintain or receive higher ratings and by the
capital levels that we target for our insurance subsidiaries.
The capital and surplus of our insurance subsidiaries has declined in
recent periods primarily as a result of the losses recognized as a result of the
transaction to transfer Senior Health to an independent trust and net realized
investment losses. The Company has taken a number of actions to strengthen the
capital position of its subsidiaries, including:
o We requested and obtained approval of a statutory permitted accounting
practice as of December 31, 2008 for our insurance subsidiaries
domiciled in Illinois and Indiana. The permitted practice modifies the
accounting for deferred income taxes by increasing the realization
period for deferred tax assets from within one year to within three
years of the balance sheet date and increasing the asset recognition
limit from 10 percent to 15 percent of adjusted capital and surplus as
shown in the most recently filed statutory financial statements. The
impact of the permitted practice was to increase the statutory
consolidated capital and surplus of our insurance subsidiaries by
$61.9 million as of December 31, 2008. In addition, the consolidated
risk-based capital ratio increased by 11 percentage points and, as a
result, the Company did not need to take additional actions in order
to meet the risk-based capital financial covenant requirement at
December 31, 2008. The benefit of this permitted practice may not be
considered by our insurance subsidiaries when determining surplus
available for dividends.
182
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
o We have entered into reinsurance agreements which have reduced the
aggregate risk-based capital of our insurance subsidiaries. For
example, during the fourth quarter of 2008 we entered into two
reinsurance transactions which had the effect of increasing our
aggregate risk-based capital ratio by 8 percentage points.
o During the fourth quarter of 2008, we completed a transaction pursuant
to which our ownership of Senior Health was transferred to an
independent trust. The completion of this transaction had the effect
of increasing our aggregate risk-based capital ratio by 18 percentage
points.
o In the first quarter of 2009, Conseco Insurance Company terminated an
existing intercompany commission financing arrangement with a non-life
subsidiary of the Company. In connection with the termination of the
agreement, Conseco Insurance Company paid $17 million to the non-life
subsidiary, representing the present value of the future commissions
Conseco Insurance Company would have otherwise paid to the non-life
subsidiary over the next several years. The termination of the
commission financing agreement had the effect of reducing the
statutory capital and surplus of Conseco Insurance Company. However,
the current cash available to the holding company increased by the $17
million termination payment.
During 2008, the financial statements of three of our subsidiaries prepared
in accordance with statutory accounting practices prescribed or permitted by
regulatory authorities reflected the establishment of asset adequacy or premium
deficiency reserves primarily related to long-term care and annuity policies.
Total asset adequacy and premium deficiency reserves for Washington National,
Conseco Insurance Company and Bankers Conseco Life Insurance Company were $53.3
million, $20.0 million and $19.5 million, respectively at December 31, 2008. The
determination of the need for and amount of asset adequacy reserves is subject
to numerous actuarial assumptions, including the Company's ability to change
nonguaranteed elements related to certain products consistent with contract
provisions.
At December 31, 2008, the consolidated RBC ratio of our insurance
subsidiaries exceeded the minimum risk-based capital requirement included in our
Second Amended Credit Facility. See the note to the consolidated financial
statements entitled "Notes Payable - Direct Corporate Obligations" for further
discussion of various financial ratios and balances we are required to maintain.
We calculate the consolidated RBC ratio by assuming all of the assets,
liabilities, capital and surplus and other aspects of the business of our
insurance subsidiaries are combined together in one insurance subsidiary, with
appropriate intercompany eliminations.
15. 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; and corporate operations, which
consists of holding company activities and certain noninsurance businesses.
Prior to the fourth quarter of 2008, we had a fourth segment comprised of other
business in run-off. The other business in run-off segment had included blocks
of business that we no longer market or underwrite and were managed separately
from our other businesses. Such segment had consisted of: (i) long-term care
insurance sold in prior years through independent agents; and (ii) major medical
insurance. As a result of the Transfer, as further discussed in the note to the
consolidated financial statements entitled "Transfer of Senior Health Insurance
Company of Pennsylvania to an Independent Trust", a substantial portion of the
long-term care business in the other business in run-off segment is presented as
discontinued operations in our consolidated financial statements. Accordingly,
we have restated all prior year segment disclosures to conform to management's
current view of the Company's operating segments.
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.
183
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Operating information by segment was as follows (dollars in millions):
2008 2007 2006
---- ---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities..................................... $ 49.2 $ 67.6 $ 64.7
Supplemental health........................... 1,795.1 1,456.4 1,240.7
Life.......................................... 187.8 175.4 155.5
Other......................................... 77.8 80.6 84.6
Net investment income (a).......................... 558.2 572.3 525.6
Fee revenue and other income (a)................... 11.0 12.0 6.0
-------- -------- --------
Total Bankers Life revenues............... 2,679.1 2,364.3 2,077.1
-------- -------- --------
Colonial Penn:
Insurance policy income:
Supplemental health........................... 8.4 9.7 11.1
Life.......................................... 175.3 115.0 99.7
Other......................................... 1.1 1.1 1.3
Net investment income (a).......................... 39.6 37.8 38.2
Fee revenue and other income (a)................... 1.8 .7 .6
-------- -------- --------
Total Colonial Penn revenues.............. 226.2 164.3 150.9
-------- -------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities..................................... 14.1 14.3 16.0
Supplemental health........................... 609.4 628.1 655.1
Life.......................................... 325.0 335.3 353.4
Other......................................... 10.4 12.2 14.3
Net investment income (a).......................... 552.5 716.3 757.2
Fee revenue and other income (a)................... 1.7 1.0 1.4
-------- -------- --------
Total Conseco Insurance Group
revenues.............................. 1,513.1 1,707.2 1,797.4
-------- -------- --------
Corporate operations:
Net investment income (a).......................... 28.5 43.4 29.8
Fee and other income............................... 5.2 10.1 11.2
-------- -------- --------
Total corporate revenues.................. 33.7 53.5 41.0
-------- -------- --------
Total revenues............................ 4,452.1 4,289.3 4,066.4
-------- -------- --------
(continued on next page)
184
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
(continued from previous page)
2008 2007 2006
---- ---- ----
Expenses:
Bankers Life:
Insurance policy benefits.............................. 2,090.4 1,684.7 1,410.6
Amortization........................................... 234.8 264.0 241.0
Interest expense on investment borrowings.............. - - .1
Other operating costs and expenses..................... 182.4 173.8 160.1
-------- -------- --------
Total Bankers Life expenses....................... 2,507.6 2,122.5 1,811.8
-------- -------- --------
Colonial Penn:
Insurance policy benefits.............................. 139.4 102.2 96.4
Amortization........................................... 32.0 20.3 17.3
Other operating costs and expenses..................... 29.6 23.7 15.6
-------- -------- --------
Total Colonial Penn expenses...................... 201.0 146.2 129.3
-------- -------- --------
Conseco Insurance Group:
Insurance policy benefits.............................. 982.7 1,129.0 1,170.6
Amortization........................................... 122.6 178.2 175.1
Interest expense on investment borrowings.............. 22.4 17.6 .8
Costs related to a litigation settlement............... - 32.2 165.8
Loss related to an annuity coinsurance transaction..... - 76.5 -
Other operating costs and expenses..................... 264.1 300.0 288.1
-------- -------- --------
Total Conseco Insurance Group
expenses........................................ 1,391.8 1,733.5 1,800.4
-------- -------- --------
Corporate operations:
Interest expense on corporate debt..................... 59.2 72.3 52.9
Interest expense on variable interest entity........... 16.2 27.4 19.7
Costs related to a litigation settlement............... - 32.2 8.9
Other operating costs and expenses..................... 44.2 42.9 39.5
(Gain) loss on extinguishment of debt.................. (21.2) - .7
-------- -------- --------
Total corporate expenses.......................... 98.4 174.8 121.7
-------- -------- --------
Total expenses.................................... 4,198.8 4,177.0 3,863.2
-------- -------- --------
Income (loss) before income taxes:
Bankers Life...................................... 171.5 241.8 265.3
Colonial Penn..................................... 25.2 18.1 21.6
Conseco Insurance Group........................... 121.3 (26.3) (3.0)
Corporate operations.............................. (64.7) (121.3) (80.7)
-------- -------- --------
Income (loss) before income taxes............. $ 253.3 $ 112.3 $ 203.2
======== ======== ========
<FN>
- --------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
185
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):
2008 2007 2006
---- ---- ----
Total segment revenues.......................................... $4,452.1 $4,289.3 $4,066.4
Net realized investment losses.................................. (262.4) (158.0) (46.6)
-------- -------- --------
Consolidated revenues....................................... $4,189.7 $4,131.3 $4,019.8
======== ======== ========
Total segment expenses.......................................... $4,198.8 $4,177.0 $3,863.2
Amortization related to net realized investment losses.......... (21.5) (35.7) (10.1)
-------- -------- --------
Consolidated expenses....................................... $4,177.3 $4,141.3 $3,853.1
======== ======== ========
Segment balance sheet information was as follows (dollars in millions):
2008 2007
---- ----
Assets:
Bankers Life.............................................................. $12,927.5 $12,936.9
Colonial Penn............................................................. 916.3 939.1
Conseco Insurance Group................................................... 14,703.7 16,278.9
Corporate operations...................................................... 222.2 263.9
Assets of discontinued operations......................................... - 3,552.4
--------- ---------
Total assets......................................................... $28,769.7 $33,971.2
========= =========
Liabilities:
Bankers Life.............................................................. $12,102.6 $11,310.5
Colonial Penn............................................................. 808.5 797.0
Conseco Insurance Group................................................... 12,370.7 13,366.9
Corporate operations...................................................... 1,868.7 1,189.0
Liabilities of discontinued operations.................................... - 3,071.9
--------- ---------
Total liabilities.................................................... $27,150.5 $29,735.3
========= =========
The following table presents selected financial information of our segments
(dollars in millions):
Value of policies
inforce at the Cost of
Effective policies Insurance
Segment Date produced liabilities
- ------- ---- -------- -----------
2008
- ----
Bankers Life................................ $ 761.7 $1,216.2 $11,622.3
Colonial Penn............................... 105.3 174.8 708.9
Conseco Insurance Group..................... 610.8 421.6 11,856.9
-------- -------- ---------
Total.................................... $1,477.8 $1,812.6 $24,188.1
======== ======== =========
2007
- ----
Bankers Life................................ $ 781.6 $ 941.6 $10,610.9
Colonial Penn............................... 119.4 130.4 709.7
Conseco Insurance Group..................... 672.6 351.0 12,334.3
-------- -------- ---------
Total.................................... $1,573.6 $1,423.0 $23,654.9
======== ======== =========
186
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
16. QUARTERLY FINANCIAL DATA (UNAUDITED)
We compute earnings per common share for each quarter independently of
earnings per share for the year. The sum of the quarterly earnings per share may
not equal the earnings per share for the year because of: (i) transactions
affecting the weighted average number of shares outstanding in each quarter; and
(ii) the uneven distribution of earnings during the year. Quarterly financial
data (unaudited) were as follows (dollars in millions, except per share data).
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. (a)
-------- -------- -------- ------------
2008
- ----
Revenues.............................................................. $1,027.5 $1,094.7 $1,021.9 $1,045.6
======== ======== ======== ========
Income (loss) before income taxes and discontinued operations......... $(9.8) $ 18.3 $ 7.8 $ (3.9)
Income tax expense (benefit).......................................... (3.5) 307.1 32.4 80.4
----- ------- ------- -------
Loss before discontinued operations................................... (6.3) (288.8) (24.6) (84.3)
Income (loss) from discontinued operations, net of tax................ .5 (198.3) (157.4) (367.5)
----- ------- ------- -------
Net loss.............................................................. $(5.8) $(487.1) $(182.0) $(451.8)
===== ======= ======= =======
Loss per common share:
Basic:
Loss before discontinued operations............................... $(.03) $(1.56) $(.13) $ (.46)
Discontinued operations........................................... - (1.08) (.85) (1.99)
----- ------ ----- ------
Net loss....................................................... $(.03) $(2.64) $(.98) $(2.45)
===== ====== ===== ======
Diluted:
Loss before discontinued operations............................... $(.03) $(1.56) $(.13) $ (.46)
Discontinued operations........................................... - (1.08) (.85) (1.99)
------ ------ ----- ------
Net loss....................................................... $(.03) $(2.64) $(.98) $(2.45)
===== ====== ===== ======
<FN>
- -------------
(a) In the fourth quarter of 2008, our net loss reflected the following:
(i) losses from discontinued operations of $367.5 million primarily
related to losses and transaction costs associated with the Transfer;
and (ii) net realized investment losses of $93.0 million.
</FN>
187
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.(a)
-------- -------- -------- -----------
2007
- ----
Revenues.............................................................. $1,004.6 $1,060.4 $1,059.6 $1,006.7
======== ======== ======== ========
Income (loss) before income taxes and discontinued operations......... $ 26.2 $ 23.0 $(68.3) $ 9.1
Income tax expense (benefit).......................................... 9.2 7.8 (26.7) 73.7
------ ------ ------ ------
Income (loss) before discontinued operations.......................... 17.0 15.2 (41.6) (64.6)
Loss from discontinued operations, net of tax......................... (17.5) (70.4) (11.1) (6.9)
------ ------ ------ ------
Net loss.............................................................. $ (.5) $(55.2) $(52.7) $(71.5)
====== ====== ====== ======
Income (loss) per common share:
Basic:
Income (loss) before discontinued operations...................... $ .05 $ .06 $(.22) $(.35)
Discontinued operations........................................... (.12) (.41) (.06) (.03)
----- ----- ----- -----
Net loss....................................................... $(.07) $(.35) $(.28) $(.38)
===== ===== ===== =====
Diluted:
Income (loss) before discontinued operations...................... $ .05 $ .06 $(.22) $(.35)
Discontinued operations........................................... (.12) (.41) (.06) (.03)
----- ----- ----- -----
Net loss....................................................... $(.07) $(.35) $(.28) $(.38)
===== ===== ===== =====
<FN>
- ---------
(a) In the fourth quarter of 2007, our net loss reflected the following: (i)
an after tax charge of $10 million as a result of changes in our
estimates of future profits for certain interest-sensitive blocks of
business in our Conseco Insurance Group segment; and (ii) an increase of
$68 million in our valuation allowance for deferred tax assets.
</FN>
17. INVESTMENT IN A VARIABLE INTEREST ENTITY
The Company has an investment in a special purpose entity that is a
variable interest entity under FIN 46 (R). The following is description of our
significant investment in a variable interest entity:
Fall Creek CLO Ltd.
Fall Creek CLO Ltd. ("Fall Creek") is a collateralized loan trust that was
established to issue securities and use the proceeds to invest in loans and
other permitted investments. The assets held by the trust are legally isolated
and are not available to the Company. The liabilities of Fall Creek will be
satisfied from the cash flows generated by the underlying loans, not from the
assets of the Company. The investment borrowings were issued pursuant to an
indenture between Fall Creek and a trustee. 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 the indenture was amended. As a result of 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 $88.0 million.
Pursuant to the amendment, we committed to provide additional capital to Fall
Creek for up to $25 million (under defined circumstances) all of which was
contributed in 2008. In addition, the indenture was amended and restated in
November 2008, to change certain terms related to the investment borrowings,
cease future reinvesting activities of Fall Creek, provide for an additional
investment in Fall Creek and remove the provision related to threshold ratios.
In conjunction with the amendment and restatement of the indenture, Fall Creek
repaid $17.5 million of investment borrowings and the Company purchased: (i)
$25.2 million of borrowings previously held by others; and (ii) $9.7 million of
newly issued borrowings of Fall Creek. Repayment of the remaining principal
balance of the investment borrowings of Fall Creek is based on available cash
flows from the assets and such borrowings mature in 2017. A $10.0 million
repayment was made in December 2008 based on such excess cash flows. The Company
has no further commitments to Fall Creek. Also, in 2008, we recognized $10.8
million of writedowns of investments held by Fall Creek resulting from declines
in fair values that we concluded were other than temporary. The carrying value
of our investment in Fall Creek was $83.8 million and $47.0 million at December
31, 2008 and 2007, respectively. The following tables provide supplemental
information about the assets, liabilities, revenues and expenses
188
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
of Fall Creek which have been consolidated in accordance with FIN 46 (R), after
giving effect to the elimination of our investment in Fall Creek and investment
management fees earned by a subsidiary of the Company (dollars in millions):
December 31,
-------------------
2008 2007
---- ----
Assets:
Actively managed fixed maturities............................ $269.7 $465.9
Cash and cash equivalents - restricted....................... 4.8 16.1
Accrued investment income.................................... 2.8 5.1
Other assets................................................. 7.2 6.9
------ ------
Total assets............................................. $284.5 $494.0
====== ======
Liabilities:
Other liabilities............................................ $ 7.8 $ 12.2
Investment borrowings due to others.......................... 306.5 447.2
Investment borrowings due to the Company..................... 81.9 47.0
------ ------
Total liabilities........................................ 396.2 506.4
------ ------
Equity (deficit):
Capital provided by the Company.............................. 16.6 1.6
Capital provided by others................................... 3.8 4.1
Accumulated other comprehensive loss......................... (118.4) (25.0)
Retained earnings (deficit).................................. (13.7) 6.9
------ ------
Total equity (deficit)................................... (111.7) (12.4)
------ ------
Total liabilities and equity (deficit)................... $284.5 $494.0
====== ======
Years ended
December 31,
--------------------------------
2008 2007 2006
---- ---- ----
Revenues:
Net investment income - deposit accounts..................... $ 23.6 $36.8 $25.2
Fee revenue and other income................................. .5 .3 .3
------ ----- -----
Total revenues........................................... 24.1 37.1 25.5
------ ----- -----
Expenses:
Interest expense............................................. 16.2 27.4 19.7
Other operating expenses..................................... .7 .5 .9
------ ----- -----
Total expenses........................................... 16.9 27.9 20.6
------ ----- -----
Income (loss) before net realized investment losses
and income taxes....................................... 7.2 9.2 4.9
Net realized investment losses............................... (24.9) (.4) (.3)
------ ----- -----
Income (loss) before income taxes............................... $(17.7) $ 8.8 $ 4.6
====== ===== =====
189
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
18. SUBSEQUENT EVENTS
The following significant events occurred after December 31, 2008.
Amendment to our Second Amended Credit Facility
On March 30, 2009, we completed an amendment to our Second Amended Credit
Facility, which provides for, among other things: (i) additional margins between
our current financial status and certain financial covenant requirements through
June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new
restrictions on the ability of the Company to incur additional indebtedness; and
(iv) the ability of the lender to appoint a financial advisor at the Company's
expense.
The following summarizes the changes to the financial covenant
requirements:
Covenant under the
Second Amended Pro Forma margin for
Credit Facility as Balance or adverse development from
amended on ratio as of December 31, 2008
March 30, 2009 December 31, 2008 levels (a)
-------------- ----------------- ------
Aggregate risk-based
capital ratio........... Greater than or equal to 255% Reduction to statutory capital
200% from March 31, 2009 and surplus of approximately
through June 30, 2010 and $290 million, or an increase
thereafter, greater than 250% to the risk-based capital of
(the same ratio required by approximately $145 million.
the facility prior to the
amendment).
Combined statutory
capital and surplus..... Greater than $1,100 million $1,366 Reduction to combined
from March 31, 2009 through statutory capital and surplus
June 30, 2010 and thereafter, of approximately $265 million.
$1,270 (the same amount
required by the facility prior
to the amendment).
Debt to total capitalization
ratio................... Not more than 32.5% from 28% Reduction to shareholders'
March 31, 2009 through equity of approximately $615
June 30, 2010 and thereafter, million or additional debt of
not more than 30% (the same $295 million.
ratio required by the facility
prior to the amendment).
Interest coverage ratio..... Greater than or equal to 1.50 2.35 to 1 Reduction in cash flows to
to 1 for rolling four quarters the holding company of
from March 31, 2009 through approximately $45 million.
June 30, 2010 and thereafter,
2.00 to 1 (the same ratio
required by the facility prior
to the amendment).
<FN>
- ------------
(a) Calculated as if the amendments made to the financial covenants on
March 30, 2009 (applicable to the period March 31, 2009 through June
30, 2010) were effective on December 31, 2008.
</FN>
190
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Pursuant to its amended terms, the applicable interest rate on the Second
Amended Credit Facility (based on either a Eurodollar or base rate) has
increased. The Eurodollar rate is now equal to LIBOR plus 4 percent with a
minimum LIBOR rate of 2.5 percent (such rate was previously LIBOR plus 2 percent
with no minimum rate). The base rate is now equal to 2.5 percent plus the
greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of
America's prime rate. In addition, the amended agreement requires the Company to
pay a fee equal to 1 percent of the outstanding principal balance under the
Second Amended Credit Facility, which fee will be added to the principal balance
outstanding and will be payable at the maturity of the facility. This 1 percent
fee will be reported as non-cash interest expense.
The modifications to the Second Amended Credit Facility also place new
restrictions on the ability of the Company to incur additional indebtedness. The
amendment: (i) deleted the provision that allowed the Company to borrow up to an
additional $330 million under the Second Amended Credit Facility (the lenders
under the facility having had no obligation to lend any amount under that
provision); (ii) reduced the amount of secured indebtedness that the Company can
incur from $75 million to $2.5 million; and (iii) limited the ability of the
Company to incur additional unsecured indebtedness, except as provided below, to
$25 million, and eliminated the provision that would have allowed the Company to
incur additional unsecured indebtedness to the extent that principal payments
were made on existing unsecured indebtedness.
The Company is permitted to issue unsecured indebtedness that is used
solely to pay the holders of the Debentures, provided that such indebtedness
shall: (i) have a maturity date that is no earlier than October 10, 2014; (ii)
contain covenants and events of default that are no more restrictive than those
in the Second Amended Credit Facility; (iii) not contain any covenants or events
of default based on maintenance of the Company's financial condition; (iv) not
amortize; and (v) not have a put date or otherwise be callable prior to April
10, 2014, and provided that the amount of such unsecured indebtedness incurred
under this provision shall not exceed the $293 million of Debentures outstanding
on March 30, 2009; and provided further that the amount of cash interest payable
annually on any new issuance of such indebtedness, together with the cash
interest payable on the outstanding Debentures, shall not exceed twice the
amount of cash interest currently payable on the outstanding Debentures.
The amendment prohibits the Company from redeeming or purchasing the
Debentures with cash from sources other than those described in the previous
paragraph. The amendment permits the Company to amend, modify or refinance the
Convertible Indebtedness so long as such new indebtedness complies with the
restrictions set forth in the previous paragraph.
In addition, pursuant to the terms of the amended debt agreement, the
lenders have the right to appoint a steering committee which has the right to
appoint a financial advisor at the Company's expense to, among other things,
review financial projections and other financial information prepared by or on
behalf of the Company, perform valuations of the assets of the Company and take
other actions as are customary or reasonable for an advisor acting in such
capacity.
Pursuant to GAAP, the amendment to the Second Amended Credit Facility is
required to be accounted for in accordance with Statement of Financial
Accounting Standards No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings". Accordingly, the effects of the modifications will be
accounted for prospectively from March 31, 2009, and we will not change the
$911.8 million carrying amount of the Second Amended Credit Facility as a result
of the modifications. However, the estimated $9.0 million of fees incurred in
conjunction with the modifications of the facility will be expensed in the first
quarter of 2009.
191
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------
Ratings changes
A.M. Best, Moody's and S&P recently downgraded the financial strength
ratings of our primary insurance subsidiaries as summarized below:
Rating agency Date of change Previous rating New rating Outlook
------------- -------------- --------------- ---------- -------
A.M. Best March 4, 2009 B+ B Under review
with negative
implications
Moody's March 3, 2009 Ba1 Ba2 Negative
S&P February 26, 2009 BB+ BB- Negative
On March 2, 2009, S&P placed the financial strength ratings of our primary
insurance subsidiaries on credit watch with negative implications. A rating on
credit watch with negative implications highlights the potential direction of a
rating focusing on identifiable events and short-term trends that cause ratings
to be placed under special surveillance by S&P. A "negative" designation means
that a rating may be lowered.
Approval of dividends and surplus debenture interest payments
On March 30, 2009, the Texas Department of Insurance approved the payment
of $25 million of extraordinary dividends from Conseco Life Insurance Company of
Texas to CDOC. In addition, on March 13, 2009, the March 31, 2009 surplus
debenture interest payments from Conseco Life Insurance Company of Texas to CDOC
totaling approximately $10 million were approved for payment by the Texas
Department of Insurance on or after March 31, 2009 and the June 30, 2009 surplus
debenture interest payments totaling approximately $11 million were approved for
payment on or after June 30, 2009.
Approval of Permitted Practices
In February 2009, we requested and obtained approval of a statutory
permitted accounting practice as of December 31, 2008 for our insurance
subsidiaries domiciled in Illinois and Indiana. The permitted practice modifies
the accounting for deferred income taxes by increasing the realization period
for deferred tax assets from within one year to within three years of the
balance sheet date and increasing the asset recognition limit from 10 percent to
15 percent of adjusted capital and surplus as shown in the most recently filed
statutory financial statements. The impact of the permitted practice was to
increase the statutory consolidated capital and surplus of our insurance
subsidiaries by $61.9 million as of December 31, 2008. In addition, the
consolidated risk-based capital ratio increased by 11 percentage points and, as
a result, the Company did not need to take additional actions in order to meet
the risk-based capital financial covenant requirement at December 31, 2008. The
benefit of this permitted practice may not be considered by our insurance
subsidiaries when determining surplus available for dividends.
192
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. Conseco's management,
under the supervision and with the participation of the Chief Executive Officer
and the Chief Financial Officer, evaluated the effectiveness of Conseco's
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended). Disclosure controls and
procedures are designed to ensure that information required to be disclosed in
reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in SEC rules and forms
and that such information is accumulated and communicated to management,
including the Chief Executive Officer and Chief Financial Officer, to allow
timely decisions regarding required disclosures.
During the evaluation of disclosure controls and procedures as of December
31, 2006, conducted during the preparation of Conseco's financial statements to
be included in the Annual Report on Form 10-K for the year ended December 31,
2006, a material weakness in internal control was identified relating to the
actuarial reporting process and the design of controls to ensure the
completeness and accuracy of certain inforce policies. As a result, Conseco's
Chief Executive Officer and Chief Financial Officer concluded that, as of
December 31, 2006, Conseco's disclosure controls and procedures 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. Consequently, Conseco's Chief
Executive Officer and Chief Financial Officer concluded that, as of December 31,
2007, Conseco's disclosure controls and procedures were not effective.
Remediation efforts to enhance controls over the actuarial reporting
process continued in 2008 under the direction of the Chief Financial Officer.
The status of the remediation efforts was regularly reviewed with management and
the Company's Audit and Enterprise Risk Committee of the Board of Directors.
This committee was advised of issues encountered and key decisions reached by
management relating to the remediation efforts. Control deficiencies in the
actuarial reporting process related to the design of controls over the
completeness and accuracy of certain inforce policies in our Bankers Life and
Other Business in Run-off segment (currently classified as discontinued
operations) were remediated, and the new controls were determined to be
effective.
However, a material weakness relating to the actuarial reporting process in
our Conseco Insurance Group segment continued to exist as of December 31, 2008.
As a result, the Chief Executive Officer and Chief Financial Officer concluded
that, as of December 31, 2008, Conseco's disclosure controls and procedures were
not effective.
Management's Report on Internal Control over Financial Reporting.
Management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rules 13a-15(f) and
15d-15(f) under the Securities Exchange Act of 1934. A company's internal
control over financial reporting is a process designed by, or under the
supervision of our Chief Executive Officer and Chief Financial Officer, to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles in the United States.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
Conseco's management assessed the effectiveness of the Company's internal
control over financial reporting as of December 31, 2008. In making this
assessment, management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -
Integrated Framework.
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's
management has concluded that, as of December 31, 2008, the following material
weakness relating to the controls over the actuarial reporting process existed:
193
Conseco 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, the design of controls over the actuarial reporting process to
ensure the completeness and accuracy of certain inforce policies in our Conseco
Insurance Group segment was not effective. These control deficiencies resulted
in an audit adjustment to Conseco's consolidated financial statements during the
fourth quarter of 2008. Additionally, these control deficiencies could result in
a material misstatement of the aforementioned accounts and disclosures in our
annual or interim consolidated financial statements that would not be prevented
or detected on a timely basis. Accordingly, Conseco's management has determined
that these control deficiencies constitute a material weakness. Because of this
material weakness, management concluded that Conseco did not maintain effective
internal controls over financial reporting as of December 31, 2008 based on
criteria in the Internal Control - Integrated Framework - issued by COSO.
The effectiveness of our internal control over financial reporting as of
December 31, 2008, has been audited by PricewaterhouseCoopers LLP, an
independent registered public accounting firm, as stated in their report which
is included herein.
Remediation Efforts. Conseco has devoted significant efforts and resources
towards remediation of the material weakness relating to the actuarial reporting
process. Significant improvements have been made to the actuarial reporting
internal control environment and the control deficiencies in our Bankers Life
and our former Other Business in Run-off segment were remediated in 2008.
Nonetheless, the material weakness related to the design of controls to ensure
the completeness and accuracy of certain inforce policies in our Conseco
Insurance Group continued to exist as of December 31, 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 2009. 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. The most significant
remaining weaknesses to be addressed by our remediation efforts relates to the
flow of information from the administrative systems to the actuarial processes
for specified disease policies in our Conseco Insurance Group segment.
Correcting these weaknesses will allow Conseco to reduce its reliance on manual
controls and procedures. Conseco intends to continue 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 processes and is
committed to making the investments for these improvements.
Changes to Internal Control Over Financial Reporting. Other than described
above under the title Remediation Efforts, there were no other changes in the
Company's internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) during the quarter ended
December 31, 2008, that have materially affected, or are reasonably likely to
materially affect, Conseco's internal control over financial reporting.
194
ITEM 9B. OTHER INFORMATION.
None.
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
We will provide information that is responsive to this Item 10 in our definitive
proxy statement or in an amendment to this Annual Report not later than 120 days
after the end of the fiscal year covered by this Annual Report. That information
is incorporated by reference into this Item 10. Additional information called
for by this item is contained in Part I of this Annual Report under the caption
"Executive Officers of the Registrant."
ITEM 11. EXECUTIVE COMPENSATION.
We will provide information that is responsive to this Item 11 in our definitive
proxy statement or in an amendment to this Annual Report not later than 120 days
after the end of the fiscal year covered by this Annual Report. That information
is incorporated by reference into this Item 11.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
We will provide information that is responsive to this Item 12 in our definitive
proxy statement or in an amendment to this Annual Report not later than 120 days
after the end of the fiscal year covered by this Annual Report. That information
is incorporated by reference into this item 12.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE.
We will provide information that is responsive to this Item 13 in our definitive
proxy statement or in an amendment to this Annual Report not later than 120 days
after the end of the fiscal year covered by this Annual Report. That information
is incorporated by reference into this Item 13.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
We will provide information that is responsive to this Item 14 in our definitive
proxy statement or in an amendment to this Annual Report not later than 120 days
after the end of the fiscal year covered by this Annual Report. That information
is incorporated by reference into this Item 14.
195
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) 1. Financial Statements. See Index to Consolidated Financial
Statements on page 110 for a list of financial statements included
in this Report.
2. Financial Statement Schedules. The following financial statement
schedules are included as part of this Report immediately following
the signature page:
Schedule II -- Condensed Financial Information of Registrant
(Parent Company)
Schedule IV -- Reinsurance
All other schedules are omitted, either because they are not applicable,
not required, or because the information they contain is included elsewhere in
the consolidated financial statements or notes.
3. Exhibits. See Exhibit Index immediately preceding the Exhibits
filed with this report.
196
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized, this 31st day of March, 2009.
CONSECO, INC.
By: /s/ C. James Prieur
--------------------
C. James Prieur
Chief Executive Officer
197
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
Signature Title (Capacity) Date
- --------- ---------------- ----
/s / C. JAMES PRIEUR Director and Chief Executive Officer March 31, 2009
- ------------------------------------ (Principal Executive Officer)
C. James Prieur
/s / EDWARD J. BONACH Executive Vice President March 31, 2009
- ------------------------------------ and Chief Financial Officer
Edward J. Bonach (Principal Financial Officer)
/s / JOHN R. KLINE Senior Vice President March 31, 2009
- ------------------------------------ and Chief Accounting Officer
John R. Kline (Principal Accounting Officer)
/s / R. GLENN HILLIARD Director March 31, 2009
- ------------------------------------
R. Glenn Hilliard
/s / NEAL SCHNEIDER Director March 31, 2009
- ------------------------------------
Neal Schneider
/s / PHILIP R. ROBERTS Director March 31, 2009
- ------------------------------------
Philip R. Roberts
/s / JOHN G. TURNER Director March 31, 2009
- ------------------------------------
John G. Turner
/s / MICHAEL T. TOKARZ Director March 31, 2009
- ------------------------------------
Michael T. Tokarz
/s / MICHAEL S. SHANNON Director March 31, 2009
- ------------------------------------
Michael S. Shannon
/s / DEBRA J. PERRY Director March 31, 2009
- ------------------------------------
Debra J. Perry
/s / DONNA A. JAMES Director March 31, 2009
- ------------------------------------
Donna A. James
/s / DOREEN A. WRIGHT Director March 31, 2009
- ------------------------------------
Doreen A. Wright
198
Report of Independent Registered Public Accounting Firm
on Financial Statement Schedules
To the Shareholders and Board of Directors
Conseco, Inc.:
Our audits of the consolidated financial statements and of the effectiveness of
internal control over financial reporting of Conseco, Inc. and subsidiaries
referred to in our report dated March 31, 2009 appearing under Item 8 of this
Form 10-K also included an audit of the financial statement schedules at
December 31, 2008 and 2007 and for the years ended December 31, 2008, 2007 and
2006 listed in Item 15(a)(2) of this Form 10-K. In our opinion, these financial
statement schedules present fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements.
As discussed in Note 18 to the consolidated financial statements, certain events
occurred subsequent to December 31, 2008, which include an amendment to the
Company's Second Amended Credit Facility, certain rating agency downgrades and
the obtainment of certain insurance regulatory agency approvals.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
Indianapolis, Indiana
March 31, 2009
199
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Balance Sheet
as of December 31, 2008 and 2007
(Dollars in millions)
ASSETS
2008 2007
---- ----
Cash and cash equivalents - unrestricted.................................................. $ 56.5 $ 84.3
Cash and cash equivalents - restricted.................................................... - 1.9
Other invested assets..................................................................... .1 .2
Investment in wholly-owned subsidiaries (eliminated in consolidation)..................... 3,261.6 5,596.9
Receivable from subsidiaries (eliminated in consolidation)................................ .8 6.6
Income tax assets, net.................................................................... - 2.2
Other assets.............................................................................. 23.5 36.4
--------- --------
Total assets.................................................................... $ 3,342.5 $5,728.5
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Notes payable......................................................................... $ 1,328.7 $1,193.7
Payable to subsidiaries (eliminated in consolidation)................................. 261.0 241.5
Income tax liabilities, net........................................................... 69.8 -
Other liabilities..................................................................... 63.8 57.4
--------- --------
Total liabilities............................................................... 1,723.3 1,492.6
--------- --------
Commitments and Contingencies
Shareholders' equity:
Common stock and additional paid-in capital ($.01 par value, 8,000,000,000
shares authorized, shares issued and outstanding: 2008 - 184,753,758;
2007 - 184,652,017) ............................................................... 4,077.9 4,070.5
Accumulated other comprehensive loss.................................................. (1,770.7) (273.3)
Retained earnings (accumulated deficit)............................................... (688.0) 438.7
--------- --------
Total shareholders' equity...................................................... 1,619.2 4,235.9
--------- --------
Total liabilities and shareholders' equity...................................... $ 3,342.5 $5,728.5
========= ========
The accompanying notes are an integral part
of the condensed financial information.
200
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Statement of Operations
for the years ended December 31, 2008, 2007 and 2006
(Dollars in millions)
2008 2007 2006
---- ---- ----
Revenues:
Net investment income................................................. $ 2.3 $ 3.6 $ 1.9
Net realized investment losses........................................ (25.9) - -
Fee and interest income from subsidiaries (eliminated in
consolidation)...................................................... .7 3.1 .7
--------- ------- ------
Total revenues.................................................... (22.9) 6.7 2.6
--------- ------- ------
Expenses:
Interest expense on notes payable..................................... 59.2 72.3 52.9
Intercompany expenses (eliminated in consolidation)................... 8.3 15.8 15.2
Costs related to a litigation settlement.............................. - 32.2 8.9
Operating costs and expenses.......................................... 34.2 41.2 35.6
(Gain) loss on extinguishment of debt................................. (21.2) - .7
--------- ------- ------
Total expenses.................................................... 80.5 161.5 113.3
--------- ------- ------
Loss before income taxes and equity in
undistributed earnings of subsidiaries............................ (103.4) (154.8) (110.7)
Income tax expense (benefit):
Income tax benefit on period income................................... (36.0) (62.1) (41.7)
Valuation allowance for deferred tax assets........................... 54.1 - -
--------- ------- ------
Loss before equity in undistributed
earnings of subsidiaries and discontinued operations............ (121.5) (92.7) (69.0)
Equity in undistributed earnings of subsidiaries
(eliminated in consolidation)......................................... (282.5) 18.7 174.7
--------- ------- ------
Income (loss) before discontinued operations............................. (404.0) (74.0) 105.7
Discontinued operations, net of income taxes:
Parent company........................................................ (166.3) - -
Subsidiary............................................................ (556.4) (105.9) .3
--------- ------- ------
Net income (loss)................................................. (1,126.7) (179.9) 106.0
Preferred stock dividends................................................ - 14.1 38.0
--------- ------- ------
Income (loss) applicable to common stock.......................... $(1,126.7) $(194.0) $ 68.0
========= ======= ======
The accompanying notes are an integral part
of the condensed financial information.
201
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Condensed Financial Information of Registrant (Parent Company)
Statement of Cash Flows
for the years ended December 31, 2008, 2007 and 2006
(Dollars in millions)
2008 2007 2006
---- ---- ----
Cash flows used by operating activities..................................... $(97.4) $(126.6) $(39.4)
------ ------- ------
Cash flows from investing activities:
Sales of investments..................................................... 13.9 - -
Purchases of investments................................................. (39.8) - -
Investments and advances to consolidated subsidiaries*................... (24.0) (86.0) .4
Change in restricted cash................................................ 1.9 (1.8) 1.9
------ ------- ------
Net cash used by investing activities.............................. (48.0) (87.8) 2.3
------ ------- ------
Cash flows from financing activities:
Issuance of notes payable, net........................................... 75.0 200.0 196.7
Issuance of common stock................................................. - 3.4 1.0
Payments to repurchase common stock...................................... - (87.2) -
Payments on notes payable................................................ (44.0) (7.8) (48.0)
Issuance of notes payable to affiliates*................................. 148.0 223.8 324.9
Payments on notes payable to affiliates*................................. (61.4) (110.3) (393.1)
Dividends paid on preferred stock........................................ - (19.0) (38.0)
------ ------- ------
Net cash provided by financing activities.......................... 117.6 202.9 43.5
------ ------- ------
Net increase (decrease) in cash and cash
equivalents...................................................... (27.8) (11.5) 6.4
Cash and cash equivalents, beginning of the year......................... 84.3 95.8 89.4
------ ------- ------
Cash and cash equivalents, end of the year............................... $ 56.5 $ 84.3 $ 95.8
====== ======= ======
* Eliminated in consolidation
The accompanying notes are an integral part
of the condensed financial information.
202
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE II
Notes to Condensed Financial Information
1. Basis of Presentation
The condensed financial information should be read in conjunction with the
consolidated financial statements of Conseco, Inc. The condensed financial
information includes the accounts and activity of the parent company. We have
reclassified certain amounts in our 2007 and 2006 consolidated financial
statements and notes to conform with the 2008 presentation.
203
CONSECO, INC. AND SUBSIDIARIES
SCHEDULE IV
Reinsurance
for the years ended December 31, 2008, 2007 and 2006
(Dollars in millions)
2008 2007 2006
---- ---- ----
Life insurance inforce:
Direct................................................................ $65,271.1 $67,831.1 $69,674.2
Assumed............................................................... 1,129.8 873.5 860.5
Ceded................................................................. (13,805.9) (14,717.2) (16,583.4)
--------- --------- ---------
Net insurance inforce........................................... $52,595.0 $53,987.4 $53,951.3
========= ========= =========
Percentage of assumed to net.................................... 2.1% 1.6% 1.6%
=== === ===
2008 2007 2006
---- ---- ----
Insurance policy income:
Direct................................................................ $2,438.0 $2,445.9 $2,444.1
Assumed............................................................... 641.0 307.8 115.1
Ceded................................................................. (164.0) (202.4) (212.4)
-------- -------- --------
Net premiums.................................................... $2,915.0 $2,551.3 $2,346.8
======== ======== ========
Percentage of assumed to net.................................... 22.0% 12.1% 4.9%
==== ==== ===
204
EXHIBIT INDEX
Exhibit
No. Description
--- -----------
2.1 Sixth Amended Joint Plan of Reorganization of Conseco, Inc. and
affiliated Debtors, incorporated by reference to Exhibit 2.2 of our
Current Report on Form 8-K filed September 15, 2003.
2.2 Order Confirming Reorganizing Debtors' Sixth Amended Joint Plan of
Reorganization, incorporated by reference to Exhibit 2.3 of our
Current Report on Form 8-K filed September 15, 2003.
3.1 Amended and Restated Certificate of Incorporation of Conseco, Inc.,
incorporated by reference to Exhibit 3.1 of our Quarterly Report on
Form 10-Q for the quarter ended June 30, 2008.
3.2 Amended and Restated Bylaws of Conseco, Inc. dated as of February 17,
2009, incorporated by reference to Exhibit 3.2 of our Current Report
on Form 8-K filed February 23, 2009.
4.1 Section 382 Rights Agreement, dated as of January 20, 2009, between
the Corporation and American Stock Transfer & Trust Company, LLC, as
Rights Agent, which includes the Certificate of Designations for the
Series A Junior Participating Preferred Stock as Exhibit A, the Form
of Right Certificate as Exhibit B and the Summary of Rights to
Purchase Preferred Shares as Exhibit C, incorporated by reference to
Exhibit 4.1 of our Current Report on Form 8-K filed January 20, 2009.
4.4 Indenture dated as of August 15, 2005 for 3.50% Convertible Debentures
due September 30, 2035 between Conseco, Inc. and The Bank of New York
Trust Company, N.A., as Trustee, incorporated by reference to Exhibit
4.4 of our Current Report on Form 8-K filed August 16, 2005.
10.1 Second Amended and Restated Credit Agreement dated as of October 10,
2006 among Conseco, Inc., Bank of America, N.A., as Agent, J.P. Morgan
Chase Bank, N.A., as Syndication Agent, and other parties,
incorporated by reference to Exhibit 10.1 of our Current Report on
Form 8-K filed October 11, 2006, Amendment No. 1 thereto dated as of
June 12, 2007, incorporated by reference to Exhibit 10.1 of our
Current Report on Form 8-K filed June 15, 2007 and Amendment No. 2
thereto dated March 30, 2009, incorporated by reference to Exhibit
10.1 of our Current Report on Form 8-K filed March 31, 2009.
10.4 Guarantee and Security Agreement dated as of June 22, 2004 among
Conseco, Inc., the Subsidiary Guarantors Party Thereto and Bank of
America, N.A., as Agent, incorporated by reference to Exhibit 10.4 of
our Current Report on Form 8-K filed June 23, 2004.
10.11 Letter of agreement dated as of August 3, 2007 between Conseco
Services, LLC and John R. Kline, incorporated by reference to Exhibit
10.11 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2007.
10.12 Amended and Restated Employment Agreement dated as of October 6, 2006
between 40|86 Advisors, Inc. and Eric R. Johnson, incorporated by
reference to Exhibit 10.12 of our Current Report on Form 8-K filed
October 12, 2006, as amended by Amendment dated as of October 14, 2008
filed herewith.
10.13 Conseco, Inc. 2003 Amended and Restated Long-Term Incentive Plan.
10.14 Form of executive stock option agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by
reference to Exhibit 10.14 of our Annual Report on Form 10-K for the
year ended December 31, 2005.
10.15 Form of executive restricted stock agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by
reference to Exhibit 10.15 of our Annual Report on Form 10-K for the
year ended December 31, 2004.
Exhibit
No. Description
--- -----------
10.16 Form of Indemnification Agreement among Conseco, Inc., CDOC, Inc.,
Conseco Services, LLC and each director of Conseco, Inc.
10.18 Closing Agreement on Final Determination Covering Specific Matters,
incorporated by reference to Exhibit 10.14 of our Current Report on
Form 8-K filed September 14, 2004.
10.20 Conseco, Inc. Pay for Performance Incentive Plan, as amended.
10.21 Closing Agreement on Final Determination Covering Specific Matters,
incorporated by reference to Exhibit 10.21 of our Current Report on
Form 8-K filed August 1, 2006.
10.22 Form of performance unit award agreement under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by
reference to Exhibit 10.22 of our Quarterly Report on Form 10-Q for
the quarter ended June 30, 2006.
10.23 Employment Agreement dated as of August 9, 2006 between Conseco, Inc.
and C. James Prieur, incorporated by reference to Exhibit 10.23 of our
Current Report on Form 8-K filed August 9, 2006.
10.24 Conseco Inc. Deferred Compensation Plan effective January 1, 2007,
incorporated by reference to Exhibit 10.24 of our Quarterly Report on
Form 10-Q for the quarter ended September 30, 2006, as amended by
First Amendment of the Conseco Deferred Compensation Plan, effective
January 1, 2007.
10.25 Amended and Restated Employment Agreement dated as of August 17, 2007
between Conseco Services, LLC and Susan L. Menzel, incorporated by
reference to Exhibit 10.25 of our Quarterly Report on Form 10-Q for
the quarter ended September 30, 2007.
10.26 Amended and Restated Employment Agreement dated as of February 27,
2008 between Conseco Services, LLC and Russell M. Bostick,
incorporated by reference to Exhibit 10.26 of our Annual Report on
Form 10-K for the year ended December 31, 2007.
10.27 Employment Agreement dated as of September 8, 2005 between Conseco
Services, LLC and Christopher J. Nickele, incorporated by reference to
Exhibit 10.27 of our Quarterly Report on Form 10-Q for the quarter
ended September 30, 2006.
10.28 Employment Agreement dated as of October 1, 2008 between Conseco
Services, LLC and Scott R. Perry.
10.31 Stipulation of Settlement - In Re Conseco Life Insurance Co. Cost of
Insurance Litigation, Cause No. MDL 1610 (Central District,
California), incorporated by reference to Exhibit 10.31 of our Annual
Report on Form 10-K for the year ended December 31, 2006.
10.32 Employment Agreement dated as of April 23, 2007 between Conseco, Inc.
and Edward J. Bonach, incorporated by reference to Exhibit 10.32 of
our Current Report on Form 8-K filed April 27, 2007.
10.33 Employment Agreement dated as of May 8, 2007 between Conseco Services,
LLC and Mark E. Alberts incorporated by reference to Exhibit 10.33 of
our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007.
10.34 Coinsurance and Administration Agreement between Conseco Insurance
Company and Reassure American Life Insurance Company, incorporated by
reference to Exhibit 10.34 of our Quarterly Report on Form 10-Q for
the quarter ended June 30, 2007.
Exhibit
No. Description
--- -----------
10.35 Employment Agreement effective as of December 10, 2007 between Conseco
Services, LLC and Dan R. Bardin, incorporated by reference to Exhibit
10.35 of our Annual Report on Form 10-K for the year ended December
31, 2007.
10.36 Employment Agreement dated as of May 27, 2008 between Conseco
Services, LLC and Steven M. Stecher, incorporated by reference to
Exhibit 10.36 of our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2008.
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 the Corporation, 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, incorporated by reference to
Exhibit 10.38 of our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2008.
12.1 Computation of Ratio of Earnings to Fixed Charges and Preferred
Dividends.
21 Subsidiaries of the Registrant.
23.1 Consent of PricewaterhouseCoopers LLP.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
COMPENSATION PLANS AND ARRANGEMENTS
10.11 Letter of agreement dated as of August 3, 2007 between Conseco
Services, LLC and John R. Kline, incorporated by reference to Exhibit
10.11 of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2007.
10.12 Amended and Restated Employment Agreement dated as of October 6, 2006
between 40|86 Advisors, Inc. and Eric R. Johnson, incorporated by
reference to Exhibit 10.12 of our Current Report on Form 8-K filed
October 12, 2006, as amended by Amendment dated as of October 14, 2008
filed herewith.
10.13 Conseco, Inc. 2003 Amended and Restated Long-Term Incentive Plan.
10.14 Form of executive stock option agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by
reference to Exhibit 10.14 of our Annual Report on Form 10-K for the
year ended December 31, 2005.
10.15 Form of executive restricted stock agreement under Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by
reference to Exhibit 10.15 of our Annual Report on Form 10-K for the
year ended December 31, 2004.
Exhibit
No. Description
--- -----------
10.20 Conseco, Inc. Pay for Performance Incentive Plan, as amended.
10.22 Form of performance unit award agreement under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan, incorporated by
reference to Exhibit 10.22 of our Quarterly Report on Form 10-Q for
the quarter ended June 30, 2006.
10.23 Employment Agreement dated as of August 9, 2006 between Conseco, Inc.
and C. James Prieur, incorporated by reference to Exhibit 10.23 of our
Current Report on Form 8-K filed August 9, 2006.
10.24 Conseco Inc. Deferred Compensation Plan effective January 1, 2007,
incorporated by reference to Exhibit 10.24 of our Quarterly Report on
Form 10-Q for the quarter ended September 30, 2006, as amended by
First Amendment of the Conseco Deferred Compensation Plan, effective
January 1, 2007.
10.25 Amended and Restated Employment Agreement dated as of August 17, 2007
between Conseco Services, LLC and Susan L. Menzel, incorporated by
reference to Exhibit 10.25 of our Quarterly Report on Form 10-Q for
the quarter ended September 30, 2007.
10.26 Amended and Restated Employment Agreement dated as of February 27,
2008 between Conseco Services, LLC and Russell M. Bostick,
incorporated by reference to Exhibit 10.26 of our Annual Report on
Form 10-K for the year ended December 31, 2007.
10.27 Employment Agreement dated as of September 8, 2005 between Conseco
Services, LLC and Christopher J. Nickele, incorporated by reference to
Exhibit 10.27 of our Quarterly Report on Form 10-Q for the quarter
ended September 30, 2006.
10.28 Employment Agreement dated as of October 1, 2008 between Conseco
Services, LLC and Scott R. Perry.
10.32 Employment Agreement dated as of April 23, 2007 between Conseco, Inc.
and Edward J. Bonach, incorporated by reference to Exhibit 10.32 of
our Current Report on Form 8-K filed April 27, 2007.
10.33 Employment Agreement dated as of May 8, 2007 between Conseco Services,
LLC and Mark E. Alberts, incorporated by reference to Exhibit 10.33 of
our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007.
10.35 Employment Agreement effective December 10, 2007 between Conseco
Services, LLC and Dan R. Bardin, incorporated by reference to Exhibit
10.35 of our Annual Report on Form 10-K for the year ended December
31, 2007.
10.36 Employment Agreement dated as of May 27, 2008 between Conseco
Services, LLC and Steven M. Stecher, incorporated by reference to
Exhibit 10.36 of our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2008.
10.38 Employment Agreement dated as of June 11, 2008 between Conseco
Services, LLC and Matthew J. Zimpfer, incorporated by reference to
Exhibit 10.38 of our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2008.